Jeff Harris and Adam Khanbhai, managers of the Strategic Equity Capital trust, talk to Cherry Reynard about the opportunities they see in the unloved UK smaller companies sector.
Just as stock markets are showing new and uncomfortable volatility, private equity is going through a purple patch. Private equity managers around the world have raised around $1 trillion (£742 billion), currently sitting on the sidelines and ready to invest.
A chunk of that money is heading towards the unloved UK market. Inbound merger and acquisition activity into the UK market amounted to $67 billion in the first quarter of 2018, up from $11 billion in the previous quarter.
This matters for the UK equity market. Corporate buyers create support for the right UK companies at a time when stock markets have been otherwise unpredictable and global investors avoiding UK assets. Global fund managers have been underweight in UK equities for 47 consecutive months, and the UK has seen outflows in five of the past six years.
Strong corporate demand
This corporate demand has a number of drivers. UK assets look cheap compared with those in the rest of the world, particularly when sterling weakness is factored in. At the same time, organic growth is hard to find and UK companies have not been inclined to take risks – Bank of England governor Mark Carney told the House of Lords Economic Affairs Committee in January that ‘disappointing business investment is one irrefutable consequence of Brexit’. If companies can find smaller companies with guaranteed growth, it is an easier solution than committing to other types of capital spending at a time of uncertainty. There is merit, therefore, in an investment strategy that aims to seek out high-quality companies likely to be a target for private equity or corporate takeovers as one of its investment considerations.
GVQ, which runs the Strategic Equity Capital investment trust and the open-ended GVQ UK Focus fund, has seen seven of its underlying holdings bid for in the past 12 months, and a ‘private equity lens’ plays an important role in its investment style. For managers Jeff Harris and Adam Khanbhai, it has been an important way to realise value in their portfolios at a time when UK equities are unpopular.
Finding these gems, where the value will be recognised by corporate buyers as well as stock market buyers, requires a certain type of approach. Private equity has long been in GVQ’s DNA, the company having originally spun out of SVG Group (the group is now wholly owned by its management team). It incorporates a private equity model as one of four pillars when assessing a firm’s value.
The group’s in-house leveraged buyout model tests the value of a company against the price paid in recent private equity transitions. Khanbhai says: ‘Private equity payments are much less volatile than those in the public markets. They don’t change with every tweet from president Trump. This helps anchor our valuations.’
It also means the group will hunt for its best ideas in areas where there has been corporate activity. Most recently this has been seen in the healthcare sector. Recent investments in the portfolio include Alliance Pharma and Ergomed, both fast-growing pharmaceutical companies in a sector that has seen corporate activity. As part of their idea generation process, Harris and Khanbhai will look at merger and acquisition transactions in the sector, leveraged buyouts and directors’ dealing.
As they operate in a relatively ‘risky’ part of the market – the smaller end of small cap between £20 million and £500 million in market capitalisation – this private equity lens can also be important for risk management. While these companies can display strong growth, this part of the market remains under-researched and illiquid. With this vacuum of information, Harris says that share prices will change by 20-30 per cent on small bits of news and that mispricing is common. Having a long-term view of intrinsic value (often to a potential acquirer) can help resolve some of this mispricing.
For example, one of the group’s largest holdings, in both the trust and the fund, is business process outsourcing group Equiniti. While the group was subject to an IPO in 2015 and is therefore unlikely to be a bid target in the near term, the recent purchase of a similar business, Capita Asset Services, by Link gives Harris and Khanbhai comfort that the valuation placed on the business is realistic and that potential buyers would step in should the share price drop.
The group does forensic due diligence on every potential holding. With a relatively small portfolio – of 15-25 stocks in both the trust and the fund – the group is clear that it needs to get extra comfort on the holdings before it invests. The managers have a three-tier due diligence process: one layer of research allows them to take a stake of up to 4 per cent, and a second layer enables them to go beyond that.
The private equity screen is not their only metric. The group also looks at metrics such as growth in cash flow, free cash flow and debt levels. The managers are keen to ensure that the companies they hold are attractive on a number of levels.
This process tends to lead them to certain types of companies: niche market leaders with stable end markets and pricing power. Nine out of the 10 top holdings in the Strategic Equity Capital trust are market leaders in their sectors. They will usually have some degree of intellectual property and high barriers to entry. Alongside healthcare, other structural growth areas such as pension and savings, infrastructure and building, and regulation and compliance feature in the portfolio.
EMIS is a typical example. This business makes software for pharmacies and GP surgeries. Its systems are well-embedded in the National Health Service – it has a market share of more than 50 per cent. There have been many acquisitions involving this type of business in recent years, and the company’s valuation looks attractive relative to those transactions. In a further five out of the top 10 holdings in the trust, merger and acquisition potential is a central part of the group’s thesis.
Another advantage of the private equity approach is that managers can bring change by engaging with firms. They don’t demand board seats or force significant change in the running of firms, but they aim to be a helpful partner to improve shareholder value. Smaller firms can struggle to get their messages to market, Khanbhai says, which can hold back share prices. ‘We don’t look for situations where we need to make a change – that can be quite risky. It is more that if we see things that can be done, we won’t sit idly by and watch shareholder value be wasted.’
Vitally important in both the decision-making process and the process of engagement with companies is the advisory panel, a group of industry figures and experts that provide a sounding board for ideas. It includes Peter Williams, former finance director at DMGT, and Chris Rickard, former chief finance officer at Meggitt. The panel meets once a month and all investment ideas have to be presented to the members before they can go into the portfolio. Harris says this brings valuable insight from people who have been at the coalface of businesses.
Both fund managers are unusual in not having been fund managers prior to joining GVQ. Harris worked in transaction services for PriceWaterhouseCoopers, working on private equity deals, while Khanbhai was a management consultant, doing due diligence for private equity firms. The group values ‘real world’ analysis and experience alongside balance sheet analysis.
Harris says: ‘These are high-conviction portfolios. Our strongest risk mitigation tool is understanding everything there is to understand. This gives us the strength to carry through when the market doesn’t see what we see.’ The managers say the portfolio is unique and won’t look anything like the benchmark, or anything like any other fund. For this reason, says Harris, their shareholders may hold it alongside more conventional small- and mid-cap funds: ‘We believe there is little overlap with our peers, so our funds should help diversify and give investors a different exposure.’
The information contained in this document does not constitute investment advice and if you are in any doubt about the suitability of the investment or service, you should obtain independent professional advice. The value of investments, and the income from them, can fall as well as rise and you may not get back the full amount invested. Past performance cannot be relied on as a guide to future performance.
GVQ Investment Management Limited (Registered No. 4493500) is a company registered in England and Wales with registered offices at 12-13 St. James’s Place, London, SW1A 1NX, United Kingdom. In the United Kingdom, GVQ Investment Management Limited is authorised and regulated by the Financial Conduct Authority.