Inflation on the up; recession threat rising; markets in the land of the bears – just three of the issues confronting the private equity sector today. Standard operating procedure for investors in private equity investment trusts when faced with such a backdrop? Assume heavy NAV markdowns, a dearth of realisations and significant widening of discounts. Batten down the hatches. Wait for markets to turn.
Quick glance at the private equity investment company sector and, true to form, the share prices of widely-followed trusts, including 3i Group (III), Oakley Capital Investments (OCI) and NB Private Equity (NBPE), are trading at discounts to NAV either at or close to 52-week highs. HgCapital Trust (HGT) is another established name trading at a discount close to its year highs in anticipation of perhaps not one but a series of NAV markdowns and a dry patch in terms of realisations. On this last, however, no one appears to have told HGT itself.
A focus on the dull
HGT is a focused rather than a generalist private equity investor. As broker Numis explains – it specialises “on software and tech-enabled services firms that seek to automate dull tasks. Hg’s sweet spot is business critical software from a proven technology, supplied to a fragmented customer base, which generates high levels of recurring revenue streams. This has led to a focus on eight industry clusters including: Tax & Accounting, ERP & Payroll, Legal & Regulatory Compliance, Healthcare and Wealth Management. The top 20 investments (78% of the portfolio) have reported aggregate sales of £7.1bn and EBITDA of £2.2bn over the last twelve months, with EBITDA margins of 31% (35% at Dec-21).”
These ‘high levels of recurring revenue streams’ add a degree of resilience to the valuations of the holdings within HGT’s portfolio. This was demonstrated by the investment company’s Q1 Quarterly Report covering the three months to 31 March 2022 which was released on 9 May 2022. Not only did the report demonstrate a stable NAV performance – NAV per share returned -0.6% over the period, but also highlighted the completion of one new and two further investments, totalling £25 million, as well as agreements in place covering four additional investments, totalling more than £170 million, that were due to complete in Q2. While not the busiest period in terms of investment activity, business, at least, was still getting done.
Commenting at the time of the release of the Q1 Report, Numis wrote: “HgCapital Trust (HGT) has released an NAV of 433.1p at 31 March which represents a 0.6% decline on a total return basis in the quarter, allowing for the 5p dividend paid. A fall in comparable company multiples was largely offset by continued ‘extremely strong’ underlying operating performance from portfolio companies. This compares with a 0.5% rise for the FTSE All Share, and a 2.4% fall in the MSCI World Index, whilst the S&P Software Service index was down c.7.6% (total return in Sterling) in the quarter. The portfolio is trading ahead of comparable figures for the last year and ahead of budgeted performance.”
The Q1 Report deals largely with the past. As for the future, HGT had this to say: “We believe our investments continue to benefit from ongoing trends in the digitalisation of business processes… Labour cost is highly correlated with software and services spend, and thus as global costs rise, the imperative for digitalisation becomes ever-greater. Investment in productivity enhancement becomes even more attractive. Consequently, as customers experience the incremental value of software, they also accept significant price rises – for example, Microsoft announced 10-25% price increases for key bundles of its Office suite1 effective from March 2022.” The trust goes on to say: “We are also aware that events rarely align perfectly along a timeline, and there is a risk that a combination of geopolitical events, fiscal tightening, supply chain constraints, and cost increases, cause broad economic challenges to which our portfolio’s end customers may respond with temporarily lower investment, before the structural factors that drive the need for software reassert themselves.”
Still doing deals
The trust’s outlook statement ends with the following sentence: “We have several exit and refinancing processes currently under way and progressing well.” So well, it turns out, that since the release of the Q1 Report on 9 May, HGT has announced no fewer than three exits/refinancings:
18 May 2022 – sale of itm8, a leading supplier of IT services for private businesses and the public sector in Europe, to Nordic PE firm Axcel. According to broker JPM: “This transaction values HGT’s investment in itm8 at £33.4m. This represents an uplift of £4.2m (14% or 0.9pps) over the carrying value of £29.2m in HGT’s 31/3/22 NAV…The uplift of 14% to the 31/3/22 valuation is a little lower to what we have become accustomed, but given market conditions is reasonable and helps to provide support for the valuation approach.”
Numis added: “Wide discounts on Listed PE funds indicate that investors are currently concerned about valuation and the outlook for portfolios given the volatile equity market backdrop. As a result, we believe it is extremely positive to see a realisation from Hg’s portfolio at above the March/December valuations which provides confidence in the carrying values of the portfolio.”
8 June 2022 – recapitalisation of The Access Group, a leading provider of business management solutions to mid-market organisations in UK, Ireland and Asia Pacific. The recapitalisation involved additional investments by existing investors HGT and TA Associates and a new investment by Singapore sovereign wealth fund, GIC. Numis commented: “The transaction was made at an enterprise value of £9.2bn. As part of the transaction, Hg Saturn Funds will make a new investment in Access, while Hg’s Genesis 8 Fund will partially reduce its holding. HGT will receive a net distribution of £55.6m (2.8% of net assets). The transaction vales HGT’s existing investments in Access at £444.1m, representing a £104.7m (31%) uplift to carrying value of £336.4m at 31 March, adding 22.9p (5.3%) to NAV, or equivalent to c.18p, 4.2% of NAV net of fees…”
Numis continued: “The valuation of the deal is also a significant marker for the rest of Hg’s portfolio given the current volatility in equity markets and negative sentiment towards technology…There will undoubtably be some headwinds from multiple contraction in equity markets impacting comparable multiples used in valuation, but today’s deal provides a significant uplift to absorb this and future private equity transactions will also be significant inputs to the valuation process…”
JPM added: “This is a very strong uplift to the 31/3/21 valuation, with net cash being taken off the table, and we note that the price at which new money is being invested is validated by the addition of a new minority investor in the form of GIC, which gives some support to the most recent valuations.”
14 June 2022 – sale of Medifox Dan, a provider of digital services for the German care and therapy sectors to ResMed, a global cloud connected medical devices and out of hospital software-as-a-service (SaaS) business. JPM noted: “The transaction values Medifox Dan at an EV of $1bn and for HGT, based on its share of the investment, results in £47.3m proceeds and a 45% uplift of £14.6m, or 3.2pps, over its 31/3/22 carrying value…The Access realisation, and the one announced today, are both encouraging. We view HGT as a defensive tech play because it has investments in businesses which are profitable today and earn predictable subscription based revenues from providing essential business services. That HGT is able to sell investments at significant uplifts to 31/3/22 carrying values amid turbulent markets should provide investors with greater confidence in the valuations for the rest of the portfolio.”
Numis had a similar view: “This is another strong endorsement of the value in the HgCapital Trust (HGT) portfolio, with the exit at a 45% uplift to March’s valuation…We believe the nature of the companies in the Hg portfolio is significantly different from the ‘blue-sky’ technology that many investors are most concerned about. Hg focuses on ‘dull tech’ that seeks to automate business processes and increase efficiency, which should be in high demand in environment where labour costs are rising, whilst the business crucial nature of the software provided leads to high levels of recurring revenues and pricing power.”
The broker continued: “The decline in comparable equity market multiples will no doubt be a headwind to valuations in coming months, but we believe that portfolio companies should continue to deliver strong operational performance…which should help to offset this, and that these private equity market transactions (which are also an input into valuations) will also be supportive to asset values. We believe the market is being overly pessimist about the outlook and the c.20% discount now provides significant headroom and offers an excellent value opportunity for a high quality portfolio run by a manager with an excellent track-record.”
A conservative approach
Coming within weeks of each other, the above three transactions demonstrate how the investment/realisation market for private equity, or at least for the “dull tech” in which HGT specialises in, remains open. This is despite the downturn in sentiment towards technology stocks being now over six months old – the tech heavy Nasdaq was trading at 15,832 on 3 January compared to 11,524 on 27 June. That’s not to say of course the sell-off won’t continue or sentiment will improve any time soon. But based on recent transactions, interest in HGT’s portfolio companies remains strong.
What’s more all three transactions listed above were agreed at prices above the relevant carrying values on HGT’s books: itm8 14% higher; Access a 31% uplift; and Medifox Dan 45% above carrying value. Not only does this demonstrate the presence of buyers, but also HGT’s conservative approach to valuing its portfolio companies. If nothing else, this ought to provide comfort to both existing and new investors in the trust when weighing up the discount at which the shares currently trade.
“Dull tech”; recurring revenues; conservative carrying values – those are the not-so-secret ingredients of HG Sauce.