DeA Capital — Alternative manager with balance sheet support

DeA Capital (DeA) one of Italy’s largest alternative investment operators, with assets under management of c €11.9bn and an investment portfolio of more than €370m as at 31 March 2019. DeA shares are listed on the FTSE Italia STAR section of the Milan Stock Exchange and the company is majority owned by De Agostini, a private group owned by the Boroli and Drago families, with operations in the media, gaming and services sectors. De Agostini currently owns 58.3% of the shares but, allowing for the cancellation of treasury shares recently approved by shareholders and due to take effect in August, this will increase to 67.1%. On the same basis, the free float will increase from the current 24.4% to 30.4%.

In alternative asset management (AAM), DeA is the leading independent (ie non-bank) promoter and manager of real estate, private equity and credit investment funds through its subsidiaries DeA Capital Real Estate and DeA Capital Alternative Funds, both now wholly owned. In addition, 45%-owned associate YARD provides property services to the real estate sector to a range of clients including DeA.

The investment portfolio comprises DeA’s investment in the AAM platform as well as co-investment in its own funds managed and direct investments. The investments are made from the group’s permanent capital base, which allows the group to take a long-term view and avoids any of the pressures to divest within a pre-determined time frame that may occur with a traditional private equity fund.

In recent years, DeA’s strategy has been to recycle the proceeds of divestment from legacy large-ticket private equity investments and reimbursements from maturing fund holdings towards investment in further building the AAM platform infrastructure, supporting new fund launches, and selective direct investment including the sponsoring of Italian special purpose acquisition vehicles (SPACs), while also returning significant amounts of excess cash to shareholders. In our view, AAM has stronger growth prospects, greater earnings visibility and more stable cash flows than direct private equity investment, and has the potential to be more highly valued by the market.

DeA’s net asset value at 31 March 2019 was €471.1m, or €1.82 per share, before the May payment of €0.12 per share (c €30m) in dividends. The net assets of the AAM business (43%), investments in private equity and real estate funds (26%) and a significant net financial position (20%) together represent 89% of the NAV. The direct investment portfolio accounted for most of the balance (8%).

DeA is already the leading independent promoter and manager of real estate, private equity and credit investment funds in Italy, and the group’s strategy is to grow this further while expanding into other countries in Europe. The latter would be targeted at taking advantage at the growth in the alternative asset subsector within the broader asset management industry, while further expanding DeA’s base of investors as well as broadening its product range.

2018 and the early months of 2019 saw two significant developments:

DeA’s existing AAM platform consists of 198 professionals and provides a wide range of products on a multi-asset platform across real estate, private equity and credit investment funds. It has a proven capability to structure and launch innovative products and benefits from a deep knowledge of, and extensive contacts in, the Italian market. We next look at the main platform components in more detail.

DeA Capital Alternative Funds manages private equity funds with aggregate AUM of €2.5bn at 31 March 2019. It manages 12 closed funds of funds, comprised of funds of funds (five), thematic funds (five) and credit funds (two).

Fund launches in recent years have been in the areas of thematic funds and credit funds, driving a gradual shift away from funds of funds, which are of older vintage and in their disinvestment phase, and have in any case proved less popular with investors. Looking forward, DeA anticipates a regular stream of new fund launches, with a seeding commitment of c 10%, consistent with its experience of recent launches.

2018 saw the launch of the thematic fund IDeA Capital Agro Fund in July (€80m commitment), and the shipping segment (‘CCR Shipping’) of the credit fund, IDeA Corporate Credit Recovery II Fund (€170m commitment), in December 2018. IDeA Capital Agro Fund is the first Italian private equity fund dedicated to investments in Italian agricultural businesses with eco-sustainable business models. CCR Shipping is a new segment for the IDeA Corporate Credit Recovery II Fund, dedicated to acquiring shipping loans from banking partners. During Q119, DeA Capital Alternative Funds launched the DeA Endowment Fund, a closed-end fund of funds intended for investment by banking foundations, and was awarded the management of a portion of Azimut Capital-managed ‘Azimut Private Debt’ closed-end fund. Together, these new mandates added €114m to AUM.

DeA Capital Real Estate

DeA Capital Real Estate is the largest independent real estate manager in Italy, with a c 20% share by AUM. It had AUM of €9.3bn at 31 March 2019 comprising 47 managed funds including two listed funds.

DeA Capital Real Estate specialises in core real estate investment strategies, targeting income-producing real estate that is bought and then held for the long term; however, it also offers value strategies. Value strategies look for opportunities to benefit from improving the income stream and value of the property acquired. Overall, it seeks investments in transactions with low-risk, stable returns and low volatility. As a result, its portfolios are focused on good-quality real estate assets in large Italian cities with a significant share of the total represented by office buildings and bank branches.

DeA Capital Real Estate’s appeal to institutional investors such as pension funds, insurance companies, sovereign wealth funds, corporations and banks, both from Italy and from abroad, is enhanced by its strong market positioning in Italy. The investor base comprises c 100 institutional investors, representing c 90% of all investments and more than 70,000 retail investors.

Business development is focused on expanding existing funds, launching new core and value initiatives, and expanding the product range. In 2018, eight new funds were launched raising AUM of €1.0bn.

DeA’s private equity investment portfolio amounted to €169.8mn at end-Q119, including real estate and private equity fund investments of €120.9m and direct investments of €48.9m. The fund investments are primarily co-investment in nine of the DeA-managed private equity funds, but also include a small amount of investment in three own-managed real estate funds, and a small balance of legacy investment in five externally managed venture capital funds. In addition to the investment portfolio, a c €55m (as at 31 March 2019) investment in DeA managed real estate funds is held within the DeA Capital Real Estate subsidiary.

The end-Q119 direct investment portfolio of €48.9m included:

The legacy large-ticket private equity investment operations have been substantially liquidated and the remaining investments refocused in recent years in a way that can be summarised as follows:

The primary purpose of the division is to support the development of the AAM activities and enhance the returns on shareholder capital. On balance, the amount of capital committed to the operation is likely to continue to reduce, providing significant net cash flow to support continuing shareholder distributions.

A summary of the historical and our forecast group financial statements (prepared under IFRS) is shown at the back of this report in Exhibit 9. The IFRS results include changes in the fair value of DeA’s fund and direct investments, and this contributes to significant volatility. We continue to suggest that investors focus on:

The AAM division segmental reporting in the DeA group accounts includes the core AAM platform comprising DeA Capital Real Estate and DeA Capital Alternative Funds, but also other activities including 45%-owned property services associate YARD and the investments being made in the European real estate platform in France and Spain. We model the AAM activity in line with the group segmental accounts and the financial results should not be directly compared with management’s comments about the (‘core’) AAM platform result.

Our forecasts for this year and next look for broadly flat AUM in alternative funds and steady growth in real estate. In alternative funds, AUM is defined as total investment commitments, whereas the actual basis for management fees may be AUM or the fund-level NAV, or in some cases other arrangements also exist. Similarly, in real estate, there is a difference between published AUM, based on the gross assets managed, and the fee earning asset base. In real estate the difference mainly arises because some funds generate fees based on net asset rather than gross assets. DeA has recently begun to publish the ‘asset base’ on which fees are generated on a regular basis and at end-Q119 this was €1.7bn for alternative funds (c 70% of AUM) and in real estate it was €8.6bn (c 92% of AUM). We expect broadly stable fee margins, although the picture is distorted in alternative funds by the recent additional performance fee income that has been earned on the Investitori Associati IV private equity fund, originally promoted by Investitori Associati SGR but managed in run-off by DeA Capital Alternative Funds since 2015. We understand that this was c €2.5m in each of Q418 and Q119. We do not forecast further performance fees given their non-recurring nature and the difficulty in doing so (this is why our forecast management fees are lower in FY20), although DeA management is hopeful that the continuing run-off process will generate further payments, while over the medium term it hopes to benefit from performance fees/carried interest in other funds.

From our discussion with the company, we expect that investment in the pan-European real estate platform development will be in the range of c €2.5–€3.0m pa over the next two years and we have allowed for this but have included no immediate revenue benefit. In Exhibit 2 this is reflected in the ‘other’ segment loss, with investment costs partly offset by other activities including 45%-owned associate YARD.

Our adjusted earnings measure tracks the underlying recurring earnings of the segment. It adds back non-cash purchase price amortisation (PPA) relating to the historical transactions that created DeA Capital Real Estate, takes out the notional ‘normalised’ earnings that we attribute to the segment in respect of the real estate fund investments that it holds (see below), and adjusts for other non-recurring items.

In addition to our estimates for the AAM profit contribution, our NAV forecasts seek to capture at least part of the potential for growth in NAV from the investment portfolio. We assume a normalised growth in the carried value of all of the fund investments (whether consolidated or equity accounted), an approach that differs from the way that these assets are actually managed, which seeks to maximise IRR, but we believe it to be a useful way of capturing at least some of the returns that may be earned over time. We assume:

Somewhat conservatively, we have assumed no changes in the value of (or income from) the quoted investments Migros, Cellularline and IDeaMI.

At 31 March 2019, the holding company net financial position (defined as holding company cash and cash equivalents, available for sale financial assets, and financial receivables less current and non-current liabilities) was €92.5m or c 20% of NAV. At a group level, including net financial assets within the subsidiaries, it was higher still, at €137.7m.

Since the end of Q119, the holding company net financial position has benefited from a €22.9m dividend distribution from the AAM business, a significant increase from €7.5m in 2018, and substantially covering the c €31m (€0.12 per share) shareholder distribution in May 2019.

As can be seen from Exhibit 3, the net financial position has been consistently strong over several years, allowing DeA the flexibility to selectively invest in the AAM platform, and fund development and new direct investments while making attractive distributions to shareholders.

Our expectation of continuing net reimbursements from fund investments is included in the net financial balances shown in Exhibit 3. In 2018, net distributions from own-managed private equity fund co-investments were particularly strong at c €80m, sufficient to fund the c €40m cash consideration element for the purchase of minorities in DeA Capital Real Estate and c €31m in shareholder distributions. We expect net flows to remain strong, although not as strong as FY18, and management looks for a potential c €100m net distributions over the next three years, driven by maturing private equity funds. Specifically, our forecast for FY19 includes net distributions of €21m with a further €30 in FY20. Capital commitments were €103m at end-Q119 and our net distribution figure allows for c €40m of this to be called up by end-FY20. It is likely that a significant part of the balance will not be called as it relates to older vintage funds.

Overall, our forecast for the net financial position through FY20 should be viewed as illustrative, as it assumes no further purchases or sales of direct investments or investments in the AAM platform. We consider both likely and welcome.

In this note we have made no revisions to our FY19 estimates, which we updated in our last note following the Q119 results. We have extended our forecast period out to FY20, as summarised in Exhibit 4. It is worth noting that we have factored in the cancellation of 40m treasury shares approved by shareholders at the AGM and effective in August, although this will have no impact on liquidity, NAV or EPS.

DeA shares trade at a P/NAV of c 0.7x, the lowest in the peer group shown in Exhibit 5. At the same time, DeA’s yield of close to 10%, with distributions supported by a strong holding company financial position and significantly net positive cash flow from its investment portfolio, is the highest in the group. In our view, there is significant value in DeA that is not captured in the current share price. In part, this reflects the low ROE that it generates compared with the peer group, partly but not wholly explained by the depressing effect of high liquidity (c 20% of NAV). As DeA continues to apply this cash to building out its AAM platform, growing its AUM base and building recurring earnings, meanwhile rewarding shareholders with generous distributions of surplus liquidity, we would expect ROE to strengthen and for this to be progressively recognised in the valuation of the company.

We have divided Exhibit 5 into two groups. The first is a ‘narrow group’ of companies that DeA management believes mostly closely resemble its own strategy of combining alternative asset management for third parties with balance sheet investment (both co-investment in funds managed and direct investment) supported by permanent capital. We have also included a broad range of other private equity, specialist and conventional asset managers, many of which focus on ‘balance sheet-light’ third-party asset management. Given this mix of strategies among its peer group, combining widely differing reliance on ‘recurring’ asset management earnings and balance sheet-driven investment earnings, we would caution against focusing on any particular valuation multiple. In our view, Exhibit 5 highlights the significant value in DeA, as well as the immediate returns to shareholders via strong and regular distributions.

In terms of share price performance, over the past 12 months DeA has outperformed both the narrow and broad peer groups, and allowing for its high yield, this outperformance would be greater if shown in terms of share price total return.

Although it has been consistently positive over the past three years, return on equity is currently relatively low, both in absolute terms and compared with the peer group. As noted in the financial section, the forecast data in Exhibit 7 for the next two years reflects the impact of both our recurring AAM earnings forecasts and the notional return on investments that we factor in. We believe that the successful execution of DeA’s strategy, subject to market conditions, should over time result in:

Our adjusted NAV replaces the stated book value of the alternative asset management platform with our assessment of a fair value based on the P/E multiples observed across the peer group. We also mark to market DeA’s quoted investments. The adjustments to the 31 March 2019 stated (IFRS) NAV, producing an adjusted NAV per share of €1.75, are as follows:

DeA’s financial results and prospects are very sensitive to financial market conditions over the short to medium term. Financial market conditions directly affect its ability to realise divestments, raise new funds and find new investment opportunities, and also influence the valuations of its investments. Although AAM is not immune from these market fluctuations, its growing significance within the overall group and the increasing share of recurring fee income within revenues, is likely to reduce the overall sensitivity of reported earnings to market fluctuations.

The valuations of the underlying investments in the private equity funds and those direct investments that are in unquoted investments are based on a rigorous but ultimately subjective assessment by management, with inevitable uncertainty about realisable values.

Annual shareholder distributions of c €31m are in excess of likely recurring earnings and are supported by the significantly positive holding company net financial position and strongly positive net cash flow from the investment portfolio. As a proxy for recurring earnings, our forecast for adjusted AAM earnings in FY19 is €11.6. Any disruption to markets, as witnessed during the global financial crisis, could be expected to slow the pace at which the PE funds are able to realise investments and reimbursements capital, and could have a noticeable effect on the net balance of capital calls and reimbursements with a negative impact on group cash flow.