Mercia Asset Management — Excellent results despite the tough market

Mercia recorded record gross performance fees in FY22 of £2.6m (FY21: £4.2m), and net performance fees of £1.6m (FY21: £3.8m), based on the continuing strong market conditions seen in 2021. Excluding these performance fees, group revenues increased 7% to £20.6m (FY21: £19.2m), with 95% of revenues (FY21: 96%) coming from fund management fees and 87% (FY21: 88%) of revenues contracted and recurring. Fund management fees represented 2.7% of closing FY22 funds under management (FUM) (FY21: 2.5%).

Admin expenses (adjusted for performance fees) increased by 5% to £16.6m (FY21: £15.9m), more than covered by Mercia’s recurring management fees for a second successive year. Adjusted operating profit more than doubled to £8.4m (FY21: £3.3m), mainly due to net finance income soaring to £4.4m in FY22 (FY21: £0.05m), partly as a result of the disposal of Mercia’s stake in Faradion, which crystallised convertible loan interest and a redemption premium. For the record, adjusted operating profit is defined as operating profit before performance fees net of variable compensation, realised gains on disposal of investments, fair value movements in investments, share-based payments charge, depreciation, amortisation of intangible assets, movement in fair value of deferred consideration and exceptional items. It includes net finance income.

On an IFRS basis and against a very tough comparator in FY21, operating profit fell by 32% to £22.9m (FY21: £34.0m), with PBT of £27.4m (FY21: £34.0m) and PAT falling to £26.1m (FY21: £34.5m). This was despite FY22 gains on disposal of £9.9m (from Faradion), which were still lower than the £20.3m of gains in FY21 (from OXGENE, Native Antigen Company and Clear Review).

FY22 was the first year that Mercia paid meaningful tax (4.6%), as historical tax losses have now largely been used up – although a potential deferred tax asset of £4.4m (FY21: £5.7m) for cumulative unrelieved management expenses and other tax losses has not been recognised in the FY22 accounts as its future use is uncertain. The majority of the FY22 tax charge relates to an allowance for the increase in corporation tax from 19% to 25% from 1 April 2023, with the group's deferred tax liability calculated at a rate of 25% as at 31 March 2022 (from 19% previously). However, despite the impending increase in corporate tax rate and paucity of remaining tax losses, gains on disposal by a company like Mercia are often exempt from corporation tax as they are sheltered by the substantial shareholding exemption (SSE).

The group held cash and short-term liquidity investments of £61m (FY21: £55m), part of which we expect to be deployed towards M&A in due course. Mercia’s record balance of cash and liquid investments represents 30% of NAV, offering a significant buffer to support the existing portfolio, make new investments as well as support potential future M&A.

As part of its progressive dividend policy, Mercia declared a final dividend of 0.5p (FY21: 0.3p), taking the total dividend to 0.8p (FY21: 0.5p) for the year. At the current share price, Mercia’s shares offer a yield of 2.7%.

FY22 was another year of real progress for Mercia, and its first year under its three-year Vision 20:20 strategy (which targets average annual PBT of £20m FY22–24 as well as to grow assets under management (AUM) by 20% on average over this period). Mercia reported FY22 PBT of £27.4m (FY21: £34.0m) and AUM rose marginally (2% y-o-y) to £959m in FY22 (FY21: £940m), passing the £1bn mark and post-year-end, with a further £45m of VCT and EIS funds raised. The group also returned £90m of distributions to investors, including £3m of dividends to shareholders.

Third-party FUM were also largely unchanged (down 1%) over the course of FY22 at £758m (FY21: £764m), although also affected by £87m of the distributions noted above. Of FY22 FUM, 83% of funds are committed to various stages of venture (EIS, VCT, venture capital (VC) and proprietary capital) with private equity (5%) and debt (12%) the remainder.

Net assets and NAV per share both rose 14% in FY22, to £200.6m (FY21: £176.0m) and 45.6p (FY21: 40.0p), respectively, driven by the sale of Faradion (Mercia’s second largest holding), a major up-round for nDreams and valuation uplifts for 10 of Mercia’s top 20 holdings. Hard NAV (portfolio fair value plus net cash) and hard NAV per share climbed 20% to £180.8m and 41.1p per share (FY21: £150.9m, 34.3p per share), respectively.

Mercia trades at 0.65x FY22 NAV/share of 45.6p and at 0.56x adjusted NAV/share (52.5p, including the value of the fund management business at 4% of FUM). Following the acquisition of the Northern Venture Trust’s fund manager, Mercia has delivered an FY20–22 NAV/share CAGR of 19% as well as a 24% CAGR in hard NAV/share.

Thanks to the fees it charges on its third-party managed funds (2.1% of FUM), of which c 87% were contracted and recurring in FY22, Mercia is structurally profitable and able to sustain a progressive dividend policy. An NAV-based valuation fails to capture the incremental value of this fund management business, an ever-widening gap as FUM increases.

We continue to estimate the value of Mercia’s embedded fee-earning funds business at 4% of FUM (at what we believe is a conservative valuation considering Mercia’s attractive fee margins) on top of the NAV-based valuation of its direct investment business. With last reported FUM of £758m, this implies a valuation for the funds business of c £30m, or 7p per share on top of the FY22 NAV of 45.6p per share, implying a hybrid valuation of 52.5p per share.

The value of Mercia’s direct investment portfolio at FY22 year-end rose to £120m, a 24% increase year-on-year (FY21: £96m), with Mercia making gross investments of £18.4m (£8.5m net) into 15 portfolio companies (FY21: £4.9m net realisation, 18 portfolio companies). In line with previous reporting periods, Mercia’s top 20 direct investments represented 99% of total portfolio value at 31 March 2022, with the top 10 representing 81% of total portfolio value. Mercia weights its efforts accordingly, with £11.1m of total investment being invested across the top 10 assets.

Although half the top 20 holdings recognised increases in fair value, the sale of Faradion and an up-round for nDreams were the two major highlights in FY22. The value of Mercia’s top 10 holdings increased by 28% over FY22.

In January 2022, Mercia announced the sale of its second largest holding, Faradion (a leading sodium-ion battery technology company), for £100m to Reliance New Energy Solar, a subsidiary of India’s Reliance Industries. Mercia received total cash proceeds of £19.4m from the sale, an uplift of approximately 50% over Faradion’s carrying value of £12.9m at 30 September 2021. The sale delivered a 4.2x return on Mercia's direct investment cost of £4.4m and an internal rate of return (IRR) of c 72%.

Mercia’s largest direct investment, nDreams, a VR games developer and publisher, completed a £20.0m third-party funding round with Aonic (aonic.co), a Stockholm-based video games investor (Mercia invested £1.3m in a prior round during the year). At year-end, Mercia held a 33.2% stake in nDreams valued at £25.8m, a rise of £6.7m from its FY21 carrying value.

At the other end of the spectrum, the publicly traded share price of MyHealthChecked (COVID-19 travel tests, £2.9m write-down) has remained under pressure, although its financial results have been positive.

Mercia made two new investments during the year, including a £1.8m direct investment into Forensic Analytics, alongside a £2.7m investment by the Northern VCTs. In November 2021, Mercia's third-party managed fund portfolio company, Pimberly, completed a £4.3m funding round, with Mercia investing £1.4m from its own balance sheet.

Mercia has delivered a direct investment portfolio IRR of 14% from its initial public offering in 2014 to 31 March 2022, as well as annual growth in NAV per share of 24% over the last two years, following completion of the acquisition of the Northern VCT fund management business.

Mercia’s Vision 20:20 strategy targets average annual growth in AUM of 20% between 2022 and 2024 (closing AUM of £1.5bn, implying a CAGR of 25% FY23–24) and average PBT of £20m per year, or total PBT of £60m over the three-year period – of which it has achieved 46% in the first year of the strategy. Management intends to increase the size of its equity holdings, taking stakes of 10–30% in a diversified portfolio of up to 30 companies (versus 23 at 31 March 2022).

With £61m of unrestricted cash on the balance sheet as at 31 March 2022, and a cash-generative model, management has indicated it will look to supplement organic growth with M&A around the group’s core and/or complementary competencies. Having demonstrated the success of the acquisition of the Northern VCT funds in 2019 for £25m (£270 FUM, 6.3x PBT) and Enterprise Ventures Group in 2016 for £11m (£200m FUM, 7.9x PBT), we believe Mercia has the means and the rationale to target further M&A opportunistically, without recourse to the markets. Acquisitions are expected to be earnings enhancing, with similar fee structures, increasing UK market FUM.

As a specialist fund manager, Mercia’s financial performance centres around realised gains, the growth in fair value of its direct investment portfolio on its balance sheet, together with the growth in FUM and the predictable, recurring management fees that result. Mercia is unusual in that its fee income more than covers central costs, meaning that it can point to a growing stream of post-tax profits and sustain a progressive dividend policy.

Valuations for the direct investor sector have fallen significantly over the last six months, with concerns over rising interest rates, high technology valuations, inflation and the war in Ukraine. However, in a more challenged investment scenario, Mercia’s model has identifiable downside protection, with its broad regional footprint aligned with the government’s levelling-up agenda, offering an investment portfolio diversified across both asset class and sector, and a model that is sustainably profitable and dividend generating. Mercia’s balance sheet portfolio also has a relative lack of public market exposure, with only around 1% of its direct investments quoted.

Mercia trades on 0.65x its FY22 NAV/share (45.6p), placing Mercia towards the middle of our field of direct investment peers, which largely trade between 0.4x and 0.75x NAV. This is even before considering the incremental value of the third-party funds business, which we estimate adds an additional 7p per share at 4% of FUM. However, when we look at specialist asset managers such as Gresham House and Intermediate Capital Group, trading at consensus FY22 P/Es of 15x and 11x, respectively, we can see there is plenty of upside potential ahead as FUM scale. Mercia trades on a P/E of 5x FY22 EPS as well as offering a 2.7% historical dividend yield.

Given Mercia’s defensive characteristics, the strength of its business, its structural profitability and underlying operating model, we believe Mercia remains undervalued at these levels.