Mercia Asset Management — FY21 a breakthrough year, with more to come

FY21 was a year of organic growth, hampered initially by the impact of the COVID-19 pandemic but benefiting significantly from the first full-year contribution from the NVM VCT fund management business (acquired in December 2019) and the ‘super-profits’ from portfolio company realisations – principally the £18m cash gain made from the sale of OXGENE (covered in more detail in The UK’s top regional investor).

Mercia reported a 16% rise in FUM to £764m (FY20: £657m), contributing £18.2m in revenues (FY20: £11.7m). Overall group revenues increased by 84% to £23.4m (FY20: £12.7m), reflecting a full-year contribution from the NVM VCT fund management contract. Revenues comprised £13.1m from fund management fees, £1.4m from initial management fees, £3.1m from portfolio director fees as well as £4.2m of one-off performance-related fees arising from the NVM VCT funds. Performance-related fees aside, 85% of fee income from fund management and monitoring is contracted and recurring.

Administrative expenses rose by 31% to £16.6m (FY20: £12.7m), with staff costs increasing 22% to £10.7m (FY20: £8.8m), with the majority of the increase reflecting the incremental operating costs of the NVM VCT fund management business. Headcount increased by 8%, from 93 to 100 employees over the year. Despite the impact of COVID-19, no staff were furloughed or made redundant and Mercia did not receive any direct government support, although its portfolio companies received £11.8m in matched funding from the Future Fund.

As a recognised metric for specialist asset managers, Mercia reports adjusted operating profit, the difference between revenues and total operating costs, excluding realised gains on disposal of investments, unrealised fair value movements, one-off items and non-cash charges. Adjusted operating profit excluding net performance fees increased to £3.3m (FY20: £0.5m) largely as a result of the first full-year contribution of the NVM VCT fund management business. With AUM expected to grow by 20% on average over each of the next three years (under Mercia 20:20) and assuming Mercia’s net fee income remains at c 2% of AUM, this suggests continuing revenue growth and strong growth in adjusted operating profits over the medium term. Reflecting £30.0m of fair value changes and realised gains (FY20: £15.8m fair value reduction), Mercia reported FY21 PBT of £34.0m (FY20: £17.5m loss) and EPS of 7.83p (FY20: 5.11p loss). At Mercia’s current share price of 37.5p, its shares are trading on an FY21 P/E ratio of 4.8x and with a proposed 0.3p final dividend, added to the 0.1p interim dividend, they offer a 1.1% dividend yield.

Although tax losses are not carried on the balance sheet, we understand Mercia’s historic tax losses are likely to be sufficient to offset taxable gains reported over the medium term, when taken together with the substantial shareholding exemption minimising tax on capital gains.

Mercia reported net assets of £176.0m (FY20: £141.5m) or 40.0p per share (FY20: 32.1p), a rise of 24% over the year. Net direct investments of £15.4m were made into 19 portfolio companies (FY20: £15.7m into 18 companies) during the year, including two new direct investments, Sense Biodetection and MIP Diagnostics. After the year end, Mercia invested a further £0.5m in Medherant and £0.3m in Eyoto, both existing direct investments.

The company ended the year with £54.7m of unrestricted cash and short-term liquidity investments (FY20: £30.2m) as well as total group unrestricted liquidity of £314m.

Focusing on the direct investment portfolio, Mercia had 23 direct investments at 31 March 2021, with four exits during the year and two new investments. In line with previous reporting periods, Mercia’s top 20 direct investments represented 98.5% of total portfolio value at 31 March 2021, with the top 10 representing almost 80% of total portfolio value.

With asset values substantially recovering in H121, before continuing to move forward in a strong private company funding environment in H221, the value of Mercia’s direct investments rose to £96.2m (2020: £87.5m). This 10% increase came after FY21 net investment of £15.4m (FY20: £15.7m), as well as four cash realisations, returning £37.0m to the group, delivering £20.3m of realised gains: Crowd Reactive (-), The Native Antigen Company (£1.8m), Clear Review (£0.5m) and OXGENE (£18.0m), with a fair value of £15.9m at 31 March 2020.

Mercia continued to support its top holdings with two thirds of net direct investment allocated to the top 10 assets. This was topped up with a further £11.8m in matched funding from the Future Fund. The principal contributors to the £10.1m fair value gain were MyHealthChecked (£3.5m), Impression Technologies (£1.9m increase, after a £3.1m reduction in fair value in FY20), Voxpopme (£1.6m), Faradion (£1.2m), nDreams (£0.6m) and Soccer Manager (£0.2m).

The diagnostics, biotech and software sectors put in a strong performance in FY21, while certain businesses in deep tech and clean tech, including in the automotive sector, were negatively affected by the COVID-19 pandemic. However, the automotive-related assets, primarily Warwick Acoustics (£0.1m fair value gain in FY21) and Impression Technologies (£1.9m fair value gain), are now seeing renewed interest from original equipment manufacturers. Eyoto (remote platform eyecare) has experienced delays in Food and Drug Administration approval for its slit lamp product, which has affected revenues, necessitating a £0.4m write-down in fair value.

In aggregate, Mercia manages AUM of c £940m, of which third-party FUM account for over 80%, approximately £764m, operating through four pools of capital under management:

Venture, including the NVM VCT fund management business, EIS and IP commercialisation, represents the majority (FY21: 64%) of the group’s AUM, with private equity (6%) and debt (12%) representing a much smaller proportion of overall funds. The remainder relates to the group’s balance sheet, the direct investment portfolio (10% of AUM), balance sheet cash (6% of AUM) and other (2% of AUM, principally intangible assets), set out in Exhibit 3.

Having substantially achieved the goals set out in its prior three-year plan to FY22 a year ahead of schedule, Mercia’s board has set a revised three-year target, Mercia 20:20. It aims to:

If Mercia is able to achieve these strategic objectives, we would expect it to lead to substantial shareholder returns over the next three years.

As Mercia has successfully built its third-party fee-earning fund business, charging an average c 2% of AUM, it is now expected to generate a positive adjusted operating profit as it scales, allowing investors to attribute additional value to these earnings. Management has signalled the sustainability of this income stream (FY21: 85% of fund management and monitoring fees are contracted and recurring), by proposing a maiden dividend of 0.4p for FY21, offering a 1.1% dividend yield.

With annual AUM growth of 20% targeted over the next three years, generating incrementally larger revenues, we believe an NAV-based valuation alone no longer adequately reflects the additional value of the fund management business within Mercia.

We estimate the value of Mercia’s embedded fee-earning funds business at 4% of FUM (a conservative valuation considering Mercia’s attractive blended fee margins of 2%) in addition to the NAV-based valuation of its direct investment business. We provide a sensitivity analysis below highlighting the valuation impact for the funds business at 3% and 5% of FUM (Exhibit 4).

With last reported FUM of £764m, this implies a valuation for the fund business of £23–38m, or c 5–9p per share. When added to the FY21 NAV of 40.0p per share, this implies a revised valuation of c 45–49p per share. Based on our hybrid approach, Mercia’s shares trade at a 17–23% discount to this valuation, based on the current share price.

Valuations of many of Mercia’s peers have risen significantly over the last 12 months, with portfolios based around technology and life sciences investments benefiting from strongly rising valuations following the initial impact of the COVID-19 pandemic.

A premium is often applied where the company owns an income-generating asset management arm (eg 3i, Gresham House, ICG, Mercia), whereas for many other direct investors, either the management vehicle is held separately from the investment vehicle (eg HgCapital, Oakley) or fees have yet to deliver structural profitability (eg Draper Esprit, IP Group).

Currently, Mercia trades at a 6% discount to the FY21 NAV (40.0p), with a number of its immediate peers trading at a premium to NAV. However, as we have set out above, we believe Mercia’s hybrid valuation, including the fund management business, lies between 45p and 49p per share, implying it is trading at a discount closer to 17–23%.

As the fund management business grows, the link to NAV becomes less relevant, as highlighted by Gresham House and ICG (Exhibit 5), with these specialist asset managers trading on more than a 20x CY21 P/E multiple.

Based on an average PBT of £20m over the next three years as targeted under Mercia’s 20:20 vision, Mercia’s shares trade on an implied targeted average FY22–24 P/E of 8x. This assumes the tax charge over the period on a blend of income and realised gains (offset by the substantial shareholding exemption) can be substantially offset by the group’s historic tax-losses carried forward.

Given the group’s increasing scale, leading to growing profitability, the performance of its portfolio, its attractive underlying operating model and the initiation of a progressive dividend policy, this leaves scope for considerable share price upside as the valuation decouples from a simple NAV premium/discount.