HgCapital Trust — High quality, high growth, high margin

Moreover, HGT visibly outperformed its peer group and ranked first over the last three years, with an annualised NAV TR of 27.8% (versus the peer group average of 20.3%, see Exhibit 3). Its performance over five years was only behind Oakley Capital Investments (which has a much more concentrated portfolio) and over 10 years it was again the top performer (with the second-ranked HarbourVest Global Private Equity having a meaningful share of venture capital/growth investments).

We believe HGT should not be viewed exclusively as a PE opportunity, but also be considered a potential component of an investor’s broader tech exposure. Therefore, we also examine HGT’s performance versus six UK-listed entities with investment strategies focused primarily on public tech companies, including IT businesses to a varying degree, alongside other tech sectors such as biotechnology, healthcare equipment, internet media or semiconductors. These include the five investment companies we list in Exhibit 4, as well as Scottish Mortgage (whose disclosed sector breakdown is not fully comparable with the other companies).

HGT has outperformed this peer average and ranked first over one, three and five years. Its outperformance over the last 12 months may be explained by the fact that PE valuations tend to be less volatile than share prices of listed equities. That said, we note that this is true both to the downside and to the upside, which means that HGT’s five-year performance should be affected by the valuation approach to a lesser extent. HGT’s NAV TR was also above the peer average over 10 years, though the trust ranked fourth, which we believe comes from the superior performance of the ‘big tech’ names to which several of the peers have had meaningful exposure. The performance of ‘big techs’ (eg Microsoft, Apple, Amazon, NVIDIA and Meta) also likely assisted the 12-month performance of some of the peers.

To better understand the potential drivers of HGT’s outperformance versus its listed tech peers, it is best to look at the attribution analysis for the 33% gross internal rate of return (IRR) Hg delivered over last 20 years to end-2022. Software sector growth, combined with Hg’s focus on strong players within selected clusters and positive operating leverage effects, were the main contributors with around 15pp. While financing leverage added a further 7pp (HGT’s average portfolio leverage is likely higher than the average gearing across listed tech portfolio), Hg’s operating skills and driven M&A (‘buy-and-build’ strategy) were also important contributors with 5pp and 6pp, respectively.

HGT’s share price declined in total return terms by more than 20% over the 12 months to end-March 2023 (more than the peer average) on the back of broader investor cautiousness towards tech and private equity investments. This was despite continued solid revenue and earnings development across its portfolio (see below).

HGT’s portfolio has benefited from the structural trend towards digitalisation for many years now, with accelerated adoption following the COVID-19 outbreak. Hg’s head of research recently examined IT spending patterns across countries and found that the share of software spending grows with the level of overall IT spending as a percentage of GDP. This suggests that the sector is not approaching saturation even in the more developed economies.

IT market growth slowed in 2022 to 0.5%, down from 10.2% in 2021, due to lower spending on devices (laptops, PCs, tablets, printers, phones) and communications services. That said, the software market (18% of IT spend) grew by 8.8% and the IT services market (28% of IT spend) grew by 3.5% (source: Gartner). Gartner expects IT market growth to accelerate in 2023 to 5.5% and by a further 8.6% in 2024. Software growth is also expected to accelerate over this period, to 12.3% in 2023 and 13.1% in 2024 as enterprises prioritise spending to capture competitive advantages through increased productivity, automation and other software-driven transformation initiatives. These measures are aimed at offsetting ‘white-collar’ wage and other cost inflation, among other things. Some of this growth is likely to be due to price increases as software companies introduce inflation-linked increases. Separately, Garner forecasts that spending on public cloud services will increase by 21.7% in 2023.

Even with the tougher external environment, SaaS companies are expected to generate healthy revenue growth and increasing profitability over the next two years. Based on a basket of c 100 SaaS companies listed in the US, Exhibit 6 below shows the rate of revenue growth and EBITDA margins over 2020, 2021 and 2022 and forecasts for 2023 and 2024. Clearly, performance remained strong despite the market sell-off and prospects continue to look strong for the sector, even if, in the short term, companies will have to navigate a slowing economy.

HGT’s 100% software and services portfolio provides high-quality exposure to the corporate digitalisation trend through leading, profitable, unquoted European mid-market businesses with an international footprint, offering software solutions to more than four million SMEs, with a high share of SaaS-based recurring revenues and high customer retention. Hg’s ‘sweet spot’ lies in defensive tech growth companies operating in one of eight core end-markets: tax and accounting; ERP and payroll; legal and compliance; automation and engineering; insurance; SME tech services; capital markets and wealth management IT; and healthcare IT (see Exhibit 7).

HGT’s portfolio consisted of 48 software and services companies at end-Q123. These are categorised into the eight clusters mentioned above. The top 10 investments represented c 55% of portfolio value (see Exhibit 8), with the top 20 making up 77%. While HGT’s portfolio is concentrated in Europe (77% of value), it has broader indirect exposure, as a number of its largest companies operate globally.

HGT’s performance is supported by the above-mentioned favourable market trends but also by Hg’s vast value creation capabilities, which represent a combination of 1) its in-house operational experts, 2) an extensive community consisting of key managers from its portfolio companies (Hg Hive) and 3) intellectual property, tools and group services on which its portfolio companies can rely.

HGT has a value creation team specialising in software and tech-enabled businesses, consisting of more than 50 senior operational specialists (each supported by a network of trusted third-party associates and partners) working with Hg’s portfolio management teams to execute value creation projects. The team’s core areas of focus include growth, data analytics, M&A, responsibility, talent and technology.

Support from Hg’s value creation team may take different forms, including 1) co-owning and directly driving specific initiatives in the portfolio company, 2) mentoring senior executives, 3) leading the recruitment of senior executives (with 66 C-suite and board placements led by Hg’s talent team over the last three years) and 4) fostering collaboration between management teams across portfolio companies. We believe that HGT’s value creation team strikes the right balance between owning the execution of value creation initiatives and empowering the key management of its portfolio companies.

The team continuously converts its project experience (gathered from more than 5,000 man hours per year) into ‘playbooks’ of value-enhancement best practices, which are increasingly being embedded in Hg’s proprietary software tools and services, allowing for swift implementation in newly acquired portfolio companies.

An example of Hg’s proprietary tools is its own business intelligence cloud platform (powered by business systems like Salesforce, NetSuite, Hubspot and Marketo), which allows it to offer business intelligence as a service to its portfolio companies at 25% of the cost of an external provider. At present, four portfolio companies are using the system, with a further eight in the implementation phase. Hg can also leverage the scale of its operations to drive cost efficiencies, with aggregate discounts achieved on various external services for its current portfolio of US$40m pa.

As an early adopter of artificial intelligence (AI), machine learning and analytics, Hg has been using AI to support value creation across its portfolio companies for many years now, eg for up-sell and cross-sell modelling, to identify potential customer churn, as well as using it in its own deal origination process. For more details, listen to a EY podcast episode from January 2022 with Nick Humphries, senior partner and executive chair of Hg.

HGT’s pure focus on software and tech-enabled services, coupled with extensive sector expertise and in-house operational improvements team, makes it more akin to a tech conglomerate in an investment company wrapper. We consider it a good alternative or complement to ‘big tech’ exposure, especially given the recent takeovers of some listed European software companies like Aveva or Micro Focus, which reduce the investible listed software large-cap universe. For further details on HGT’s fund profile and investment process, see our update note published on 12 September 2022.

The valuation of software companies has been volatile over the last three years, as illustrated by the performance of US-listed stocks (see Exhibits 12 and 13). The BVP Nasdaq Emerging Cloud Index serves as a proxy for SaaS software companies, tracking the performance of 70 US-listed companies that provide cloud-based software or services. We note that c 15% of these companies by count are forecast to be loss-making this year (based on current Refinitiv consensus), while the vast majority of HGT’s portfolio holdings are profitable, according to the company.

The sector outperformed the three major indices in 2020 as software companies benefited from accelerating adoption of cloud-based services during the pandemic. Stocks continued to rise during 2021 before reaching a peak in November 2021, following which performance declined through the course of 2022, with lows reached in November. Since the start of 2023, performance has improved, albeit with a dip in March when the banking crisis triggered by Silicon Valley Bank threatened technology companies’ cash. The index also saw a dip at the end of April when some technology companies reduced guidance and announced lay-offs due to inflation and higher interest rates affecting customer demand, but has since started to recover again.

Meanwhile, average LTM EV/EBITDA across HGT’s top 20 holdings stood at 27.3x at end-March 2023, broadly unchanged versus 27.4x at end-2021. Valuations had a 9% negative impact on HGT’s portfolio during 2022, so the stability in the multiple is due to mix, ie a different set of constituents within HGT’s top 20 holdings due to acquisitions/exits/fair value changes. Consequently, this suggests that HGT’s portfolio has not been subject to a major de-rating since end-2021. While the current multiple looks high in absolute terms, we believe there are several factors that support it.

Firstly, PE portfolio valuations tend to be less volatile than public equities, both to the upside and the downside (for details, see our recent sector note, Listed private equity: A gateway to an expanding equities universe).

Secondly, top PE general partners such as Hg value their portfolios conservatively. This is well documented by the consistent delivery of uplifts to previous carrying values across the listed PE space (again, see the above-mentioned sector note for details). In the case of HGT, the average uplift to prior year-end carrying value stood at a healthy 38% over 2017–22. Importantly, there has been no disposal below previous carrying value across HGT’s portfolio over the last 10 years. Hg normally underwrites a multiples contraction when acquiring its platform investments (ie companies forming the base of a buy-and-build strategy), but the contraction did not materialise to a meaningful extent in the past. Even in the more demanding environment in 2022, HGT was able to realise investments above previous carrying value: Medifox (agreed in June, closed in November at a 48% uplift), itm8 (closed in October 2022, 12% uplift) and Transporeon (signed in December 2022, closed in April 2023, 18% uplift). HGT also completed a refinancing of Access at a 26% uplift.

HGT’s exit activity has been muted so far in 2023, with no major partial or full realisations from its portfolio (it usually targets 8–16 liquidity events a year). However, earlier this year, it sold 25% of its limited partner (LP) position in Genesis 8 at a price in line with end-2022 NAV, realising a strong 3.2x multiple of invested capital. That said, we note that it will receive proceeds from the sale in two delayed instalments: the first on 31 March 2024 and second on 31 March 2025. The average discount to NAV of secondary transactions in buyout portfolios stood at 13% in 2022, according to Jefferies’ Global Secondary Market Review 2022. HGT highlighted during the recent capital markets day (CMD) that despite the downward pressure on pricing, the portfolios of strong performers held at reasonable valuations can still expect full pricing in the secondary markets.

Thirdly, we note that the lower risk appetite and greater emphasis on cash generation and profitability resulted in a greater de-rating of unprofitable and less established businesses, while the valuations of more resilient, cash-generative businesses backed by recurring revenues from mission-critical, low-spend products and services (such as HGT’s portfolio holdings) held up better.

Furthermore, despite more muted platform investments recently (only one £9.8m investment in GTreasury, a US-based treasury, payments and risk management software provider), HGT saw continued activity in terms of add-on acquisitions to existing portfolio holdings (Howden and Rhapsody in particular so far in 2023). Apart from value accretion from synergy effects, these also support HGT’s NAV TR because of multiples arbitrage, with add-on acquisitions normally executed at multiples which are several EBITDA turns below the multiple of the platform2.

Finally, the 27.3x EV/EBITDA multiple is based on LTM earnings, while HGT’s portfolio companies normally grow their earnings significantly. As a rule of a thumb, software stocks with combined revenue growth and EBITDA margins of 40% or more typically generate higher valuations. This is often referred to as the Rule of 40. The chart below demonstrates this for our basket of US SaaS companies. The average EV/Sales ratio (based on Refinitiv consensus estimates for the current fiscal year) for companies with combined revenue growth and an EBITDA margin above 40% stands at 9.1x, a 113% premium to the 4.3x for businesses below 40%.

As the valuation of software stocks started to decline from the peak in 2021 and the economic environment worsened, companies started to shift from a growth mindset to seeking to balance growth and profitability, recognising that raising money in the current environment has become much tougher. Therefore, as companies look to preserve cash, we expect to see a shift from revenue growth to margins making up the Rule of 40 score.

Since 2018, when more than 90% of HGT’s portfolio was already invested in software and services businesses, the revenue and EBITDA of HGT’s top 20 companies has grown each year by 20–30% pa (see chart on front page), usually split broadly equally between organic growth and M&A. Therefore, we believe that HGT’s portfolio fulfils the Rule of 40, justifying a certain valuation premium to the broader private IT market.

The 27.3x average EV/EBITDA (at end-March 2023) and 29% EBITDA margin (in 2022, last reported figure) across HGT’s top 20 holdings imply an EV/Sales multiple of c 8x, which represents a c 14% discount to the average EV/Sales ratio (based on last reported revenue figures) of c 9.3x for the above-mentioned set of US SaaS companies fulfilling the Rule of 40. On top of this, HGT’s shares trade at a c 17% discount to last reported NAV versus a five-year average of 6% (see Exhibit 15), although the discount is narrower than its peer average of c 34% (see Exhibit 2). The two-layer discount seems to cover a meaningful part of the c 20–30% illiquidity discount investors normally demand for a privately held business versus its listed peers. While some discount may also be warranted by Hg fees charged on the portfolio, it may be at least partially offset by the premium justified by 1) Hg’s active ownership approach and synergies discussed above, and 2) the fact that HGT is an evergreen investment vehicle with a certain portfolio turnover rate rather than a static portfolio of companies.

Importantly, organic growth remained largely unaffected by the tough macro environment last year, with both organic revenue and EBITDA growth at c 10–20% year-on-year between April and December 2022 (see Exhibit 16).

Hg highlighted that it expects to see some pressure on sales to new customers as they become more reluctant to commit to new software and services in the current challenging macroeconomic backdrop. However, Hg believes its portfolio can maintain strong momentum based on other major organic drivers, primarily value-based price optimisation, upselling (and cross-selling for newly acquired businesses) and an improving share of wallet. The full impact of the second round of price adjustments implemented in 2022 will be reflected across HGT’s portfolio in 2023. LTM revenue and EBITDA growth to end-March 2023 for its top 20 holdings was 30% and 27%, respectively. We note that the EBITDA margin across HGT’s top 20 holdings declined somewhat in 2022 from the record-high 35% in 2021, but this was primarily the result of a post-COVID-19 normalisation in operating expenses and the 2022 margin is in line with the 2017–20 average.

Nevertheless, the investment manager highlighted that personnel inflation is somewhat ahead of revenue momentum (employment growth across Hg’s portfolio was 20% in 2022 in full-time equivalent terms, like-for-like including M&A). Gartner recently highlighted that it believes demand for tech talent will continue to outstrip supply until at least 2026.

Net debt to EBITDA across HGT’s top 20 holdings (representing 77% of portfolio value at end-March 2023) stood at 7.6x (down from 8.0x at end-2022). While this may look high in absolute terms at first glance, we note that: 1) HGT’s equity cushion across its holdings is c 60–75% (based on the average EV/EBITDA multiple at end-March 2023, the ratio is c 70%), 2) its businesses grow their EBITDA at a double-digit rate of 20–30% (half of which comes from organic growth), while the net debt to EBITDA ratio is based on LTM earnings, and 3) underlying businesses are highly cash generative, which often allows for relatively swift deleveraging, if necessary.

Hg acknowledged at the recent CMD that the cost of senior debt recently moved closer to the level of weighted average cost of capital (equity and debt) during the post-global financial crisis low interest rate environment. According to Hg, higher interest rates may reduce its prospective gross IRR by c 3–4pp (versus the 33% gross IRR achieved over the 20 years to end-2022). That said, Hg benefited from a flight to quality in the debt markets (at the expense of more cyclical, consumer-facing and lower-growth sectors) and even towards the back of 2022, it was able to price deals on more favourable terms than the market average and maintain flexibility in its documentation and capital structure, according to the company.

Hg highlighted that it started to deploy interest rate hedging more towards the back of 2022, but now has 80% of the portfolio hedged for around two years. We also note that it has no major debt maturing in the next three years across its portfolio. Finally, Hg highlighted that the covenant headroom on debt funding across its portfolio holdings is comfortable.

HGT invests primarily through private funds managed by Hg (94% of current portfolio), making investment commitments to these funds which are then gradually drawn over the duration of the fund’s investment period (usually c three to five years). HGT is the largest LP in Hg funds, accounting for c £3bn of the total c £52bn AUM (defined as NAV plus unfunded commitments). Therefore, HGT needs to strike the right balance between keeping a liquid reserve to fund these commitments and effective use of capital.

The company introduced several measures to improve its coverage ratio amid muted global M&A markets. As discussed above, in March 2023, it sold 25% of its LP position in Hg Genesis 8 (a 2017 vintage mid-market fund focused on buyouts with an enterprise value between £250m and £1.0bn) for c £91m proceeds, which will be used for fee-free co-investments (now 6% of portfolio, with HGT targeting 10% in the medium term). We note that co-investments offer greater flexibility in terms of capital deployment (as they are carried out on a case-by-case basis and capital is deployed faster), leading to higher capital efficiency and easier balance sheet management. Secondary transactions like the one HGT completed recently have become easier to execute in recent years as secondary PE markets have grown larger and more liquid. Total transaction volumes stood at US$108bn (of which US$56bn was LP volume) in 2022, despite the 18% year-on-year decline, compared to US$37bn (US$28bn) in 2016, according to Jefferies’ Global Secondary Market Review 2022.

HGT also upsized its credit facility from £250m to £350m (or 14.3% of end-March 2023 portfolio value), which can be used to bridge any gaps between new investments and realisations (it is not meant to be used for structural leverage). Moreover, HGT and Hg agreed to reduce HGT’s outstanding commitments to Hg Saturn 3 (which stood at £612.6m at end-2022) by c 15% given the change in the deal environment since the fund was established, as well as appreciation of the US dollar (in which the commitments are denominated) against sterling. According to Hg, the capital drawn so far will be repaid pro rata to HGT, with no negative impact on HGT’s balance sheet.

As a result, HGT had available liquid resources of £647m at end-March 2023, including the undrawn credit facility. These resources cover c 65% of its outstanding commitments of c £1.0bn, a level we consider relatively safe and above the 10-year average of 51%. If we remove the £91m proceeds from the secondary sale (which now represent a deferred consideration), the coverage ratio stands at c 56%. Finally, we note that HGT (unlike many of its peers) has the right to opt out of any commitments to Hg funds, even if it does not intend to use this right under normal circumstances and considers it ‘disaster insurance’.

Hg actively integrates ESG factors into its business, which is reflected in the highest possible scores from the United Nations-supported Principles for Responsible Investment of AA++ in the most recent assessment. Three core tenets of Hg’s ESG and sustainability strategy are sustainable business practice (ie the manager’s efforts to reduce its carbon footprint at the fund level and invest in sustainable businesses), job creation (building diverse teams internally and at its portfolio companies and generating employment growth across the portfolio) and charitable giving.

The manager has been certified as carbon neutral since 2019, which it achieved thanks to the reduction of its own carbon footprint and offsetting the remaining emissions with carbon certificates. As part of its environmental commitments, Hg is targeting a 50% reduction of its direct emissions (Scope 1 and 2) by 2030 and plans to adopt science-based carbon reduction targets across its portfolio companies by at least 2040. Hg continues to monitor the progress of ESG performance across its portfolio holdings with an internal ESG assessment framework, which is based on 170 questions (of which 98 are scored) to which each portfolio company responds. Hg highlighted that all companies improved by implementing certain ESG-focused actions in the past year, but some companies had a lower score based on the 2021/22 assessment compared to the previous year, which reflects Hg’s updated assessment criteria and scoring methodology. The job creation tenet at Hg is benchmarked against relevant key performance indicators, including the percentage of women in Hg’s investment team (38% now compared to 25% four years ago), the number of nationalities across Hg’s team (c 48 at present versus 30 in FY20) and the average Glassdoor score as a proxy for employee satisfaction (4.3 out of 5.0 on average at portfolio companies). Finally, the manager has committed more than US$12m to support the causes of the Hg Foundation from its launch in July 2020 to date, the goal of which is to help develop the skills most required for employment in the technology industry, with a focus on individuals who may otherwise experience barriers to accessing these skills.

HGT is primarily a capital appreciation vehicle, but has been paying regular dividends, with the LTM payment implying a dividend yield of 1.8%. HGT’s dividend per share from 2022 profit was 7p (stable year-on-year), of which a 4.5p final dividend will be paid in May (ex-dividend 23 March 2023). HGT does not follow any explicit dividend policy and the payments depend on its income streams, investment structures and liquidity events. However, HGT can only retain up to 15% of income to qualify for investment trust tax status.

HGT does not deploy structural gearing but has a £350m credit facility in place to optimise balance sheet management (most notably to bridge the gap between investments and realisations) and to help manage foreign exchange risk. The facility expires on 7 October 2024 and was undrawn at end-Q122 (vs £151m drawn at end-FY21). The interest rate on the amount drawn from the facility stands at Libor plus a 3.25% margin and HGT pays a commitment fee on the undrawn part of the facility of 1.15% per year. Hg usually applies leverage at the level of its underlying investments, which is serviced using the underlying investment’s own cash flows.

HGT pays a management fee specific to each of the Hg funds and calculated in respect of either HGT’s commitments to or capital invested alongside the respective Hg fund (see Exhibit 19). HGT’s co-investments alongside Hg funds are exempt from fees. In FY22, total priority profit charged to HGT stood at £27.4m, operating expenses were £7.2m and finance costs amounted to £10.3m, bringing ongoing charges (excluding carried interest) to c 2.2% of average NAV. Other than fees payable for each of the underlying funds, Hg charges a small management fee (flat at £20k a year, paid quarterly) and an administrative fee (0.1% pa, calculated and paid quarterly).

HGT is also charged carried interest of 20% of aggregate profits, subject to a preferred return of 8% capitalised annually. The carried interest charge amounted to £68.9m in FY22, down from £122.5m in FY21.

HGT’s share capital consisted of 457.7m ordinary shares as at end-March 2023. It raised £12.3m via equity tap issuances in H122 when the trust was trading at a premium to NAV (none in H222), compared to £143m raised in FY21. Each year, HGT’s directors renew the authority to buy back up to 14.99% of the issued share capital, at prices below the prevailing NAV per ordinary share. HGT spent £1.4m on share buybacks in FY22. A general authority to allot shares (or to grant rights over shares) up to a maximum nominal amount of £3.8m (representing c 33% of HGT’s ordinary share capital) was also given to directors by the AGM in 2023.

HGT’s board, led by Jim Strang (chair of the board since May 2020), consists of six non-executive directors. We described the background of the directors in our July 2020 note, apart from Pilar Junco, who we described in the March 2021 note. From 1 August 2022, the board was extended to include Dr Erika Schraner, who has 25 years of experience from a number of senior leadership positions in Silicon Valley, the UK and Europe, including Fortune 500 companies and the Big Four accounting firms. She served as a non-executive director (NED) and chair of the audit committee of Aferian until 2022 and is now a NED and chair of the nomination committee at JTC Group, as well as a NED at Bytes Technology, Pod Point Group Holdings and Videndum.