Mercia Asset Management — Huge stride towards an evergreen model

Mercia reported a net asset value of £128.4m (FY19: £126.1m) or 42.3p per share (FY19: 41.6p), representing a small rise of 2% in H120. Direct investment of £11.1m was made into 16 portfolio companies (H119: £9.2m, 11 companies) during the period, including one new direct investment of £0.5m into Clear Review (HR and performance management software). Unrestricted cash and short-term liquidity investments fell to £17.8m (FY19: £29.8), although this will be supplemented by proceeds from the share placing (we estimate c £15m net of the initial cash payment for NVM and net of expenses) assuming the acquisition is approved at the general meeting set for 20 December 2019.

Funds under management (FUM) fell by 5.2% to £361.3m (FY19: £381.0m), partly attributable to the final winding up of the successful RisingStars Growth Fund (lifetime IRR of 15%, total value to paid-in capital (TVPI) of 528%), as well as returns from a mature PE fund (2.4x return, 19% IRR).

Group revenues increased by 5.1% to £5.5m (H119: £5.3m), while net expenses rose to £0.9m (H119: £0.7m), due to investment in a central services platform, internal corporate advisory and the increase in headcount reported at FY19 to manage prior fund mandate wins.

Management also reiterated its intention to achieve a profitable trading position (which the acquisition of the NVM VCT business delivers) and an evergreen balance sheet.

Mercia invests in growing both its pipeline and its existing portfolio companies through four pools of capital under management: balance sheet (NAV of £128m, including £102m portfolio fair value and £18m unrestricted cash), venture (£210m), private equity (£60m) and debt (£91m). In aggregate, the company manages assets under management (AUM) of c £490m, of which third-party FUM, accruing management fees, represent £361m.

Mercia’s direct investment portfolio grew by 16.4% to £102.0m (FY19: £87.7m), with £11.1m of cash invested in 16 companies (H119: £9.2m, 11 companies) and a fair value uplift of £3.2m (H119: £2.6m). Similar to previous reporting periods, Mercia’s top 20 direct investments represented 97.5% of total portfolio value (FY19: 98.4%), with a single new direct investment during the period (Clear Review) and Concepta dropping out of the top 20 holdings.

Notable fair value uplifts since FY19 have included: Voxpopme (£2.0m) – a common holding with NVM; Oxford Genetics (£1.6m); Crowd Reactive (£0.5m); Intechnica (£0.5m); and Soccer Manager (£0.1m), whose prospects improved with an acceleration in revenues following an intervention by Mercia. Holdings that attracted a write-down in value included PsiOxus (£0.3m) and The Native Antigen Company (£0.2m).

Mercia’s major H120 cash investments included:

Exhibit 2 below sets out the latest portfolio analysis.

Alongside, its interim results, Mercia also announced the acquisition of the VCT fund management business from NVM, including the fund management contracts for Northern Venture Trust PLC, Northern 2 PLC VCT and Northern 3 PLC VCT, which together consist of c 60 portfolio companies, including 17 listed companies, 27 private venture companies and 16 private equity companies. The consideration is up to £25m, comprising £16.6m upfront (75/25 cash/equity) and a three-year deferred contingent consideration of £8.4m (75/25 cash/equity) – a two-thirds, one-third split. The acquisition increases Mercia’s total AUM (H120: £490m) by £270m, c 50%, to £760m.

The implied multiples assume a maximum consideration of 3.5x revenue (based on pro forma revenues of £7.2m to March 2019) and 6.25x pro forma EBITDA/net income to March 2019 (£4.0m). The deal is expected to be earnings enhancing in FY21 and will be funded by a £30m institutional placing at 25p per share, a 22% discount to the closing price of 32p on 2 December 2019, conditional on shareholder approval at a general meeting set for 20 December 2019. Funds will be used to meet the initial cash payment for the acquisition (£12.4m), with the remaining c £15m (net of expenses) used to strengthen the balance sheet.

The acquisition of the NVM VCT fund management contracts represents a carve-out of the VCT funds from NVM Private Equity, with a team of nine specialist staff transferring across.

As well as the strategic benefits of the deal (increased scale, an additional investment product, an enhanced team, a portfolio of more mature VCT investee companies), NVM also brings additional revenue (£7.2m, of which £6.3m is recurring revenue) that means the combined business will be profitable before fair value adjustments, realisation gains, amortisation and share based payment charges. This removal of the monthly cash burn is a significant step towards Mercia developing a fully sustainable model, with management targeting an evergreen model by FY22.

Both Mercia and NVM are significant regional investors in UK technology, with some portfolio overlap (eg Voxpopme). As such, Mercia has added a VCT string to its bow and in the process cemented its position as the ‘number one regional provider of capital to SMEs’.

Following two recent block trades, one at the end of October (at 25p) and the other in early November (at 27p), we understand that a substantial part of the overhang over Mercia’s shares has now been resolved. Following the intervention by Link Fund Solutions, BlackRock (now managing the remaining Woodford Investment Management stake) has reduced its stake to c 11% and Invesco has also reduced its holding to c 19.5%.

Under the placing announced in parallel with the NVM VCT acquisition, we estimate these stakes will dilute further, to c 8% and 14%, respectively, assuming neither fund manager participates in the placing to a material extent.

In line with Mercia’s remit as a leading regional provider of supportive balance sheet, venture, private equity and debt capital in transaction sizes typically below £10m, we have broadened Mercia’s valuation peer group to include a range of specialist asset managers, direct private equity and venture capital investors, and reduced the IP commercialisation comparator group as the majority of these are balance sheet-only investors. With the growth of Mercia’s third-party fund management business, we will reconsider the most appropriate comparator universe in future notes.

In Exhibit 5, we include analysis for Mercia as at the end of H120 and then include adjustments for the placing and acquisition to provide a pro forma estimate of Mercia including the acquisition of the NVM VCT fund management contracts, assuming shareholder approval at the general meeting on 20 December 2019.

Post-acquisition, Mercia trades at a 20% discount to the adjusted H120 NAV (see Exhibit 5: adjusted for the placing and acquisition of NMV), below its technology peer group and well below the valuation of other specialist asset managers. In our view, this represents an unwarranted discount given the progress the business has made and the strength of its underlying operating model, and this also ignores the value of the embedded fund management business.

The acquisition of the NVM VCT business is already a transformative deal in that the additional revenue (and profit) that it brings (see Exhibit 3) means that Mercia no longer burns cash on an operational basis. This delivers the first part of management’s three-year strategic plan, to put Mercia on a sustainable footing – and also starts to deliver the scale that management believes will allow it to operate an evergreen model by FY22.

An evergreen model is where annual portfolio realisations are greater than net investment, meaning that Mercia will no longer be dependent on the market for further fund-raising, but will become self-sufficient and fully sustainable. Management believes that the headroom from the latest £30m fund-raising, together with organic growth and anticipated portfolio realisations, should be sufficient to achieve the goal of an evergreen balance sheet without the need for further recourse to the markets.

As set out in Exhibit 1 (even before the acquisition of the NVM VCT business), Mercia is now more of a fund manager with a direct investment arm (an 80/20 business split), than a direct investor with a fund management business.

As Mercia moves towards its goal of an evergreen balance sheet, this further underlines that the NAV-based valuation does not properly reflect the embedded value of Mercia’s growing fund management business, whose fees (post the acquisition of the NVM VCT business) will more than cover the group’s net expenses. Placing these fees (£17.9m) on a relatively conservative 3x EV/sales multiple implies a value of £54m or 12.2p per share (adjusted for the placing and the acquisition of the NVM VCT business) for Mercia’s fund management business (from 10.6p previously).

The 12.2p for the fund management business represents incremental value not captured under the existing NAV valuation methodology. Adjusting the NAV calculation for this embedded value would suggest that Mercia trades at an even deeper discount to fair value (0.59x) than a pure NAV calculation indicates.

In our view, this level of discount does not reflect either the strategic positioning of the portfolio, the probability of material exits in the next 12-18 months, or the strength of Mercia’s underlying operating model.