DeA Capital — Strong H118 investment return and cash flow

DeA Capital is a leader in the Italian AAM sector. It manages assets of around €11.2bn across its integrated AAM platform, comprising private equity, real estate and NPLs, and operates as an investor in its own funds managed and directly from its permanent capital base. The group is majority-owned by De Agostini, a family-owned private group founded in 1901 and owned by the Boroli and Drago families. De Agostini operates in the media, gaming, services and, through DeA Capital, AAM sectors. De Agostini has a 58.3% stake in DeA and, through the loyalty share scheme approved by shareholders in 2015, has a voting interest of 73.4%.

In recent years, DeA’s has been reducing its ‘large ticket’ direct private equity investments and refocusing on supporting the growth of its AAM platform, investing in new capabilities and seeding new fund launches. AAM has good growth prospects as low interest rates continue to stimulate demand for alternative assets (private equity, real assets and hedge funds) from investors seeking sustainable yields. The AAM platform mainly comprises DeA Capital Real Estate, a 64.3%-owned subsidiary that is the leading real estate manager in Italy with AUM of €9.0bn and DeA Capital Alternative Funds, which manages €2.2bn (measured by total commitments) of private equity funds. In addition, 80.0%-owned SPC provides NPL management, and the 45%-owned associate YARD provides property services to the real estate sector, including DeA. Key strategic goals for the AAM business are to further expand the base of investors and the range of products offered and DeA recently announced the creation of DeA Capital Real Estate France, a first step in creating a pan-European real estate platform.

DeA has a strong and liquid balance sheet. Net asset value at 30 June 2018 was €473m, or €1.87 per share, after payment (in May) of €0.12 (c €30m) in dividends. The net assets of the AAM business (30%), investments in private equity and real estate funds (38%), and a significant net financial position (18%), together represent 86% of the NAV. The direct investment portfolio account represents the balance of 14%.

For a detailed analysis of DeA Capital and its strategy, please see our June Outlook note.

The key features of DeA’s results for the six months to 30 June 2018 were the strong disposal gains and cash flows generated by investment realisation, particularly in Q2. NAV increased strongly in Q2 from the Q1 position, adjusted for the €0.12 per share distribution (a yield of more than 9% on the current share price) made in May. The key highlights were:

As can be seen in Exhibit 1, DeA ended H118 with a private equity investment portfolio of €243.3m, to which can be added c €40m of real estate fund co-investments that are held through DeA Capital Real Estate and which form part of the €143.8m invested in the AAM platform. The investments include co-investment in DeA-managed funds as well as direct investments, and are variously accounted for as available for sale assets (AFS) measured at fair value, equity accounted associates and fully consolidated subsidiaries. The development of the fund investments is shown in Exhibit 2, with an aggregate fair value adjustment (DeA share) of €31.9m or 14.6% of the opening value.

A substantial share of the gain was generated within the 47% owned and fully consolidated IDeA Opportunity I, of which DeA’s share of the gain was €26.4m. The driver of this was a binding agreement in May, which completed in July, for the sale of its interest in Corin Orthopaedics Holdings to Pemira for c €66m. The sale value was more than 4x the value at end-FY17.

The direct investments saw a decline in value of c €16m, almost entirely driven by the weakness of Migros and the Turkish Lie (Exhibit 3).

DeA’s financial statements combine recurring external asset management earnings with balance sheet-driven changes in the value of investments. For this reason, we recommend that investors focus on:

Our updated forecasts for the AAM division are shown in Exhibit 4, alongside our last published forecasts.

Since we last published we have adjusted our forecasts to include the change in accounting principles that became effective from 1 January 2018, which sees unrealised changes in the fair value of available for sale investments taken through the income statement rather than to other comprehensive income (until such time as the investment was sold or impaired, when the gain or loss was posted to the income statement) as was previously the case. The majority of DeA’s fund investments are held outside of the AAM division, within the private equity segment, but this is not the case for c €40m invested in DeA Capital Real Estate funds. We continue to assume a ‘normalised’ 4.0% per year growth in value for these funds, of which we would expect the majority to represent the yield on the assets, but now show this within the AAM division rather than group’s other comprehensive income. This change explains the increase in FY19 ‘other income’ and is also present in FY18, but masked by the H118 negative fair value adjustment of €2.0m. The impact on attributable earnings is smaller than implied by the change to other income, as the changes in value include the minority interest in the real estate subsidiary and we deduct the full impact, after tax and minority from adjusted (recurring) earnings.

Despite lower AUM and management fees for the current year, the negative impact is offset in our adjusted earnings forecast by higher associate income (YARD, post-merger), higher income from services (we have increased our assumptions for SPC fees in line with recent experience) and lower tax and minorities (a greater share of the earnings from wholly owned DeA Capital Alternative Funds). We expect the real estate business to recover some of the Q218 weakness in AUM through H218, with growth continuing in FY19, and as a result the reduction in our forecast for FY19 management fees is smaller and more than offset by higher income from services (SPC) and lower assumed expenses.

In addition to assumed investment gains, our adjusted earnings adds back the recurring non-cash purchase price amortisation (PPA) in relation to the intangible value of customer relationships that was recognised on formation of the real estate subsidiary.

We now look for adjusted earnings from AAM of €10.5m in FY18 (was €10.0m) and €10.9m in FY19 (was €10.7m).

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 majority of the investment portfolio that is not captured within the AAM segment. This includes the private equity fund holdings and the direct investments (Kenan Investments/Migros, Crescita/Cellularline and IDeaMI).

Within the private equity fund investments, 47% DeA-owned IDEA Opportunity Fund I (OF1 Fund) is fully consolidated and the IDeA Energy Efficiency and 30.4% DeA-owned Sustainable Development Fund (EESS) is equity accounted. We assume a 7.5% per year ‘normalised’ growth in the carried value of all of the private equity fund investments (whether carried as AFS, consolidated or equity accounted). This approach differs from the way these assets are actually managed, which seeks to maximise IRR, but we believe it to be a useful way to capture at least some of the returns that may be earned. Our forecasts assume no change to the last published value (or income from) the quoted investments, Migros (Kenan Investments), Crescita/Cellularline and IDeaMI, but in our valuation (see below) we do adjust the value of Migros on a mark-to-market basis.

In Exhibit 5, we break down our group forecasts (shown in Exhibit 12) by segment, as reported by the company.

As noted above, positive net cash flow from the investment portfolio since 30 June 2018 will have further increased 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) from the €86.9m (€0.34 per share) or c 18% of NAV reported at that date.

Our forecasts assume H218 investment in the funds (capital calls of commitments) of €15.6m (including the €2.9m to early September) and reimbursements of €50.5m (including the €40.4m to early September), taking the annual net positive balance to €60.8m. Making no assumption of new investment, this takes our forecast for the holding company net financial position to c €120m by year-end, equivalent to €0.47 per share. Again assuming no new investment but allowing for continued distributions of €0.12 per share, although we forecast the net financial balance will decline in FY19, it will remain well above €100m.

Our FY19 cash flow projections assume a positive net balance from the investment portfolio of €20m as shown in Exhibit 7, with the main driver continuing to be the maturation of a number of the older funds. As a further indication of DeA’s balance sheet strength, we estimate that the holding company net financial position at end FY18 and FY19 will be well above the level of undrawn fund commitments.

Overall, our forecasts for the net financial position through 2018 and 2019 should be viewed as illustrative, as they assume no further purchases or sales of direct investments, although these are likely, or strategic investments in the AAM platform. In particular, we would note the potential for a medium-term exit from the remaining Migros investment as the investment vehicle through which the stake is indirectly owned reaches maturity. The carrying value of the remaining Migros investment was €30.1m at end-Q218, but the weakness of the Turkish equity market and currency has reduced this to c €17m more recently.

The most significant change to our group forecasts is the increase in the holding company net financial position and to a lesser extent the increase in forecast NAV per share, both resulting from the significant investment gains realised in H118.

As noted above, in our valuation we mark-to-market the value of DeA’s indirect stake in Migros, held via Kenan Investments, but we do not do so in our year-end NAV forecasts, given market volatility and the inherent uncertainty in doing so. If the Migros share price and TRY/€ exchange rate end the year at current levels, the impact on our forecast NAV per share would be to reduce it by c €0.05.

DeA shares trade at a significant discount of 30% to the H118 published NAV per share of €1.87, and a slightly larger discount of 32% to our adjusted NAV per share of €1.91, which replaces the stated book value of the alternative asset management platform with our assessment of a fair value based on P/E multiples observed across a group of both alternative and more conventional asset management companies listed in Exhibit 9. Even if the shares were to trade at this adjusted NAV, DeA would still be trading at a lower price to book value (P/BV) than any other company in this group, which has a median P/BV of c 2.0x.

We have divided Exhibit 9 into 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 investments, both co-investment in funds managed and direct investment. We have also included a broad range of other private equity, specialist and conventional asset managers, many of whom focus on ‘balance sheet light’ third-party asset management.

Given the mix of strategies, combining widely differing reliance on ‘recurring’ asset management earnings and balance sheet-driven investment earnings, we would not suggest focusing on any particular valuation multiple. Before examining the DeA valuation in more detail, we first explain our adjusted NAV calculation.

Exhibit 10 shows our calculation of adjusted NAV per share (€1.91). The adjustments to stated NAV are:

Our adjusted NAV includes the investment portfolio and other assets and liabilities (overwhelming cash) at the reported NAV (other than for Migros). DeA’s substantial cash balances (18% of NAV and increasing) provide it with considerable financial flexibility to continue the highly attractive level of shareholder distributions (including an active share repurchase programme) while at the same time investing primarily to grow the AAM platform. The unusually low valuation of DeA shares in terms of the discounts to reported and adjusted NAV compared with peers is clear. The near-term downside from the strongly liquid balance sheet is that at current interest rates it acts as a drag on overall returns as can be seen from the NAV total return analysis in Exhibit 11 (the annual change in NAV during the period plus shareholder distributions).

The immediate catalyst to a re-rating of DeA shares is recognition by investors of the low inherent valuation of the company. But more than that, the successful deployment of this excess capital has the potential to lift overall returns and accelerate the growth of the potentially more highly valued AAM platform.