Mercia Asset Management — Sustainable model remains undervalued

AUM remained fairly flat at £948m in H122 (FY21: £940m), although still up 9% y-o-y (H121: £872m). However, this does not take account of distributions to investors in Mercia’s various funds, which totalled £39m in the period (H121: £4m) from nine successful exits. Third-party FUM were also largely unchanged in H122 at £762m (FY21: £764m), although up 6% y-o-y, with £38m of the overall £39m of investor distributions falling to third-party fund investors. Although these distributions do not flatter Mercia’s top line, they will be well received by investors and clearly strong returns are likely to encourage investors to consider investing further funds through Mercia.

Of FUM, 83% of funds are committed to various stages of venture (EIS, VCT, VC and proprietary capital) (Exhibit 1), with private equity (6%) and debt (11%) the remainder.

In June 2021, Mercia received a further £5m from the British Business Bank for the Midlands Engine early-stage proof of concept fund, together, post period-end, with £26m for the Northern Powerhouse activities (£15m equity, £11 debt). Exhibit 2 provides a further breakdown of Mercia’s funds, highlighting the investment criteria that apply to each asset class, the relative breadth of the portfolios and showing total liquidity across the group of c £284m.

Excluding the impact of performance fees (H122: £2.6m gross, £1.6m net, H121: nil), group revenues increased 21% in H122 to £10.1m (H121: £8.4m). In total, 96% of revenues came from fund management fees, with 88% of revenues contracted and recurring. Administrative expenses (excluding performance fees) increased by 9% to £8.0m (H121: £7.3m), despite headcount growth of c 17% to 106 people since the first lockdown in March 2020, meaning revenues more than covered central costs in the period. With further recruitment, administrative costs are expected to accelerate in H222.

PAT rose by 35% to £11.2m in H122 (H121: £8.2m), including the net performance fees, with EPS also increasing by 35% to 2.53p (H121: 1.87p). This strong performance left the group with cash and short-term liquidity investments of £52m (FY21: £55m), part of which we expect to be deployed towards M&A in 2022.

Following the strong first-half performance, confidence in the sustainability of Mercia's hybrid investment model, together with the group’s good liquidity position, has enabled the board to declare a tripling of the interim dividend to 0.3p per share (H121: 0.1p). Assuming a more conservative uplift in the final dividend for FY22 than was seen in FY21, we estimate that Mercia might offer a prospective FY22 dividend yield of c 2% as part of a progressive dividend policy.

Net assets rose 6% during the period to £186.4m (FY21: £176.0m), with unrestricted cash and short-term liquidity investments of £52.1m (FY21: £54.7m) and total liquidity across the group of c £284m. Hard NAV (portfolio fair value plus net cash) rose by 8%% to £162.4m in H122 (36.9p per share) from £150.9m (34.3p per share) in FY21 and net assets per share rose by 6% to 42.4p (FY21: 40.0p) over the period.

The value of Mercia’s direct investment portfolio at H122 period-end rose to £110m, an increase of 15% over FY21 (£96m), with Mercia investing £5.4m (net) into five portfolio companies (Faradion, Medherant, Locate Bio, VirTrade and Eyoto) (H121: £10.9m net, 14 portfolio companies), together with net fair value gains during the period of £8.7m (H121: £6.7m).

As can be seen in Exhibit 4, the group has a balanced portfolio spread across four sectors: life sciences, software, deep tech and digital entertainment. As well as 23 existing direct investments at period end, management has identified a further 12 companies in Mercia’s ‘shadow portfolio’ (following post period-end investments in Forensic Analytics and Pimberly) from the broader fund portfolio, that Mercia is tracking closely and may become future direct investments. Management anticipates a maximum portfolio size of c 30 investments.

We have interviewed the two games company CEOs in Mercia’s top 10 holdings, nDreams and Soccer Manager (Exhibits 5 and 6), to get more insight into their businesses, discussing the impact of lockdown and the metaverse to try to understand where these businesses might be headed next.

In line with previous reporting periods, Mercia’s top 20 direct investments represented 98% of total portfolio value at 30 September 2021, with the top 10 representing 81% of total portfolio value. Mercia weights its efforts accordingly.

Management reported commercial progress has continued to be made by the majority of the direct investment portfolio including each of the top five direct investments, with in-bound interest noted on the analyst call in each of the top three holdings. Eight direct holdings saw a fair value upgrade in H122, with one valuation reduced as its publicly traded share price fell, as well as full provision made for a smaller holding at period-end.

Of the top 10 portfolio companies within the direct investment portfolio, driven by significant commercial progress, Faradion (sodium-ion batteries) saw the largest rise in valuation (£5.8m), along with Intechnica (SaaS technical services, £2.8m); Soccer Manager (mobile football management game, £1.0m) also made progress. At the other end of the spectrum, the publicly traded share price of MyHealthChecked (COVID-19 travel tests, £2.4m write-down) has remained under pressure and LM Technologies was fully provisioned (a key enabler of the internet of things with its products assembled in China, £0.3m write-down).

The value of Mercia’s top 10 holdings increased by 19% over the six months since 31 March 2021. There were no exits from the direct portfolio during H122.

Management has set out its strategic goals for 2022–24 in its Mercia 20:20 vision, including average annual growth in AUM of 20% over the period (closing AUM of £1.6bn by FY24) and average PBT of £20m per year, or total PBT of £60m over the three-year period.

Growth in AUM will be driven by returns from investment into new and existing direct holdings which are intended to contribute to the £60m of PBT targeted between FY22-24, as well as growth in FUM. Management intends to increase the size of its equity holdings, taking direct investment stakes of at least 10% in a diversified portfolio of up to 30 companies (versus 23 at 30 September 2021). The group also intends to grow FUM organically, including providing seed funding for the launch of new funds, as well as through M&A.

If Mercia can achieve these strategic objectives, we anticipate it would likely lead to further substantial share price gains over the next three years.

Mercia has delivered a direct investment portfolio IRR of 14% from its IPO in 2014 to 30 September 2021, as well as annual growth in NAV per share of over 24% over the last two years, following completion of the acquisition of the Northern VCT fund management business.

Since their acquisition, the Northern VCT funds have raised £38m of new capital to 30 September 2021 (with a further £40m fund raise targeted), have delivered 13 exits and eight cross-referred investments, together with £6.1m of performance fees paid to Mercia (including £2.6m of gross performance fees received in H122).

With a cash-generative model and £52m of unrestricted net cash on the balance sheet as at 30 September 2021, 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 (and Enterprise Ventures Group in 2016), we believe Mercia has the means and the rationale to target further M&A in 2022, without recourse to the markets.

As a specialist fund manager, Mercia’s financial performance centres around 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 results. Mercia is unusual in that its fee income more than covers central costs, meaning it can point to a growing stream of both post-tax profits and dividends.

Sector valuations have fallen recently with renewed concerns over rising interest rates, high technology valuations and growing unease over the Omicron variant of COVID-19. However, in a more challenged investment scenario, Mercia’s model has identifiable downside protection, with its broad regional footprint offering an investment portfolio diversified both across asset class and sector, and a model that is both sustainably profitable and dividend generating.

Mercia trades on an H122 NAV of 0.87x, before considering the incremental value of the third-party funds business (we estimate an additional 7p per share at 4% of FUM), towards the bottom of our field of direct investment peers, which largely trade between 0.8x and 1.2x NAV. However, when we look at specialist asset managers such as Gresham House and Intermediate Capital Group, these trade at multiples of NAV as their valuation is increasingly referenced to earnings multiples. Mercia trades on a P/E of 7.3x annualised H122 EPS (vs average FY21/22 P/E multiples for Gresham House and ICG of 19x and 18x, respectively). After the trebling of its interim dividend, we estimate that Mercia might offer a prospective FY22 dividend yield of c 2%, assuming a more conservative uplift in the final dividend for FY22 than in FY21.

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

Thanks to the fees it charges on its third-party managed funds (c 2% of AUM), of which c 88% are contracted and recurring, Mercia is structurally profitable and dividend generating. An NAV-based valuation fails to capture the incremental value of this fund management business within Mercia, which represents 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 (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 £762m, this implies a valuation for the funds business of c £30m, or 7p per share on top of the H122 NAV of 42.4p per share, implying a hybrid valuation of 49.4p per share.