Is Private Equity — Valuation yet to reflect improving conditions

Is Private Equity (İş Girişim Sermayesi, or ISGSY) is a private equity investor, focusing on the lower/mid-market sized Turkish companies. It was established in 2000 by one of the largest Turkish banks, Turkiye İş Bankasi (or Işbank) as a way to both invest in, and support the development of, Turkish SMEs with high growth potential. ISGSY listed on the Borsa Istanbul in 2004, when shares representing 37.7% of the company were offered in an IPO, and İşbank affiliates still control 57% of the shares, representing a valuable and supportive core shareholder base.

ISGSY focuses on lower/mid-private equity transactions where it faces less competition for deals from the large international private equity firms, which prefer larger transactions. Its first two investments came in 2002, following an initial period of research and fund-raising, and it has now made a total of 17 investments, with an investment volume of US$148.5m since inception. There have been 11 exits to date, realising US$166.9m from total investment in those assets of US$72.5m. The company calculates an IRR from its exits of 26.4% on a dollar basis. At the end of 2017, the fair value of investment in the current six private company holdings was TRY182.6m, with other investments, mainly private sector bonds and fund holdings, of TRY46.4m, and cash of TRY29.4m. The company itself has no debt, although investee companies do have debt.

Small and medium-sized enterprises (SMEs) are the backbone of the Turkish economy, accounting for more than 90% of all enterprises by number, more than 50% of GDP and providing more than three-quarters of all jobs. In a relatively fast developing economy, access to capital is an important issue for these companies and private equity investors, like ISGSY, make an important contribution by providing permanent capital commitments and strategic support. ISGSY aims to help its investee companies expand into new markets and compete, not only in Turkey, but also in international markets where appropriate, and to grow organically or through acquisition. Private equity investment generally has a long-term time horizon as it typically takes from three to seven years for investee companies to implement their strategies, but long-term industry returns, compared with listed equity investment, have generally been attractive.

An investment in ISGSY offers:

The Turkish business environment has been affected by geopolitical tensions over the past three years, including war in neighbouring Syria and Iraq and the failed coup attempt in July 2016. In headline terms, the economy has remained resilient; while GDP growth slowed to 2.9% in 2016 from 4.4% in 2015, it remained above the OECD average of closer to 2%, and rebounded strongly to c 7% in 2017, and most forecasters look for continued strong growth of c 4.0% or more in 2018. The IMF recently increased its forecast from 3.9% in January 2018 to 4.3%.

Growth in the past year was supported by government incentives to stimulate the economy (tax holidays, a business credit guarantee fund), as well as improved exports, responding to the weaker lira and, more recently, falling unemployment and an improvement in domestic consumption. Less helpfully, inflation hit a 14-year high of 13.0% in November 2017 and remains in double digit territory at 10.3% in February 2018. The authorities expect it to remain high through the year, but fall to 7.9% by year-end. As a result, monetary conditions remain tight; the key official interest rate increased to 12.75% in December 2017 and any reduction is likely to require a further moderation in inflation. More importantly than official rates, private banks are charging rates of interest of up to 20%. High rates of cost inflation and high borrowing costs mean that the business environment is more challenging than the headline GDP growth figures may suggest, especially for domestically focused SMEs. However, if inflation moderates as expected there should be room for interest rates to decline, providing welcome relief to corporate borrowers.

Having lost a third of its value versus the US$ in the past three years, the Turkish lira has been showing signs of stability more recently. Losses in the past year are modest and it is stable in 2018 ytd.

Quoted shares have seen a strong performance since the coup attempt and have increased by c 50% in Turkish lira terms since the beginning of 2017, exceeding the c 38% gain in terms of US$.

ISGSY’s strategy is to invest in Turkish SMEs with strong growth prospects and good historical performance, with the potential to become a significant player in their sector, and where possible with some exposure to foreign markets. ISGSY looks for investments with sustainable growth and operational improvement opportunities. When assessing growth prospects, the team targets companies that operate in growth markets and can capture additional market share. All of its investments are equity stakes, although convertible debt or a structured mix of debt and equity are considered. Investments mainly take the form of growth capital and buyouts, but may be project-based restructuring transactions. Other criteria include:

ISGSY is sector agnostic, but focuses on niche sectors with growth potential and structural drivers based on long-term trends, such as data centres and online travel agencies. It tends to take majority stakes in order to establish control, but will co-invest if the size of the required investment is above its preferred range. ISGSY will also consider taking a significant minority stake where a secure exit strategy exists and where it can be certain of having sufficient influence to ensure that any decisions taken in running the investee company are in line with its own plans and strategy.

ISGSY has a team of 10 investment professionals with broad experience in consultancy, strategic planning, corporate finance, operational management, risk management and industry. The team screens c 100 opportunities a year and aims to achieve an IRR of 15-20% in US$ terms over a three- to seven-year investment horizon. If a company passes the initial screening process, a more detailed assessment is carried out, which includes research into the wider sector, competitor analysis and benchmarking, calls with management and to referees, as well as financial and commercial analysis. ISGSY seeks to introduce competitiveness, superior management and reporting processes, and to foster leadership in portfolio companies to bring depth to the management team.

The investment team works up its own deal entry forms and investment proposals on each target company before approving (or not) each proposal internally. Successful proposals are then presented to the investment committee, which may make a recommendation to the board of directors that is responsible for the final decision. After a deal has closed, ISGSY proposes representatives on the investee company’s board and monitors the company until a decision to exit is made and executed. ISGSY, through its board member representation, does not become directly involved in the day-to-day management of its investees, but does seek to determine strategy, will replace senior management if necessary and help create the most suitable capital structure for the company.

As noted above, ISGSY has made 17 investments to date and has exited 11 of these, the last exit being that from Aras Kargo in 2013. We show details of the exited investments in Exhibit 4, with proceeds amounting to US$166.9m from US$72.5m of invested capital, a money multiple of 2.3x. The current investments, discussed in the next section, have a carrying value of TRY182.6m, equivalent to c US$48m.

The six current private equity investments are detailed in Exhibit 6. As we show on page 2, the portfolio is well spread by investee company, and overall has a significant (65%) exposure to consumer services (restaurants, sports goods, tourism).

During 2017 ISGSY made follow-on investments in Toksoz Spor, Ortopro and Nevotek amounting to TRY45.25m/US$12.0m, increasing its ownership in each of the companies (Exhibit 5).

The proceeds of the capital increase at Nevotek are to be used to support its new cloud-based product in the US, aimed at the hospitality sector (Exhibit 5). Ortopro will mainly direct the cash proceeds of its capital increase at a reduction in borrowings. This includes an additional TRY4.75m, which was committed in 2017 and paid in February 2018.

With its permanent capital base, ISGSY is under no time pressure to make exits from its investments in the way that a limited partnership fund may typically be. However, its portfolio is relatively mature, with investments in Nevotek (2003) and Ortopro (2007) in particular dating back some time. Capital recycling is a common feature of private equity, whereby IRRs may be optimised by divesting of mature investments to enable reinvestment in new opportunities. The level of activity in M&A serves as a barometer of the market potential for exits and, despite economic and political challenges in the market, there were signs of an increase in Turkish M&A activity in 2017. The increase in aggregate deal value followed a particularly weak 2016 and overall activity generally remains at a low level by historical standards.

Total deal value is dominated by a small number of large transactions where foreign investors are disproportionately represented. More positive for ISGSY than the increase in total deal value is the further increase in the number of deals, indicating improving liquidity in the SME segment of the market in which it operates. A continuation of the favourable trend would represent a positive backdrop for ISGSY to return to more active capital recycling.

ISGSY reports according to Turkish Accounting Standards (TAS), as per the Turkish Commercial Code, and is IFRS compliant, with financial statements prepared on an historical cost basis, with the exception of investment securities, which are measured at fair value. The investment securities measured at fair value include the private equity investments as well as the liquid asset investments, the bond and investment fund holdings, and a small amount of listed investments. Changes in the fair value of these assets are taken through the profit and loss account, in line with practices in most other countries.

During the year ended 31 December 2017, net asset value increased by TRY0.8m, or 0.3%, to TRY256.9m and NAV per share by a similar amount to TRY3.44. As in the previous year, income from the liquid asset portfolio was sufficient to meet the administrative costs of the company and cover a negative fair value movement in the value of the PE investments. The latter amounted to TRY2.0m or 1.4% of the opening value. The interest rate applicable to ISGSY’s Turkish time deposits ended the year at 15.0% compared with 11.5% a year earlier, while two-year government bond yields were between c 11% and c 13% during the year.

As noted above, during the year, ISGSY invested further in three of the existing assets: Nevotek, Ortopro and Toksoz (see below). The aggregate investment was TRY45.25m, funded by a reduction in the liquid asset investments.

By the end of 2017, private equity investments comprised 71% of total assets, up from 54% a year earlier. The main reductions in liquid assets were from the government bond portfolio as well as in the substantial cash position. Cash and cash equivalents continued to represent 11% of total assets at the 2017 year end, and other liquid investments 18%. ISGSY continues to have considerable flexibility to undertake further long-term investment as it identifies suitable opportunities, although the reduction in liquid assets is likely to have a negative impact on revenues in the current year in the absence of unrealised or realised gains from the PE investments.

There is no company debt (the long-term liability represents provisions for employee benefits), although there is an undisclosed amount of operational debt within the investee companies, and this is reflected in the external valuation of the portfolio carried out by Deloitte.

As in previous years, the PE investments were valued externally by Deloitte using a discounted cash flow and peer comparison methodology. ISGSY publishes the discount rate and growth rate assumptions used for each investee company, and this year the data are presented as a single number, which we have compared with the midpoint of the previously disclosed range. For each company the discount has increased, with an average increase of 2.1% weighted by closing fair value, although the increases vary quite considerably according to the external valuer’s assessment of the appropriate risk premium.

There has been no change to the assumed growth rates, with the exception of a small increase in the rate assumed for Nevotek. The growth rates assumed are in nominal terms and appear relatively low compared with current Turkish inflation, but reflect the external valuer’s assessment of long-term inflation prospects. The Nevotek growth rate assumption continues to be noticeably below that of the other companies because the external valuation is conducted in US$ terms, reflecting Nevotek’s underlying operations.

ISGSY has also provided an updated sensitivity analysis, showing the effect of changes to the assumptions on the value of the investments. An increase of 0.5% in the revenue growth assumption would add TRY6.3m to fair value (TRY4.9m in 2016), an increase of 0.5% in the assumed growth of EBITDA would add TRY10.2m to fair value (previously TRY7.6m) and a 0.5% reduction in the risk rate would add TRY13.4m to fair value (previously TRY8.2m). Changes to the assumptions in the opposite direction are anticipated to have broadly symmetrical impacts.

As noted above, the value of the PE investments increased significantly as a result of new investment, but this was partly offset by a negative fair value adjustment, amounting to TRY2.0m or 1.4% of the opening value of the PE investments.

Although the economic and geopolitical environment remained challenging in 2017, ISGSY reports that the investee companies saw aggregate revenue growth of 35%. Despite higher discount rates being applied across the portfolio, Nevotek and Tatil Budur saw good increases in fair value, but this was offset by the declines at Toksoz and Ortopro.

The accounts of Is Yatirim (ISMEN), which owns 30.5% of ISGY and consolidates it as a subsidiary, do provide some insight into developments. The accounting principles applied by ISMEN not only consolidate ISGSY but also its majority-owned subsidiaries, and equity account for Radore and Tatil Budur. In respect of ISGSY, the 2017 ISMEN accounts (Exhibit 15) show a further increase in gross profits and a slight decline in expenses, with the operating performance improving significantly. This result gives a sense of the trading results of Numnum, Nevotek, Ortopro and Toksoz Spor. The result from associates also improved significantly, a positive indication for Radore and Tatil Budur.

The improving operational result is encouraging, while the increased investment in certain subsidiaries may well see a reduction in net interest expense going forwards.

ISGSY trades at a substantial discount of c 52% to its end-2017 NAV. ISGSY’s dividend policy is to distribute at least 30% of distributable profit as bonus shares and/or cash. Historically, the company has a reputation for paying high dividends, particularly when realising gains from the disposal of investments, but not during 2016 and 2017 (see Exhibit 1 on page 2).

Although there are other quoted private equity companies in Turkey, none is included within the Morningstar database, used by the Association of Investment Companies and our source for comparison of ISGSY with other similar companies. From Morningstar, we can extract data on a small number of closed-ended private equity funds that invest in emerging markets (EM). Unfortunately, that list has become smaller with the transition of East Capital Explorer (previously included in our analysis) to an externally managed real estate investor in the Baltics. Exhibit 16 shows their performance, which is presented in sterling terms for each.

Broadening the comparison to include a larger group of listed PE investment companies, not limited to EM-specific investment, we can see that in the period up to 2013, ISGSY saw its P/NAV ratio reach a relative high, with a peak premium of c 5%. This valuation peak coincided with the realisation of a TRY82.5m profit from the sale of Aras Kargo in July 2013, making the declaration of a substantial TRY0.45 per share special dividend for the year possible (see page 2). The subsequent period of de-rating began with the first Gezi Park protests in Istanbul, which has been followed by a period of significant macroeconomic and geopolitical challenge.

The narrowing of the discount to NAV in the past c 18 months, from a high of c 60% in mid-2016, broadly mirrors that of the wider sector but is supported by the improved domestic political and economic conditions in Turkey since the attempted coup in mid-2016. The gap with the broader group of PE investors has been maintained, with the latter showing stronger gains in NAV TR to support their share price advances. The one-year return for the LPX Direct Index is a little more than 50%.

Further improvements in the Turkish political and economic environment have the potential to both support underlying NAV TR through improved business conditions for investee companies, and narrow the P/NAV ratio, enhancing share price total return.

Although the domestic political environment has become more settled, geopolitical tensions and war in the region continue to represent risk factors beyond the control of management that may have a significant impact on both the business and trading environment of investee companies and the market valuation of Turkish assets.

However, economic conditions have improved materially, which is a positive indication for the performance of the existing asset portfolio, and raises the prospect of exits for some of the mature assets. ISGSY’s balance sheet remains liquid, providing the resources for new investment as opportunities arise.

A lack of visibility to the look-through performance of the underlying (private) assets is a feature of the private equity industry and valuations are inevitably subjective, not being based on traded prices. In this respects, ISGSY can point to a track record of profitable exits and the fact that its portfolio valuations are independently and externally produced.