Mercia is very cheap and has a durable growth flywheel

Mercia Asset Management (LON:MERC) takes some digging and thinking to understand as it’s a bit layered. I recommend you do that before buying as not understanding the dynamics of business and how it creates value means you will likely get shaken out inopportunely.

Superb value…but I only care if it comes with a growth engine

They publish annual results Tuesday 5 July and I expect them to show meaningful incremental value creation and in this post I outline why I think it presents superb value and probably excellent long term growth. ‘Growth’ is always more intangible and deferred than ‘value’ but IMO value is never a reason to buy a share in an operating company. Buy Mercia if you agree with what I see as a growth flywheel created through synergy of its two value drivers. More on the growth engine later.

Mercia is two companies folded into one

1) A listed investment vehicle (akin to an investment trust) hold a portfolio of c.20 VC investments and cash. I estimate the year end value (31 March) to be at least £177.4m (£111.4m investments and £66m cash). Note, these numbers are estimates taking into account reported value changes and disposals since interim results for 30 Sept 2021 and things like write downs in underlying holdings or further deployment of cash will change both the portfolio valuation and the amount of cash available to be deployed. Its very likely actual cash is lower by £5m or so due to deployment I haven’t been able to account for but I’m not going to guess that number and will wait to see what is reported (so remember this when I go through some crude value arguments below).

2) An asset management business with approx £850m AUM (my estimate for 31 March year end based on disclosed information) excluding direct VC investments and cash in unlisted early stage UK companies. Looking at past reporting there is an average total fee revenue of approx 2.5%pa (before performance fees) on AUM. That’s high fee income well in excess of what a Jupiter or Impax can charge.

As of market close on 1 July 2022 you get the above for £126.5m.

The value cut

This is a very simplified look at valuation. It contains assumptions by me re FY22 results and dividend payout. These are not wild guesses but parsing publicly available information mainly in RNSs:

Let’s break things down in pure value terms:

• Assuming £66m cash is valued at par the rest of the business is given a value of £60.5m.
• So giving a zero value to asset management you are getting £111.4m of VC investments for £60.5m — that a 46% discount to quoted value (which I believe is marked conservatively and not hype priced like other VCs).
• Alternatively, saying that the VC direct investments are worthless then you are paying £60.5m for VC asset manager with approx £850m AUM that is very long duration, sticky and high fee compared to competitors that manage more liquid assets like public equities. Revenue last year was £23.4m (including performance fees) and this year is likely to be higher. Conservatively, I estimate that excluding performance fees revenue will be around £22m for this past year. IMO £60.5m for that profile of asset management business is pretty muted at 2.6% of AUM or 2.75x revenues.

In addition, Mercia pays a dividend driven from the excess profits of the third party asset management business. Management says they are targeting approx 2% yield. I think that means of plc NAV (which egregiously undervalues asset management) so running yield for fy22 is likely to be approx 3% at 0.9p per share. Actual yield TBD when they report on Tuesday. They may do 0.6p total dividend (so 0.3p year end on top of 0.3p already paid from interim) to deliver a 2% annual dividend and leave more space to raise in future.

However you cut Mercia seems to present compelling value. What could be wrong with the value argument?

Is the price right and my value argument wrong?

There are many negative arguments that could be made and I’d welcome them in the comments. I’m going to focus on the obvious one that is very current: VC assets are getting marketed down as Nasdaq, cryptos, fintech, etc get hammered and that’s even before we have seen tangible economic cycle deterioration (which may or may not be recessionary in various countries). Undoubtedly this is weighing on the sector. Just look at a former high flyer like Molten Ventures in the UK as an example. For its 31 March year end it reports a 937p NAV and, assuming that NAV remains static to 1July you can get that for 407p per share, a 56.5% discount . Simplistically, it’s cheaper than Mercia…or, if you believe that Molten is priced right for the carnage and Mercia is the exact same beast under the surface then Mercia has some price correction still to take on board?…

I think this comparison is erroneous although it might partly explain some of the pricing in Mercia today. Why?

Like Mercia, Molten is a hybrid but with much more of the value of the business weighted towards its portfolio of venture holdings (valued at approx £1.45bn at its year end) so best to consider this bit in isolation in terms of what drives value/share price. Molten invests in much bigger more mature private businesses than Mercia and has a few recent listings too that have gone from private to public (Trustpilot, Cazoo, UiPath). Typically, it invests in ‘club deals’ alongside other venture capital managers and only owns a small slither of any one particular company meaning its influence on company management and valuation is very limited. Portfolio companies tend to go through repeat rounds of funding with each step raising at valuations in excess of prior rounds (down rounds are avoided by the industry like the plague and VC investors would rather see a company struggle on or go under than contribute to a down round!). This combination of factors means that firms like Molten have effectively been a high beta play on US tech valuations and associated trends in things meme-y and ARK-y (eg, ARK are the biggest holders of UiPath at 10.4% of its $10.1bn market cap).

Mercia ain’t a VC clone

The above big boy follow the leader VC game is just about as far away as you can be from the Mercia model. It’s understandable that Mercia may be cursorily benchmarked against such peers but it misses the substance that makes Mercia more durable and better. Of course, it also explains why Mercia didn’t participate in the ‘value creation’ (or market beta) seen by other VCs like Molten during the recent go-go years.

The value creation process for Mercia is much more idiosyncratic and with greater control and influence by them over investee companies. Beyond temporary bouts of mania and potential bounty that may wash over the industry this is a good thing. Mercia tends to be early (often first) investors in a business usually through their asset management business. They are focused on UK regions beyond London and SE England. A company may go through several rounds of investment, commonly led by Mercia, before it has matured sufficiently to be considered for a direct balance sheet investment.

Compared to the London or West Coast US VC investment a Mercia investment company is smaller. Healthcare is a focus with software, technology and industrial innovation also prevalent. Investments are highly unlikely to be in a hot thematic area like crypto or fintech with each choice more idiosyncratic and tangible than VC blue sky. Initial and follow on valuations are more modest meaning portfolio holdings are held at more conservative marks. Mercia investments are in start-up growth ventures so I’m not suggesting it’s a portfolio of discount to book value situations!

Exits are much more likely to be to an industry buyer than to listing on the market. Along with Mercia’s ample liquidity (both on balance sheet and approx £200–250m in the asset management business), conservative valuation marks and exits to industry mean that Mercia value realisation is not a function of market sentiment. They can steer their course to value realisation more independently than the club deal crowd can. Clearly, economic reality can bite and a period of global GDP contraction or disturbances (like sustained very high inflation — something I don’t believe will occur but separate discussion) and impact valuations and exits due to suppression of overall real economy animal spirits. However, it’s important to note this is a very different and less turbulent and disturbed dynamic than what is in front of many of their more well known VC peers.

I’ve heard a few people tout Molten as a value buy recently and they could be correct. They may be very good at what they do but I don’t like how their future hinges very significantly on market sentiment in US high growth tech. I’d dumbly give odds of 50:50 on a rebound over the next couple of years or a decade of pain. Additionally, note that Molten have repeatedly tapped the market for funding for investment since listing with over £100m in each of the last financial years. This mimics their unlisted peers in an environment where people have been keen to shepherd more and more funds into the area.

Anyway, this isn’t a note about a Molten, I’ve just used them to illustrate similarities and differences with Mercia. I believe you should emphasise the differences.

At most a slight trim for direct investments

The above is mainly about placing where value is in Mercia. As a rough value take I think the third party asset management business is attributed no value and that the direct VC investments are held at a discount of around 50% of their last valuation. I don’t believe you should assume that the haircut for direct investments is justified by what you see more broadly in tech and VC land. Mercia portfolio marks are more ‘real world’ sensitive rather than market valuation and sentiment driven. They have not ridden a covid surge valuation process as seen elsewhere in tech/VC. In fact, covid drove them to conservatively mark down a number of their non healthcare related holdings (particularly industrial) and to some extent I’d argue that there is already a protective valuation buffer built into some portfolio holdings as a result.

Nevertheless, if a deep economic malaise takes hold some portfolio companies could struggle and that be reflected in valuations. This is a trim not a haircut. Over the years Mercia have shown a good discipline in terms of exiting from and/or stopping funding to businesses they no longer believe in. If they continue to like a business that’s temporarily struggling they are not embarrassed to support through a down round funding protecting value for their investors.

Flywheel escape velocity to perpetual motion has been reached

Obviously, I know perpetual motion is not possible…I just want to use the exaggeration to illustrate why the thing to focus on at Mercia is its growth engine. If the growth engine is sound then the value will be realised through the power of its output.

Mercia’s third party asset management business in EIS, VCT and other venture funds in regions of the UK invest in a broad selection of very early stage innovative businesses. Historic returns are good but very lumpy as is to be expected. This is typical for VC, a minority of investments make outsized returns and the rest of the portfolio is a mix from meh to bleh with some zeroes in there.

The third party asset management business is the feeder for the balance sheet direct investments where ‘acceleration and scaling capital’ is applied to a selection of companies that Mercia is already deeply knowledgeable about and involved in from at or near inception. This process somewhat fundamentally de-risks the investments that get taken to the balance sheet. A trajectory of something like 5–7 years of further investment and growth is envisioned for these holdings before an exit is found.

IMO this is a significant spoke to a mainly self contained growth and risk management engine. To be very simplistic, tax incentivised EIS and VCT money (plus some other vehicles including from govt backed growth funds) is helping source and de-risk balance sheet investments. This process was weak to start with as it hadn’t aged and matured (lack of supply to top of funnel and so poorer choices, too early or limited scaling ability goes into the funnel).But the longer the flywheel turns the more fine tuned and accretive the funnelling process becomes with greater ability to choose favourable risk-return situations.

I’m not going to detail exits to date here. RNS releases and half yearly reporting provides details. From a flywheel perspective an important subtext and other spoke is the J-curve investment effect. A portfolio of private investments always takes time to develop. Bad investments and write downs are much more likely to appear earlier than the winners prove themselves out, particularly if the portfolio manager is disciplined about capital allocation and doesn’t throw good money after investments that have soured. Mercia have taken some of these early lumps and more recently we are starting to see some good exits. This motor is just getting into gear and with maturity the J-curve should be smoothed. There will still be hiccups along the way particularly following any clustering of successful exits pushing available and deployed capital to a less mature average in terms of companies backed.

A further spoke to the flywheel is operational synergy between third party asset management and the balance sheet investments. Having fees from asset management defrays the cost of running a balance sheet portfolio when compared to a standalone investment trust sort of vehicle. This means trading at NAV and then premium (as market confidence leads it to assume future uplift in portfolio) is not an outrageous fair value assumption. Another important operational synergy is that balance sheet companies have a helluva lot more cash to back prospective growth capital requirements than can be seen purely on plc balance sheet as all the cash sitting in the third party asset management business is available (approx £250m currently to add to c.£60m on balance sheet). This means that short to medium term economic or market stress doesn’t undercut Mercia’s ability to fund their investee companies and a negative internal capital cycle doesn’t kill returns.

The last flywheel spoke is that cash levels on the balance sheet are now high enough to both fund further portfolio investments and acquisitions. Mercia has publicly stated that they would like to grow third party asset management inorganically as well as organically. The acquisition of Northern Ventures in late 2019 has been a success and added value. However, many did not like that they raised capital at a discount to NAV. I think that dilution risk is past now and it’s probable that bolt on acquisitions will be from internal funds increasing the potential to create future value for shareholders.

Conclusion

Great value + a ‘flywheel’ growth engine.

It’s a tricky company to pull together the pieces so it will take time for people to appreciate the value. I guess annual results tomorrow (5 July ) will be good and the outlook stable to positive despite the recent market and economic wobbles. Given lack of understanding and current market sentiment this may not move the price much and there’s always a chance of a let down particularly if they write down any investments. However, I think the risk-reward of entering now is superb and I have a pretty full position.

Warning: My analysis contains estimates and may be erroneous. Do you your own work before investing.