Mercia Asset Management — A safe haven for investors awaiting the upturn

Mercia is a specialist asset manager with a stated intent to become the leading regional provider of supportive balance sheet, venture, private equity and debt capital in transaction sizes typically below £10m. Mercia tends to invest in businesses with relatively modest capital needs, up to c £20m in total across multiple funding rounds. The upside of targeting regional markets is that competition for investments is lower and these markets tend to be less exposed to the extreme valuation swings (as we are experiencing) in mainstream markets through the economic cycle.

Mercia provides growth capital to private companies in the UK’s regions. It offers a blended investment model, with net fee income from its third-party managed funds (valued at a percentage of funds under management) allowing it to commit to a progressive dividend policy, while its maturing portfolio of direct balance sheet investments (valued relative to net asset value) now offers an evergreen balance sheet where future investments are covered by net portfolio realisations.

At its simplest, net fee income covers operational costs, while realisations from the balance sheet direct portfolio offer the opportunity for super-returns. We do not believe the market adequately recognises the value of Mercia’s risk-balanced strategy, nor does it appear to assign full value for the fund management business.

In 2021, management set out its strategic goals for FY22–24 in Vision 20:20, including average annual growth in AUM of 20% over the period (with a target for AUM to reach £1.5bn 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 on direct balance sheet holdings, as well as growth in third-party funds under management (FUM). Returns from the direct investment portfolio will also contribute to the £60m of combined PBT targeted in FY22–24, of which it has achieved 46% in the first year of the strategy. With the greater cash resources available following recent exits, management intends to increase the size of its average equity holdings, taking direct investment stakes of at least 10% in a diversified portfolio of up to 30 companies (versus 20 at 31 March 2022). 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 lead to further substantial share price gains in the period up to FY24.

Valuations for the direct investor sector have fallen significantly over the last six months, with concerns over rising interest rates, high technology valuations, inflation and the war in Ukraine. This has caused discounts to NAV in the sector to widen materially (now 0.43–0.86x historical NAV). However, in a more challenged investment scenario, Mercia’s model has identifiable downside protection, with its broad regional footprint aligned with the government’s levelling-up agenda, offering an investment portfolio diversified across both asset class and sector, and a model that is sustainably profitable and dividend generating. UK regional investment multiples remain far more subdued than investments in more competitive, global markets and Mercia has the cash to support its portfolio, as well as to take advantage of lower investment pricing. Finally, Mercia’s balance sheet portfolio has a relative lack of public market exposure, with only around 1% of its direct investments (by value) quoted.

Mercia reported a 2% rise in AUM to £959m in FY22 (FY21: £940m), a resilient performance considering that distributions to investors came to £90m and given the market falls seen in 2022. Third-party FUM fell by 1% to £758m in FY22 (FY21: £764m), with £87m of the distributions noted above again a key factor. Net assets for FY22 were £201m (FY21: £176m), with unrestricted cash and liquid investments of £61m (FY21: £55m) and NAV per share growing by 14% to 45.6p (FY20: 40.0p). Hard NAV (portfolio fair value plus net cash) rose by 20% to £181m for H122 (41.1p per share) from £151m (34.3p per share) for FY21.

Mercia’s NAV per share track record was interrupted by the acquisition of the Northern VCT fund management business in December 2019, when the company placed shares at a discount to NAV to part fund the acquisition. However, Mercia has delivered a direct investment portfolio IRR of 15% from its IPO in 2014 to 31 March 2022, as well as annual growth in NAV per share of 19% over the last two years (FY20–22). Mercia’s Vision 20:20 strategy targets FY24 closing AUM of £1.5bn, implying a CAGR of 25% in FY23–24. Mercia trades on an historical FY22 P/E multiple of 5x.

With £61m of unrestricted cash on the balance sheet as at 31 March 2022 and a cash-generative model, management has indicated that 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 for £25m (£270m FUM, 6.3x PBT) and Enterprise Ventures Group in 2016 for £11m (£200m FUM, 7.9x PBT), we believe Mercia has the means and the rationale to target further M&A opportunistically, without recourse to the markets. Acquisitions are expected to be earnings enhancing, targeting businesses with similar fee structures that will increase UK market FUM and therefore recurring fee income.

Management has carried out the majority of the work of scaling a regional investment franchise, having built a sustainably profitable, cash-generative specialist asset manager. This model delivers high levels of contracted recurring revenue (87% of FY22 fee income) that fully offset central costs, as well as seeding the market to provide a filtered pipeline of opportunities for Mercia’s direct investment portfolio. For these reasons, we believe Mercia offers investors an attractive balance of risk and reward as a cash-generative business, with increasing upside from portfolio realisations (eight cash exits to date) and a proven, mature business model.

Mercia has successfully built a broad-based and resilient business, deploying capital into private companies based on a UK regional footprint. As a people-based business, the company remains reliant on its senior investment team, the team’s network and its market reputation to attract the best businesses in which to invest. The direct investment portfolio relies on Mercia’s managed funds as an effective sourcing network. As the direct portfolio builds in scale and maturity, the company will need to ensure efficient recycling of capital to deliver its evergreen funding model. Realisations depend critically on the state of the market, the valuations of quoted peers and investor appetite to continue to fund high-growth companies.

Mercia trades on 0.65x its FY22 NAV/share (45.6p), placing it towards the middle of its direct investment peers, which trade between 0.43x and 0.86x NAV. This is before considering the incremental value of Mercia’s third-party funds business, which we estimate adds an additional 7p per share at 4% of FUM. Mercia trades on a P/E of 5x FY22 EPS (versus consensus FY22 P/E multiples for Gresham House and Intermediate Capital Group (ICG) of 16x and 12x, respectively), as well as offering a 2.7% historical dividend yield. Mercia has substantial cash reserves (FY22: £61.3m) to support its portfolio as well as for further M&A, to drive growth in FUM and fee income through acquisitions. We believe these characteristics (broad regional footprint, profitable model with high recurring revenue, ability to scale through M&A) make Mercia an attractive investment for investors positioning ahead of the upturn.

Mercia is a specialist asset manager with a stated intent to become the leading regional provider of supportive balance sheet, venture, private equity and debt capital in transaction sizes typically below £10m. It targets businesses in its regional markets (in England, the North, North East, North West, Midlands and Scotland) with relatively modest capital needs, generally up to c £20m in total, across multiple rounds.

Mercia’s diversified investment model means it can offer the right type of capital for high-growth businesses at different stages of maturity. It also offers investment options, whether for private investors interested in tax-efficient saving via Mercia’s enterprise investment scheme (EIS) or Northern VCT (venture capital trust) funds, or institutional investors seeking investment in long-term debt, private equity or VC (venture capital) funds. Any investor can also become a shareholder in Mercia Asset Management PLC, allowing multiple channels to invest in the group.

Mercia’s investment model is to target appropriately priced regional businesses seeking modest capital, in part, to protect Mercia from major cyclical price corrections. The group offers a spectrum of capital including, SEIS, EIS, VCT, VC, private equity and debt funding.

Mercia invests from four pools of owned or managed capital (Exhibit 2):

Venture, including the NVM VCT fund management business, EIS and proprietary capital, represents the substantial majority (FY22: 62%) of group AUM. Proprietary capital, including direct investment portfolio (later-stage venture) and balance sheet cash makes up a further 21% of assets, taking the total venture allocation to 83% of AUM. This leaves private equity (5%) and debt (12%) representing the remaining minority.

In FY22, AUM rose 2% to £959m (FY21: £940m), a resilient performance considering total distributions of £90m in the year, as well as the market falls seen in 2022. Third-party FUM fell by 1% to £758m in FY22 (FY21: £764m), including distributions to outside investors of £87m.

Mercia has set itself a target of being one of the leading regional providers of supportive balance sheet, VC, private equity and debt capital in transaction sizes typically below £10m in its targeted regional markets (in England, the North, North East, North West, Midlands and Scotland). Research from Beauhurst (The Deal 2021) shows that Mercia was, once again, one of the most active VC investors nationally in 2021 (as it was in 2020). Ahead of Mercia in Beauhurst’s 2021 rankings (Exhibit 4) are three crowdfunding companies, two government funds and one angel network.

Mercia’s third-party fund business is critical to the group’s overall success as its direct balance sheet investments are all sourced through its third-party fund investments. Mercia’s strategy allows management to identify the best opportunities from the regions to bring to its balance sheet.

Historically, Mercia has been closely associated with IP commercialisation, using its university links and partnerships to attract and qualify deal flow. Through its 19 ongoing university partnerships, IP commercialisation remains an integral element of Mercia’s overall investment proposition. However, this categorisation no longer reflects the growth of the business nor the diversity of its deal sourcing. Today the IP commercialisation channel represents only one of five principal sources of deal flow, the others being direct sourcing from Mercia’s own network, client referrals, adviser referrals and investee company cross-referrals.

The value of Mercia’s direct investment portfolio at FY22 year-end rose to £120m, a 24% increase year-on-year (FY21: £96m), with Mercia making gross investments of £18.4m (£8.5m net investment) into 15 portfolio companies (FY21: £4.9m net realisation, 18 portfolio companies). In line with previous reporting periods, Mercia’s top 20 direct investments represented 99% of total portfolio value at 31 March 2022, with the top 10 representing 81% of total portfolio value. Mercia weights its efforts accordingly, with £11.1m of the £18.4m total investment committed across the top 10 assets.

The group divides its portfolio into four principal sectors:

The direct investment portfolio is balanced across these four sectors.

Current focus areas for Mercia’s investment team include digital health, business efficiency, energy transition and enabling technology.

Although half the top 20 holdings recognised increases in fair value in FY22, the sale of Faradion and an up-round for nDreams were the two major highlights (Exhibit 7). The value of Mercia’s top 10 holdings increased by 28% over FY22.

In January 2022, Mercia announced the sale of its second largest holding, Faradion (a leading sodium-ion battery technology company), for £100m to Reliance New Energy Solar, a subsidiary of India’s Reliance Industries. Mercia received total cash proceeds of £19.4m from the sale, an uplift of approximately 50% over Faradion’s carrying value of £12.9m at 30 September 2021. The sale delivered a 4.2x return on Mercia's direct investment cost of £4.4m and an internal rate of return (IRR) of c 72%.

Mercia’s largest direct investment, nDreams, a VR games developer and publisher, completed a £20.0m third-party funding round with Aonic (aonic.co) a Stockholm-based video games investor (Mercia invested £1.3m in a prior round during the year). At year-end, Mercia held a 33.2% stake in nDreams valued at £25.8m, a rise of £6.7m from its FY21 carrying value.

At the other end of the spectrum, the publicly traded share price of MyHealthChecked (COVID-19 travel tests, £2.9m write-down) remained under pressure, although its financial results have remained positive.

Further details on Mercia’s top 10 direct holdings can be found in the appendix.

Mercia made two new investments during the year, taking its total portfolio to 23 companies. These investments were a £1.8m direct investment into Forensic Analytics, alongside a £2.7m investment by the Northern VCTs. In November 2021, Mercia's third-party managed fund portfolio company, Pimberly, completed a £4.3m funding round to expand into the US market and accelerate its growth in the UK, with Mercia investing £1.4m from its balance sheet.

Mercia’s ‘shadow portfolio’ comprises companies from the group’s broader, third-party managed fund portfolio, which Mercia is tracking closely and which may become future direct investments.

Within Mercia’s shadow portfolio are Axis Spine Technologies (next-generation spinal implants for anterior lumbar fixation), Nova Pangaea Technologies (uses steam to convert biomass waste into fuel and chemical precursors), Uniphy, a business developing smart surface technology aimed at the human/machine interface, Mindtech, a platform that offers a novel approach to training artificial intelligence to recognise visual images, Tribosonics (smart sensing technology for industrial use) and Dxcover, a cancer diagnostics company aiming to be a world leader in liquid biopsy and artificial intelligence for early detection of cancer and other diseases.

Management expects a number of companies to move from the shadow portfolio to the direct portfolio over the course of FY23, as the group grows its portfolio to c 30 investments.

Mercia has a growing track record of successful exits, having received approximately £70m to date from eight full cash exits since its 2014 IPO, three of which were from its software and e-commerce portfolio, with four from life sciences investments and one company from the EMME portfolio. Mercia’s latest profitable exits have included Faradion (January 2022, £9.9m gain, 4x return, 72% IRR), Oxgene (March 2021, £18.0m gain, 5x return, 51% IRR), Clear Review (October 2020, £1.0m in cash, 2x return, 72% IRR) and Native Antigen Company (July 2020, £2.5m gain, 8x return, 65% IRR). IRR and RoI figures for earlier exits are not available.

Mercia follows the International Private Equity and Venture Capital Valuation (IPEV) Guidelines, which set out best practice where private investments are reported at ‘fair value’. As can be seen from Exhibit 10, more than half of the FY22 portfolio value was based on the price of the latest investment round, with 5% held at cost and 10% at impaired valuations. Mercia’s balance sheet portfolio has a relative lack of public market exposure, with only around 1% of its direct investments (by value) quoted.

The remaining 32% of valuations use calibrated valuation approaches, including a discounted cash flow (DCF), but with a ‘hand-on-the-heart’ final review meaning that management believes a reasonable change in estimate would not result in a material change in the value of an investment.

The price of the latest funding round is still the most relevant technique to measure fair value for early-stage investments. However, the group also takes into consideration time elapsed since the investment round, the company’s performance and external market factors to help inform its judgements.

Mercia applies the price of a recent investment for up to six months after the last funding round, subject to there being no material change in the investee company's prospects. Beyond six months, Mercia seeks assurance that the investee company is progressing against its development milestones. After 18 months from the last funding round, Mercia looks to a calibrated valuation using a DCF methodology.

Management is committed to evolving its responsible investment agenda, guided by the UN’s Principles for Responsible Investment, recognising that environmental, social and governance (ESG) awareness is associated with better business performance. Mercia’s history of making a positive impact in the regions (both in terms of investment and employment) reflects its core corporate values as well as its motivation to enhance financial returns.

Over the last 12 months:

Mercia reported record gross performance fees in FY22 of £2.6m (FY21: £4.2m) and net performance fees of £1.6m (FY21: £3.8m), based on the continuing strong market conditions seen in 2021. Excluding these performance fees, group revenues increased 7% to £20.6m (FY21: £19.2m), with 95% of revenues (FY21: 96%) coming from its fund management activities and 87% (FY21: 88%) of revenues contracted and recurring. Fund management fees represented 2.7% of closing FY22 FUM (FY21: 2.5%).

Administrative expenses (adjusted for performance fees) increased by 5% to £16.6m (FY21: £15.9m), more than covered by Mercia’s recurring management fees for a second successive year. Adjusted operating profit more than doubled to £8.4m (FY21: £3.3m), mainly due to net finance income soaring to £4.4m in FY22 (FY21: £0.05m), partly as a result of the disposal of Mercia’s stake in Faradion, which crystallised convertible loan interest and provided a redemption premium. For the record, adjusted operating profit is defined as operating profit before performance fees net of variable compensation, realised gains on disposal of investments, fair value movements in investments, share-based payments charge, depreciation, amortisation of intangible assets, movement in fair value of deferred consideration and exceptional items. It includes net finance income.

Research carried out by Marco Bigelli and Fabio Manuzzi (The valuation of asset management firms, 2019) found that the average value of asset management firms was 3% of assets under management (AUM) based on average annual fees of 1% of AUM, with higher valuations significantly positively correlated to higher fee percentages.

As set out above, Mercia’s average fees of 2.7% of FUM in FY22 are materially above the benchmark. On this basis, we would propose to reflect the value of the group’s fee-earning funds business at 4% of FUM. With FUM of £758m, this implies a valuation for the funds business of £30m, or 7p per share, on top of the FY22 NAV of 45.6p.

On an IFRS basis and against a very tough comparator in FY21, FY22 operating profit fell by 32% to £22.9m (FY21: £34.0m), with PBT of £27.4m (FY21: £34.0m) and PAT falling to £26.1m (FY21: £34.5m). This was despite FY22 gains on disposal of £9.9m (from Faradion), which were still lower than the £20.3m of gains in FY21 (from Oxgene, Native Antigen Company and Clear Review).

FY22 was the first year that Mercia paid meaningful tax (4.6%), as historical tax losses have now largely been used up, although a potential deferred tax asset of £4.4m (FY21: £5.7m) for cumulative unrelieved management expenses and other tax losses has not been recognised in the FY22 accounts as its future use is uncertain. The majority of the FY22 tax charge relates to an allowance for the increase in corporation tax from 19% to 25% from 1 April 2023, with the group's deferred tax liability calculated at a rate of 25% at 31 March 2022 (from 19% previously). However, despite the impending increase in corporate tax rate and paucity of remaining tax losses, gains on disposal by a company like Mercia are often exempt from corporation tax as they are sheltered by the substantial shareholding exemption.

In FY22, the group held cash and short-term liquidity investments of £61m (FY21: £55m). Mercia’s record balance of cash and liquid investments represents 28% of FY22 total assets (Exhibit 3), offering a significant buffer to support the existing portfolio, make new investments as well as for potential future M&A.

As part of a progressive dividend policy, Mercia declared a final dividend of 0.5p (FY21: 0.3p), taking the total dividend for FY22 to 0.8p (FY21: 0.4p). At the current share price, Mercia’s shares offer a yield of 2.7%.

FY22 net assets rose by 14% y-o-y to £200.6m (FY21: £176.0m), with unrestricted cash and short-term liquidity investments of £61.3m (FY21: £54.7m) and total liquidity across the group of c £297m. Hard NAV (portfolio fair value plus net cash) rose by 20% to £180.8m in FY22 (41.1p per share) from £150.9m (34.3p per share) in FY21, rising at a 24% CAGR in FY20–22. Net assets per share rose by 14% to 45.6p (FY21: 40.0p), with a two-year CAGR of 19% in FY20–22.

As a specialist fund manager, Mercia’s financial performance centres around realised gains, 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 result. Mercia is unusual in that its fee income more than covers central costs, meaning that it can point to a growing stream of post-tax profits and sustain a progressive dividend policy.

Valuations for the direct investor sector have fallen significantly over the last six months, with concerns over rising interest rates, high technology valuations, inflation and the war in Ukraine. However, in a more challenged investment scenario, Mercia’s model has identifiable downside protection, with its broad regional footprint aligned with the government’s levelling-up agenda, offering an investment portfolio diversified across both asset class and sector, and a model that is sustainably profitable and dividend generating. Mercia’s balance sheet portfolio also has a relative lack of public market exposure, with only around 1% of its direct investments (by value) quoted.

Mercia trades on 0.65x its FY22 NAV/share (45.6p), placing it towards the middle of our field of direct investment peers, which trade between 0.43x and 0.83x NAV. This is before considering the incremental value of the third-party funds business, which we estimate adds an additional 7p per share at 4% of FUM. However, when we look at forward multiples (which take into account the full extent of recent market turbulence) for specialist asset managers such as Gresham House (with no material balance sheet investments) and ICG, trading at consensus FY22 P/E multiples of 16x and 12x, respectively, we can see there is plenty of upside potential ahead as FUM scale. Mercia trades on a P/E of 5x FY22 EPS and offers a 2.7% historical dividend yield.

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

Thanks to the fees it charges on its third-party managed funds (2.7% of FUM), of which c 87% were contracted and recurring in FY22, Mercia is structurally profitable and can sustain a progressive dividend policy. A NAV-based valuation fails to capture the incremental value of this fund management business, 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 (at what we believe is a conservative valuation considering Mercia’s attractive fee margins) on top of the NAV-based valuation of its direct investment business. Given the last reported FUM was £758m, this delivers a valuation for the funds business of c £30m, or 7p per share on top of the FY22 NAV of 45.6p per share, implying a hybrid valuation of 52.5p per share.

A summary of the principal risk factors relating to Mercia is set out below: