HgCapital Trust — Improving its commitment coverage ratio

HGT posted a 5.4% NAV TR in FY22 (with its end-2022 NAV per share reaching 456.6p), which may be considered a satisfactory result given the tough market environment last year (HGT’s pro forma NAV per share as at 28 February 2023 was 450.9p, adjusted for foreign exchange). This has brought HGT’s five- and 10-year NAV TR to 21.0% and 16.8% pa, respectively, which is significantly above the UK All-Share Index at 2.9% and 6.5% pa, respectively, and MSCI World Small Cap Index at 6.4% and 12.0% pa, respectively, see Exhibit 1.

While HGT’s one-year NAV TR of 5.4% is somewhat below the peer average (affected by the contraction in tech multiples throughout 2022), its three-, five- and 10-year NAV TRs remains well above the peer averages. Its 10-year NAV TR of 16.8% pa compares with the peer average of 15.1% pa and is the second-highest in the peer group (only below HVPE, which has a meaningful share of higher-risk venture capital and growth investments).

HGT’s FY22 NAV TR was driven by earnings momentum across HGT’s portfolio and exits at significant uplifts to previous carrying values. Revenue and EBITDA growth across HGT’s top 20 investments (making up 77% of portfolio value at end-2022) were 30% and 25% in 2022, respectively, resulting in a £566.1m positive contribution from trading to HGT’s unrealised portfolio gains, further assisted by £89.1m in foreign exchange gains (see Exhibit 4). The average EBITDA margin across HGT’s portfolio declined to 29% from 35% in 2021, which may potentially indicate some pressure on margins but could also stem from a different portfolio composition following new investments and realisations in 2022. While volume growth has historically been the main contributor to top-line growth, Hg noted that the full-year recognition of price increases implemented in 2022 mean that the latter will have a somewhat greater contribution this year compared to the past.

The positive contributions from earnings and foreign exchange were partially offset by the impact of lower peer multiples (£185.8m), with management highlighting during the analyst call that the like-for-like contraction in average EV/EBITDA multiple from the end-2021 level of 27.4x to end-September 2022 was c 2.5x (ie around 10%).

If we consider HGT as a tech conglomerate, we can estimate an EV/EBITDA multiple applied to HGT as a whole (ie fund level + portfolio), based on: the aggregate EBITDA attributable to HGT’s holdings; ongoing charges at HGT’s level; carried interest accrued to date; cash and other items at the HGT level; and the premium or discount to NAV at which HGT’s shares are currently traded. The average last 12 months (LTM) EV/EBITDA for HGT’s top 20 investments at end-2022 was 27.2x. If we extrapolate this multiple to the entire portfolio and account for the above-mentioned items at the HGT level, we arrive at an LTM EV/EBITDA of 21.0x. This represents a 16% premium to the average FY22 EV/EBITDA of 18.1x for selected listed European tech companies, such as SAP or Dassault Systemes (weighted by FY22 EBITDA; see Exhibit 5). However, we consider these listed European tech companies only a broad reference point given the differences in business profile and growth potential of HGT’s portfolio companies versus these listed peers. Based on current Refinitiv consensus estimates, these peers are expected to grow their EBITDA by 10% and 15% in FY23 and FY24, respectively.

HGT’s carrying values were reduced by an increase in net debt across the portfolio (£260.0m valuation impact), with average net debt to LTM EBITDA of the top 20 holdings at 8.0x (vs 7.1x at end-2021). Management noted that 80% of portfolio company debt (most of which is euro-denominated) is subject to interest rate hedges, normally with a duration of over two to three years. We also understand that Hg remains confident in the capacity of HGT’s portfolio companies to further pursue add-on acquisitions, given the sizeable equity cushion expressed as net debt to enterprise value, as well as some business disposals carried out last year (eg by Visma).

HGT recorded realised gains of £45.6m in FY22. The company completed three full exits in 2022 at an average 28% average uplift to end-2021 carrying values, realising a healthy 3.9x multiple of invested capital (MOIC). Firstly, HGT agreed the sale of Medifox Dan (a provider of digital solutions for the German care and therapy sectors) in June 2022 at a 47% uplift to end-2021 carrying value, with realisation proceeds of £48m. Secondly, the sale of Itm8 (a supplier of IT services for private businesses and the public sector in Europe) was agreed in May 2022 at a 9% uplift to end-2021 carrying value, translating into realisation proceeds of £32.7m. Finally, team.blue (HGT’s portfolio company) sold Register for £16m in realisation proceeds. HGT also agreed the exit from Transporeon (a cloud-based transportation management software platform) in December 2022 (expected to be closed in H123) at a 17% uplift to end-September 2022 carrying value. Transporeon was HGT’s sixth-largest holding at end-September 2022 valued at £92.5m (or 4.5% of NAV). Medifox Dan and Transporeon were sold to strategic buyers (Resmed and Trimble, respectively), which we believe is of particular importance with respect to validating HGT’s portfolio valuations. Itm8 was sold to Axcel, a Nordic private equity fund, which will merge Itm8 with one of its portfolio companies, AddPro (a Swedish IT company).

HGT also carried out several partial realisations in the form of recapitalisations or refinancings, with the most notable transaction being Access (described in detail in our previous note) with net proceeds to HGT of £90.8m (or c £63m after carried interest). The revaluation of Access was the key contributor to portfolio revaluations in 2022 with a £120.3m valuation gain. Moreover, the partial sale of Intelerad (a global provider of enterprise medical imaging solutions) to TA Associates was executed at a 26% uplift to end-2021 carrying value and translated into gross realisation proceeds of c £27.7m

As highlighted in our previous update note, HGT’s pro forma coverage ratio at end-September 2022 of 29% was at the lower end of the historical range and below the 2017–21 average of 58%. This was a function of HGT’s commitments to 2022 vintages of Hg Saturn and Hg Genesis (expected to be drawn gradually over 2022–25), but also continued new investments and a lower realisation volume in the second half of 2022. HGT’s total investments in FY22 stood at £527.1m, though we note that this includes c £160.6m related to re-investments in Access, Lyniate and Argus Media (as part of refinancings/recapitalisations). HGT only announced the £9.0m investment in TrustQuay (a technology provider to the global trust, corporate and fund services industry) in Q422.

We believe that listed PE companies should put even greater emphasis on prudent balance sheet management, given the currently muted global M&A volumes, with limited debt availability for buyouts being one of the main factors dampening activity. The US leveraged loan market saw institutional new-issue loan volumes at a mere US$35.7bn in Q422, the second-weakest quarterly level in the past decade, according to Partners Group citing Leveraged Commentary & Data. Similarly, European leveraged loan issue volumes were at a modest €4.5bn in Q422 (down from €7.2bn in Q322) versus €24.8bn in Q321 and €41.3bn in Q221. Nevertheless, as discussed in our previous note, it is worth noting that, except for some of HGT’s largest assets by enterprise value (eg Access, Visma, Howden), the company’s holdings may be largely classified as small- and mid-market buyouts (especially investments through Hg’s Mercury and Genesis funds). Given that private debt funds (which filled in some of the funding gap) mostly focus on this market segment, we believe that it may be somewhat easier for HGT to secure debt for its new investments (and for potential buyers of HGT’s portfolio companies to refinance debt upon acquisition) compared to large/mega buyouts. Moreover, HGT proved that it is able to realise attractive returns by selling assets to trade buyers, who may not be dependent to a similar degree on debt funding than private equity funds.

The market conditions remain challenging and HGT has addressed these by improving its balance sheet flexibility and optimising its portfolio structure. As a result of the review of HGT’s facility arrangements, the company upsized its credit facility from £250m to £290m last year and now again to £350m, with the facility remaining fully undrawn as at 28 February 2023. The size of the facility is around 17% of HGT’s end-2022 NAV, therefore broadly in line with its listed peers (c 10% to 25%). Together with its other liquid resources, HGT’s total liquidity as at 28 February 2023 (on a pro forma basis, ie accounting for all announced transactions and the May 2023 dividend payable) stood at £606m.

To further optimise HGT’s portfolio structure and liquidity, HGT decided to sell 25% of HGT’s LP position in Hg Genesis 8 (a 2017 vintage mid-market fund focused on buyouts with an enterprise value between £250m and £1.0bn) in March 2023, with expected proceeds at just over £90m. The fund interest was sold to a secondary fund, an institutional private equity buyer of mature fund interests. Given that Hg Genesis 8 is largely invested, we estimate that the transaction reduces HGT’s outstanding commitments by a minor c £5m.

HGT intends to use the additional liquidity for new co-investments (which are not subject to Hg fees) in potentially more attractive vintages (given moderating valuations). Hg expects these to have a greater return potential than the remaining upside from the Hg Genesis 8 LP interest, which is already valued at a healthy MOIC of 3.2x, higher than the fully realised performance of all Hg’s historical funds (HGT’s average MOIC on realisations over the 10 years to Q322 was 2.6x). It is also well above the median multiple for global buyouts fully realised in 2009–21 with more than US$50m of invested capital at 2.2x, according to Bain & Co. Importantly, the LP interest was priced at 100% end-December 2022, which compares with average pricing of LP buyout portfolios in the secondary market at 87% of NAV in 2022 (according to Jefferies Global Secondary Market Review), providing a further validation of HGT’s portfolio valuations. That said, we note that proceeds will be paid in two instalments on 31 March 2024 and 31 March 2025, rather than collected immediately.

HGT and Hg also agreed to reduce HGT’s outstanding commitments to Hg Saturn 3 (which stood at £612.6m at end-2022) by c 15% given the change in the deal environment since the fund was established, as well as the appreciation of US dollar (in which the commitments are denominated) against sterling. Capital drawn so far will be repaid pro-rata to HGT with no negative impact on HGT’s balance sheet, according to Hg.

As a result of the above measures, HGT’s pro forma coverage ratio as at 28 February 2023 stood at c 55% (more aligned with the historical average); see the chart on the frontpage. As a reminder, HGT has a right to opt-out from any commitments to Hg funds, even if it does not intend to use this right under normal circumstances and considers it as ‘disaster insurance’.

We also note that HGT recently highlighted that there is little to no impact on it from the collapse of Silicon Valley Bank (SVB), with only a small number of underlying portfolio companies having limited deposits with SVB, but no portfolio business is at risk as a result of this.