Mercia Asset Management — Scaling, sustainable and evergreen by FY22

Mercia reported a material 73% rise in funds under management (FUM) to £658m (FY19: £381m), with the acquisition of the NVM VCT fund management business delivering a c £250m uplift, supplemented by a further £38.2m of new capital raised by NVM for its own funds in March 2020, as well as a further allocation of £54.3m from the British Business Bank (BBB), split between Mercia’s PE and Debt funds. The group also raised £10m of additional EIS funds. The additional scale that these funds deliver, together with the boost to fee revenue, is a major step on the way to Mercia achieving management’s strategic goal of an evergreen funding model.

Group revenues increased by 19.4% to £12.7m (FY19: £10.7m), reflecting an approximately three-month contribution from NVM. Revenues comprised £8.9m from fund management fees, £1.3m from initial management fees and £2.4m from portfolio director fees.

Importantly, operating costs only rose 4.5% to £12.7m (FY19: £12.1m), with staff costs also increasing 4.5% to £8.8m (FY19: £8.4m), despite a 9% increase in headcount (from 85 to 93 over the course of the year). With revenue growth outstripping growth in staff costs, Mercia has been able to declare its first positive annual net revenues, transitioning from annual net expenses of £1.44m in FY19 to net revenues of £0.09m, a year ahead of plan.

With NVM making a full-year contribution in FY21, we fully expect the transition to be sustainable, with revenues covering expenses before realised gains and fair value movements, reversing the historical operational NAV erosion. If average fees are maintained at c 2% of assets under management (AUM) and at current fund levels, this would suggest FY21 revenues of £15m+, making allowance for a c £2m reduction in fees due to recent COVID-19-related falls in fund values.

Mercia announced net assets of £141.5m (FY19: £126.1m) or 32.1p per share (FY19: 41.6p), a fall of 23% over the year, largely as a result of the £30m equity placing (at 25p per share) in December 2019 to fund the acquisition of the NVM VCT fund management business. Direct investments of £17.5m gross (£15.7m net) were made into 18 portfolio companies (FY19: £19.4m, 17 companies) during the year, including one new direct investment, One Touch Apps (trading as Clear Review). The company ended the year with £30.2m of unrestricted cash and short-term liquidity investments (FY19: £29.8m) as well as total liquidity of £320m across all asset classes.

Mercia’s full FY20 results presentation can be reviewed in Exhibit 1.

The value of Mercia’s direct investment portfolio at year-end at £87.5m was relatively unchanged versus FY19 (£87.7m), despite gross portfolio investment of £17.5m (FY19: £17.7m). On a net basis, investment of £15.7m was more than offset by a COVID-19-related decrease in fair value of £15.8m (FY18: £3.9m increase), representing an 18% fall in portfolio fair value. As has been seen by other investment companies, although valuations of private investments tend to lag the public markets, they ultimately follow similar trends. In this downturn, investors favour profitable businesses (or those at least close to break-even), with strong recurring revenues, particularly those in sectors seen to benefit from lockdown, such as software, digital entertainment, medtech, digital healthcare, diagnostics and biotech.

In line with previous reporting periods, Mercia’s top 20 direct investments represented 98.7% of total portfolio value as at 31 March 2020, with the top 10 representing over 77% of total portfolio value. Mercia weights its efforts accordingly.

Within the direct investment portfolio, Warwick Acoustics, Impression Technologies (both serving the automotive sector), Crowd Reactive (events management) and LM Technologies (Chinese supply chain) suffered notable falls in valuation. Together, these four businesses represented 79% of the £15.8m downward adjustment in fair value. Fair value uplifts included: OXGENE (£1.6m); The Native Antigen Company (£0.6m); Voxpopme (£1.0m) and Soccer Manager (£0.1m).

Post year-end developments include:

As summarised in a speech by the Bank of England (Covid-19 and monetary policy, 28 May 2020), the sectors that have proven most resilient to the COVID-19 pandemic to date have been the ICT and healthcare sectors. With a portfolio focused on life sciences, software and the internet and digital entertainment, as well as electronics, materials, manufacturing and engineering, we fully expect Mercia’s direct portfolio to remain resilient, although as we have noted above, there are already clear winners and losers.

As outlined in its recent update (COVID-19 Business Impact), Beauhurst highlights that the UK’s scaleup companies are vulnerable to COVID-19, with almost a quarter (22%) at severe or critical risk of disruption to their operations and a further 43% at moderate risk. The regions furthest from London, notably the South West and Scotland, have the highest proportion of critically affected businesses of all UK regions (Exhibit 4), whilst London has the highest proportion of positively impacted businesses (Exhibit 5), with a weighting towards technology businesses in the capital. Beahurst also concludes that seed stage companies are the least likely to be negatively affected by coronavirus, whilst later stage businesses most at risk.

Sectors that rely on customer footfall such as leisure and entertainment and retail are the most significantly affected, whilst technology-driven sectors that enable remote working, such as VoIP, EdTech, eHealth and Digital security, have the highest numbers of positively impacted businesses.

From Mercia’s perspective, the group operates in many attractive sectors (that potentially benefit from lockdown) and is well-funded, with £30m of unrestricted balance sheet cash and c £320m of uninvested cash across the group. Its position is further strengthened by the fact that 15 of its top 20 investments are funded through FY21 and beyond. This means that Mercia has the resources, patiently but selectively, to support its direct investments, while the broader fund management business can focus on identifying quality investments that require additional capital at attractive valuations.

With Mercia committed to its regional investment strategy and looking to grow its market share from c 18% today to over 20%, as one of its key strategic targets, a more difficult trading environment presents a real opportunity for a patient and well-resourced investor to consolidate its market position, while other funds retrench to London.

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. To achieve this, management expects to take a market share of 20%+ of its targeted regional markets (in England, the North, Northeast, Northwest, Midlands and Scotland), with market share calculated based on data from Beauhurst, the British Business Bank and the British Venture Capital Association. Latest research from Beauhurst has shown Mercia to be the fourth most active investor nationally and the second most active in the North of England (by number of deals).

Historically, Mercia has been closely associated with IP commercialisation. However, this categorisation no longer reflects the growth of the business, the diversity of its deal sourcing or the breadth of its investment portfolio, both debt and equity. Through its 19 university partnerships, IP commercialisation will remain an important element of Mercia’s overall investment proposition, but today represents one of five principal sources of deal flow (the others being direct sourcing from Mercia’s own network, client referrals, advisor referrals and cross-referrals).

Mercia invests in both growing its pipeline and its existing portfolio companies through four pools of capital under management:

In aggregate, the company manages AUM of c £800m, of which third-party funds under management account for over 80%, approximately £658m.

Venture, including the NVM VCT fund management business, EIS and IP commercialisation, represents the majority (FY20: 72% of FUM) of the group’s FUM, but private equity (9%) and debt (19%) together represent a substantial proportion of overall funds. Including the direct investment portfolio and balance sheet cash (hard NAV), the proportion of Venture funds falls to 61%, as set out in Exhibit 7 below.

Management has stated its intent to become the leading regional provider of supportive balance sheet, venture, private equity and debt capital in transaction sizes typically below £10m. To achieve this, management expects to take a market share of 20%+ of its targeted regional markets (in England, the North, Northeast, Northwest, Midlands, and Scotland). Management estimates that the group currently has a market share of c 18% of these markets.

The acquisition of the NVM VCT fund management business has been transformative in that the additional revenue from ongoing management-related fees means that Mercia no longer burns cash on an operational basis. This delivers the first part of management’s three-year strategic plan, to put Mercia on a sustainable footing, and also starts to deliver the scale that management believes will allow it to operate an evergreen model by FY22.

The acquisition of the NVM VCT fund management contracts in December 2019, together with the new capital they raised of £38.2m prior to the 2020 tax year end, increased Mercia's total AUM to c £740m. Together with the BBB allocating a further £54.3m to funds managed by Mercia and an additional £10m of EIS funds, this means that AUM has now risen to c £800m. The AUM target delivers the scale that management believes is necessary to deliver a fully sustainable, evergreen business model.

An evergreen model is where annual portfolio realisations are greater than net investment, with management fees covering other operational costs. Despite the downturn in valuations from the COVID-19 pandemic, management believes that the current cash headroom (£30.2m as at 31 March 2020), together with organic growth and anticipated portfolio realisations, should be sufficient to achieve the goal of an evergreen balance sheet by FY22 without the need for further recourse to the markets.

To remain an attractive proposition for future institutional fund allocations and to be able to scale its business, Mercia needs to continue to deliver market-beating returns. Although not immediately relevant to public market investors, the company is targeting a 15% equity IRR benchmark at its underlying equity funds. Although the current downturn has affected valuations in the short term, management is confident that it will achieve this benchmark in the medium to long term.

In line with Mercia’s intent to become the leading regional provider of supportive balance sheet, venture, private equity and debt capital in transaction sizes typically below £10m, we have broadened Mercia’s valuation peer group to include a broader range of direct private equity and venture capital investors, as well as IP commercialisation companies.

Following the share placing at 25p in December 2019, Mercia has traded at a widened discount to its NAV, due in part to the NAV/share erosion that entailed. Currently, Mercia trades at a 40% discount to the FY20 NAV, below the mean and median of the peer group and, in our view, this is unwarranted given the strength of the business and its underlying operating model.

The additional revenue bought via the acquisition of NVM (£6.3m of annual recurring revenue) means the group is now profitable before fair value adjustments, realisation gains, amortisation and share-based payment charges. The removal of the monthly cash burn is a significant step towards Mercia developing a fully sustainable model, with management targeting an evergreen funding model by FY22. This progress helps to underline that the NAV-based valuation does not properly reflect the embedded value of Mercia Fund Managers.

From research covering 50 listed US and European asset management firms (The Valuation of Asset Management Firms, 2019), Marco Bigelli and Fabio Manuzzi calculated average EBIT margins of 28% for the companies reviewed and earnings margins of 17%. Average yearly fees were equal to 1.0% of AUM, with an average firm value of 3.0% of AUM. They found that higher valuations were significantly positively correlated with higher earnings margins and higher fees as a percentage of AUM.

Management confirmed on the FY20 results call that the group continues to sustain average fund management-related fees of c 2% of AUM, implying fees >2% of FUM. Using the above analysis as a benchmark, we propose to reflect the value of Mercia’s embedded fee-earning funds business at 3% of FUM (although a higher percentage would be justified by Mercia’s fee margins) on top of the NAV-based valuation of its direct investment business. With FUM of £658m, this implies a valuation for the funds business of £20m, or 4.5p per share, on top of the FY20 NAV of 32.1p per share.