Mercia Asset Management — The UK’s top regional investor

Mercia is a provider of 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 FUM) allowing it to commit to a progressive dividend policy in FY20, while its portfolio of direct balance sheet investments (valued relative to net asset value (NAV)) continues to grow and mature, moving towards an evergreen balance sheet where future investments are covered by net portfolio realisations.

We do not believe the market adequately recognises the value of Mercia’s risk-balanced strategy.

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. Given its financial resources, Mercia invests in businesses with relatively modest capital needs, typically 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 seen in mainstream markets through the economic cycle.

In its H121 results presentation, Mercia stated its strategic goals for FY21–22 as follows:

Mercia reported a 9% rise in AUM to £872m in H121 (FY20: £798m), a resilient performance over the first six months of the COVID-19 pandemic. Third-party FUM rose by 10% to £722m in H121 (FY20: £658m). Growth of AUM and FUM over the last 12 months has been 78% and 100%, respectively, reflecting the contribution from the acquisition of the Northern VCT fund management business completed in December 2019.

H121 reported net assets were £149.9m (FY20: £141.5m), with unrestricted cash of £24.9m (FY20: £30.2m) and NAV per share growing by 6% over the period to 34.1p (FY20: 32.1p). Hard NAV (portfolio fair value plus net cash) rose by 7.5% to £126.5m for H121 (28.7p per share) from £117.7m (26.7p per share) for FY20.

Mercia has successfully built a broad-based 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, their network and the team’s 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.

We believe Mercia has done the majority of the work of building and scaling a regional investment franchise, accelerated by the acquisition of the NVM VCT business in December 2019. As with all early-stage investors, there can be a long wait until the portfolio is sufficiently mature to start to generate more frequent, attractive exits. With seven cash exits to date, we believe Mercia is almost at that point. In addition, management has built a sustainably profitable, cash-generative specialist asset manager that, as well as delivering high levels of contracted recurring revenue, seeds the market to provide a filtered pipeline of opportunities for Mercia’s direct investment portfolio. We believe Mercia offers investors an attractive balance of risk and reward, but the market has yet to appreciate the transition it has made from a sub-scale portfolio dependent on periodic capital injections to a cash-generative business, with increasing upside from portfolio realisations.

Currently, Mercia trades at a 21% discount to its H121 NAV (34.1p per share), while a number of its immediate peers trade at a premium to NAV, having delivered consistent, strong NAV growth and reflecting the latent value of their portfolio. Mercia offers exposure to an attractive portfolio of high-growth, COVID-19 resilient businesses and the inclusion of the fund management business (we value at between 5–8p per share) takes the overall valuation to between 39–42p per share, implying a discount of closer to 31–36% to Mercia’s true value.

Given the breadth of Mercia’s business, the group’s growing profitability combined with a progressive dividend policy, the performance of its portfolio and its underlying operating model, we believe Mercia remains undervalued at these levels and investors could further reassess the group’s prospects over the course of 2021.

Mercia Fund Management was co-founded by Dr Mark Payton (the current CEO) as a venture capital fund manager in 2010, after a buyout of WM Enterprise. The group then listed on AIM as Mercia Technologies PLC in December 2014, before being renamed as Mercia Asset Management in July 2019, to better reflect its business mix. Today, 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. Given its financial resources, Mercia targets businesses in its regional markets (in England, the North, Northeast, Northwest, Midlands and Scotland) with relatively modest capital needs, typically up to c £20m in total, across multiple rounds.

Mercia’s ‘Complete Connected Capital’ solution ensures it can offer the right type of capital for high-growth businesses at different stages of maturity at the right time. It also offers investment options, whether for private investors interested in tax-efficient investing via Mercia’s EIS or Northern VCT funds, or institutional investors seeking investment into long-term debt, private equity or VC funds. All investors can also become shareholders in Mercia Asset Management plc.

Mercia invests from four pools of owned or managed capital:

At the end of H121, Mercia reported AUM of £872m (FY20: £798m), with 9% growth over the six months from 31 March 2020. Third-party FUM rose by 10% over six months to £722m in H121 (FY20: £658m). Growth of AUM and FUM over the 12 months to 30 September 2020 was 78% (H120: £489m) and 100% (H120: £361m), respectively, with the heightened growth reflecting the contribution from the acquisition of the Northern VCT fund management business acquired in 2019.

Venture, including the NVM VCT fund management business, EIS and IP commercialisation, represents the majority (H121: 76%) of the group’s FUM (Exhibit 2), with private equity (8%) and debt (16%) together representing the remainder. In terms of AUM, the proportion of Venture funds falls to 63%, as set out in Exhibit 1, or reflects 78%, after including both the direct investment (later-stage venture) portfolio and cash intended to invest in direct investments.

Management’s three-year strategic plan, set out in FY20, is to achieve growing profitability, based on adjusted operating profits, to increase assets under management to at least £1bn and to ‘evergreen’ the group’s balance sheet. To achieve these strategic goals, in its H121 results presentation, management stated the following five targets for FY21 and FY22:

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.

To be integral to its regional markets and ensure it sees the best deal flow, management is looking to establish a market share of 20%+ of its targeted regional markets (in England, the North, Northeast, Northwest, Midlands and Scotland), with calculated market share based on data from Beauhurst, the British Business Bank and the British Venture Capital Association. Latest research from Beauhurst shows Mercia was the most active VC investor nationally in 2020 as well as the most active investor across the Midlands and the North of England, its core regions of focus.

According to Beauhurst data, of the c 26,000 high-growth English companies on its platform, 19% are based in the North of England (North East, North West, Yorkshire and the Humber), 11% are in the Midlands, 32% are headquartered in the South (South East, South West and the East of England) and 38% are in London.

In 2020, the North was most affected by the drop in deal numbers related to COVID-19, with 194 equity investments recorded up to November 2020, a 20% decline on the 241 reported in the full year 2019. In total, high-growth companies in the North secured 14% of English equity deals, with 5% in the Midlands. The vast majority of completed equity deals by number were in the South (81% of the total, 15% y-o-y decline in deal numbers), with London representing 58% of English deal flow (a 12% y-o-y decline). This reflects a re-concentration of capital in London and the South, with the North and the Midlands seeing a disproportionate decline in equity funding in 2020 due to COVID-19. Mercia sees this as a clear opportunity, which it is well-placed to address.

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 through four pools of managed capital:

In aggregate, the company held AUM of £872m at the end of H121, spread over almost 400 investee companies, of which c £722m (83% of AUM) represented fee-earning third-party FUM.

Venture, including the NVM VCT fund management business, EIS and IP commercialisation, represents the substantial majority (H121: 63%) of group AUM. The direct investment portfolio (later-stage venture), together with balance sheet cash (hard NAV) makes up 15% of assets, taking the total venture allocation to 78% of AUM. This leaves private equity (6%) and debt (13%) to represent approximately a fifth of assets, with goodwill the majority of the remainder.

In H121, the most active funds (by deal number) were the Venture funds, with 52 investments made including 16 new investments, followed by the debt funds with 15 loans made, including 10 new loans. In its direct investment portfolio, Mercia made 14 investments, with only one new investment emerging from the managed fund portfolio during the period. Of these 14 investments, 11 (65% by value of Mercia’s direct portfolio) were supported with matched funding (in the form of a convertible loan) from the UK government’s Future Fund. Subsequently, Sensible Soccer was the 12th member of Mercia’s direct portfolio to receive matched funding from the Future Fund as part of a £3m funding round announced in February 2021.

Mercia manages a network of funds, with a variety of mandates, targeting businesses of different sizes and stage of maturity across multiple regions. These funds attract different types of investors, offering commercial returns commensurate with their mandate and their level of risk. Through the cycle, management targets a 15% internal rate of return (IRR) across Mercia’s underlying equity funds. This level of return recognises that Mercia needs to deliver market-beating returns to remain an attractive proposition for future institutional fund allocations, thereby allowing the group to continue to scale its business.

We set out below a summary of Mercia’s principal managed funds.

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 and its motivation to enhance financial returns.

Environmental management is high on Mercia’s agenda. Mercia considers both the environmental impact of its own activities and those of its investment portfolio. As a group, Mercia has undertaken a digital transformation to improve efficiencies and lessen travel, paper consumption and energy costs. In addition, the group’s investment in, for example, clean technology has led to portfolio investments including Faradion, which is developing a sodium-ion battery technology resulting in cheaper, cleaner energy, and Aceleron, which is developing a lithium battery with a longer lifetime and turning waste battery components into second-hand batteries.

Social awareness drives Mercia’s culture and is a factor in both recruitment and investment. The group has a diverse team (40% of the team is female and nearly 30% of the investment team) and is proud of its regional presence, having created 426 regional jobs in FY20 alone.

As an AIM-listed business, good governance is critical to Mercia. The group is diligent in both internal governance and for its investee companies, where it actively ensures good stewardship. Mercia’s procedures incorporate anti-bribery and corruption policies for all employees. The group also requires its portfolio companies to have policies in place around equal opportunities, health and safety, and a range of other regulatory matters.

The value of Mercia’s direct investment portfolio at H121 period-end rose to £101.6m, an increase of 16.2% over FY20 (£87.5m), with Mercia investing £10.9m (net) into 14 portfolio companies, together with net fair value gains during the period of £6.7m (H120: zero). Mercia delivered a profitable exit during the period (Native Antigen Company: £1.7m gain, 8x return, 65% IRR) and another after the period end (Clear Review: £1.0m in cash, 2x return, 72% IRR).

Mercia’s H121 performance highlights the resilience of the business, with the group benefiting from its long-term contracted fund management fees, diversified portfolios and good liquidity. Investors also favoured sectors seen to benefit from lockdown where Mercia is active, such as software, digital entertainment, medtech, digital healthcare, diagnostics and biotech.

In response to COVID-19, management took proactive steps to ensure that Mercia’s portfolio companies were well supported over the pandemic, with 75% of the top 20 portfolio companies funded through to FY22. Financial support was also forthcoming from the UK government, with 11 of Mercia’s top 20 portfolio companies (c 65% by value) benefiting from Future Fund support. In total, as stated above, Mercia invested £10.9m (net) into its balance sheet portfolio in H121 (H120: £11.1m), with an additional £11.5m committed by the Future Fund and £10.5m from other investors, including £3.6m from Mercia-managed funds.

In line with previous reporting periods, Mercia’s top 20 direct investments (Exhibit 9) represented 98.6% of total portfolio value at 30 September 2020, with the top 10 representing over 80% of total portfolio value. Mercia weights its efforts accordingly.

The value of Mercia’s top 10 holdings rose by 23% over the six months to 30 September 2020, by 6% over the 12 months since 30 September 2019 and by 51% since 31 March 2019.

Of the top 10 portfolio companies within the direct investment portfolio, nDreams (a virtual reality game developer) saw a small rise in valuation (£0.6m) after the release of its VR game Phantom: Covert Ops; OXGENE (gene therapy) rose 29% (£3.4m), driven by continuing strong revenue growth, the launch of a new product and a funding round (subsequently exited in H221); Intechnica (SaaS technical services, £1.6m) and Voxpopme (video analytics, £1m) both saw strong revenue growth; and Intelligent Positioning (SEO platform) was the only business in the direct investment portfolio to see a reduced valuation of c 5% (a drop of £0.2m) due to high churn, which has since stabilised.

The valuations of the other five businesses in the top 10 holdings were largely unchanged, although Warwick Acoustics completed a syndicated funding round shortly after period end (see below) and, as has been discussed previously, Mercia achieved profitable exits from of the Native Antigen Company (£1.7m gain) during H121 and Clear Review (£0.5m gain, see below) post period end.

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

The group focuses on some of the highest growth sectors in the UK, leveraging deep expertise across a number of areas:

The COVID-19 pandemic has accelerated structural changes across industry in general, but especially across the sectors in which Mercia invests. Areas of particular challenge included deal origination, employee engagement and stakeholder communications, but the group adjusted its approach effectively with minimal disruption. In its key sectors of life sciences, software and digital entertainment, representing c 82% of its direct investment portfolio by value, the group saw a marked acceleration in growth trends, positioning the group well for the future. Other sectors, principally electronics, materials, manufacturing/ engineering, have been more affected by COVID-19, resulting in the value of investments held at impaired cost (Exhibit 11) increasing from 6% at end H120, to 19% in H121.

Life sciences is one of Mercia’s areas of focus and investment expertise. Seven of Mercia’s top 20 holdings at 30 September 2020 were in life sciences, valued at £33m in aggregate or 32% of total portfolio value, with another c 40 earlier-stage life sciences investments across its third-party managed funds. COVID-19 accelerated the opportunity for a new generation of novel and recombinant vaccines, which require diagnostics and bio-manufacturing support to scale supply. These are areas where Mercia has invested. The sale of Oxgene in March 2021 (51% IRR) highlights the growing strength of Mercia’s life sciences portfolio.

At 30 September 2020, software and ecommerce investments accounted for five out of the group's top 20 direct investments, valued at £25m in aggregate and representing c 25% of the total direct portfolio by value. Within its managed funds, software and ecommerce investments accounted for c 30% by number of total investments. The sale of Clear Review in October 2020 (72% IRR as stated below) and the growing strength of software and ecommerce portfolio are indicators of Mercia's ability to identify and nurture early-stage businesses to create shareholder value.

Mercia has a growing track record of successful exits, having returned approximately £51m to date from seven full cash exits since its 2014 IPO, three of which were from its software and ecommerce portfolio. Mercia’s latest profitable exits have included Oxgene (March 2021, £14.6m gain, 5x return, 51% IRR), Native Antigen Company (July 2020, £1.7m gain, 8x return, 65% IRR) and Clear Review (October 2020, £1.0m in cash, 2x return, 72% IRR).

Mercia follows the International Private Equity and Venture Capital Valuation (IPEV) Guidelines, as well as the IPEV Board’s Special Valuation Guidance issued in response to COVID-19, which together set out best practice where private investments are reported at ‘fair value’.

Where a funding round has been completed recently, management uses it as the carrying value. However, the updated guidelines necessitate valuations to be updated where there has been a material change in fair value since the last funding round, with Mercia tending to use a DCF valuation approach in these circumstances. Given the early stage of its investments, a valuation based on peer multiples is not always appropriate. Since March 2020, Mercia has updated its company valuations using revised forecasts to reflect the anticipated impact of COVID-19. Updating the valuation from the basis of historical funding rounds arguably offers a better view of fair value, but still leaves group NAV as a significantly trailing indicator for a high-growth portfolio.

As of H121, 42% of Mercia’s direct portfolio were valued on the basis of recent funding rounds, with an additional 2% held at investment cost, while 36% are valued based on a DCF and 1% are based on peer multiples. 19% of holdings had been impaired, principally due to COVID-19.

Mercia reported a 9% rise in AUM to £872m in H121 (FY20: £798m), a resilient performance over the first six months of the COVID-19 pandemic. Third-party FUM rose by 10% to £722m in H121 (FY20: £658m), with year-on-year growth in AUM and FUM of 78% and 100%, respectively, reflecting the contribution of the Northern VCT fund management business acquired in December 2019.

With a proportion of Mercia’s revenues directly linked to asset prices, at the start of the lockdown in March 2020 management anticipated some contraction of its revenue base. However, this did not occur as the group performed better than management initially expected during the COVID-19 pandemic. The portfolio’s strong performance was achieved without any government-backed financial support, furloughing or redundancies.

H121 group revenues increased by 51% y-o-y to £8.4m (H120: £5.5m), reflecting a full six-month contribution from the Northern VCT fund management business acquired in December 2019, of which 87% is annual recurring revenue from fund management and monitoring fees. Revenues comprised £6.2m from fund management fees, £0.7m from initial management fees and £1.4m from portfolio director fees, as well as £0.1m in other consultancy revenues. Despite the large increase in revenues, staff and administrative expenses increased by a lower 16.5% to £7.3m (H120: £6.3m), despite an increase in headcount from 93 staff at FY20 to 100 at H121. Cost growth was restrained as the pandemic slowed recruitment and through savings in travel-related costs.

Adjusted operating profit (before fair value adjustments, realisation gains, amortisation and share-based payment charges) was £1.1m (H120: £0.6m loss). Together with the sale of The Native Antigen Company (£1.7m realised gain, H120: zero) and net fair value gains (£6.7m, H120: £3.2m), this led to PAT of £8.2m (H120: £2.1m) and EPS of 1.87p (H120: 0.69p).

H121 reported net assets were £149.9m (FY20: £141.5m), with unrestricted cash of £24.9m (FY20: £30.2m) and NAV per share growing by 6% over the period to 34.1p from 32.1p. Hard NAV (portfolio fair value plus net cash) rose by 7.5% to £126.5m for H121 (28.7p per share), from £117.7m (26.7p per share) for FY20.

As a profitable business with £2.0m of operating cash flow, management implemented a progressive dividend policy in H121, declaring a maiden interim dividend of 0.1p per share.

In a trading update released on 1 March 2021, Mercia confirmed it traded robustly in H221, with continuing revenue growth and lower than anticipated staff-related costs, in part due to lockdown restrictions. As a result, management expects FY21 adjusted operating profit to be materially ahead of current consensus forecasts. Together with the £30.7m (7.0p per share), cash proceeds from the sale of Oxgene (a gain of £14.6m, 3.3p per share, over the direct investment holding value as of 30 September 2020), management expects FY21 PAT to be above £23m, with unrestricted cash of c £49m as at 31 March 2021.

As an investment company with an illiquid portfolio of high-growth, early-stage private businesses, Mercia has historically been valued based on its balance sheet, the growth in fair value of its investment portfolio and the resultant growth in NAV per share. Growth in portfolio fair value is irregular and the timing of realisations and exits can be hard to predict. Given this variability, there is no easily defined revenue and profitability trend, so the business is typically valued at a premium or discount to NAV rather than on a profit multiple.

Mercia provides formal NAV valuations twice a year, representing a trailing indicator to the ‘true’ value of the portfolio. This gap to ‘true’ value is widened further by a substantial proportion of assets being held at the value of the last funding round, in itself a historical yardstick.

As Mercia has successfully built its third-party fee-earning funds business, charging on average c 2% of AUM (Exhibit 13), it has now reached the stage where it generates positive underlying profitability from fee income, allowing investors to attribute additional value to this earnings stream. Management has signalled the sustainability of this income stream (with 87% of fee income recurring in H121), by declaring a maiden interim dividend as part of the H121 results.

As FUM continues to grow as a proportion of the group’s business, generating incrementally larger revenues, we believe an NAV-based valuation alone no longer adequately reflects the additional value of the fund management business within Mercia.

We continue to estimate the value of Mercia’s embedded fee-earning funds business at 3% of FUM (which we consider a conservative valuation considering Mercia’s attractive blended fee margins of 2%+) in addition to the NAV-based valuation of its direct investment business. Below we also provide a sensitivity analysis reflecting a higher valuation for the funds business at 5% of FUM (Exhibit 14).

With last reported FUM of £722m, this implies a valuation for the funds business of £22–36m, or c 5–8p per share. With the addition of the H121 NAV of 34.1p per share, this implies a hybrid valuation of c 39–42p per share. Based on our hybrid approach, the current share price trades at a 31–36% discount to this valuation.

Valuations of many of Mercia’s peers have risen over the last 12 months, with portfolios based around technology and life sciences investments benefiting from rising valuations following the initial impact of COVID-19.

We believe investors prefer direct investment companies with a well-diversified, high-growth portfolio, a history of value realisation and exits, a consistent long-term track record and strong corporate governance. A premium is often applied where the company owns an income-generating asset management arm (eg 3i, Gresham House, ICG, Mercia), whereas for many other direct investors, either the management vehicle is held separately from the investment vehicle (eg HgCapital, Oakley) or fee generation has yet to offset costs (eg Draper Esprit, IP Group).

Currently, Mercia trades at a 21% discount to the H121 NAV (34.1p), while a number of its immediate peers trade at a premium to NAV, reflecting consistent, strong NAV growth and the latent value of their portfolios. However, as we have set out above, we believe Mercia’s hybrid valuation, including the fund management business, lies between 39–42p per share, implying a discount of closer to 31–36% to this value.

Given the group’s growing profitability following the acquisition of the NVM VCT fund management business in H220, combined with a progressive dividend policy declared in H121, the performance of its portfolio and its underlying operating model, we believe Mercia remains undervalued at these levels and investors could further reassess the group’s future prospects.

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