Defined time horizons
There is a lot of evidence to suggest investor holding periods have shortened materially over recent years. Short-termism appears rife in public markets. Annual reporting and compensation periods affect investor psychology as the year progresses.
PE fund investments typically have a minimum of three to five-year investment plans. This approach can be adopted with confidence in closed-ended vehicles such as investment trusts without the demands of daily fund liquidity.
Maintaining focus on value
An attractive entry valuation is a critical component of a successful investment, whether public or private. There are a number of factors that make entry valuations compelling in UK small-cap listed equities.
Investor sentiment towards UK equities has been poor in recent years as the global equities narrative has proven more alluring than the domestic market plagued by stagnant economic growth, concentrated large-cap indices in a handful of mature industries, Brexit and political turmoil.
In reality, UK small companies often have significant overseas exposures, generate exciting levels of growth and exceed more than 700 companies across a wide range of sectors.
Consistent investor outflows have contributed to a gradual de-rating when compared with almost all other overseas stock markets and the valuations at which private transactions are completed. It is no surprise that both overseas investors, trade buyers and PE companies are launching takeover offers in this space.
A reduction in available research on the smallest companies, a loss of broker interest due to collapsed dealing commission rates, and a growing concentration of UK small-cap assets under management in larger companies has created an inefficient market.
Outstanding value typically appears when companies have disappointed their shareholders. This occurs through a loss of management effectiveness, poor financial control, weak strategic development, unmet growth plans, and often poor acquisitions or capital allocation.
General economic conditions are cyclical and can amplify profitability issues, leading to financial stress through excess leverage. Change replaces complacency with energy, unearths inefficiencies, catalyses strategic change and the path to recovered profitability and ultimately fair value.
Once a value trap has been ruled out, the focus needs to be on what operational and strategic improvements can be made, and what level of sales and profitability could be achievable if effective management was in place.
Valuation work is necessary relative to peers, history, private transactions and, most importantly, in relation to the company’s future cash flows. Scenario analysis regarding possible strategic, trade or PE buyers of the company in the longer term is required.
Using leverage
PE has mainly used leverage to effectively enhance returns for investors. Financial stress is the number one risk to the permanent destruction of shareholder value and thus should be considered very carefully.
