The secret behind 20 years of 15% returns

Luke Finch of Hg Capital sits down with ii's Sam Benstead to discuss how Hg Capital Trust is managed. He explains how they look for boring, but high-growth, business-to-business software firms, including companies that own accounting, human resources, and audit tools. 

This approach has led to compound annual share price returns of around 15% for the past 20 years, making it one of the best investment trusts during this period - but with excellent returns still to come, according to Finch. 

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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Luke Finch of Hg Capital, which manages the HgCapital Trust Ord (LSE:HGT) investment trust. Luke, thank you very much for coming into the studio.

Luke Finch of Hg Capital, which manages Hg Capital Trust: Thanks for having me again, Sam.

Sam Benstead: So, we last had you in about two and a half years ago, but for listeners and viewers who aren't familiar with the trust, can you explain how it's managed?

Luke Finch: HGT invests alongside Hg Capital. We are a private equity manager based in London. We're actually one of the biggest European private equity managers these days.

We invest exclusively in business-to-business (B2B) software, B2B data, and B2B tech-enabled services companies. What that means is HGT gets access and is invested in a portfolio of 50 companies, all private, all in B2B software data and services.

Sam Benstead: And what is the link between HGT and the parent company HG Capital?

Luke Finch: Good question. So, HGT is a standalone investment trust listed in London on the main board. It is an investor in funds that we, as Hg Capital, raise and manage. So, we are a private equity firm, we raise funds every three to four years and HGT comes into those funds as what we call a limited partner.

HGT has its own independent board and that board decides how much to invest in our funds, or even if to invest at all, so they could decide not to if they wanted to. So, they are effectively Hg's biggest client.

Sam Benstead: Over the past two and a half years, what have been the most significant buys and sells in the trust?

Luke Finch: We've been pretty busy over the last two and a half years and nicely in balance, actually.

If we look just [at] pure numbers, we as Hg, have exited a number of businesses. We've had about 40 liquidity events, some full exits, some refinances, some part sales. That means we've returned just under a billion pounds to HGT's balance sheet.

At the same time, we have invested in new businesses and put follow-on investments into the portfolio, and we've drawn down about a billion pounds. So, to within about £30 million, we are almost perfectly in balance over that period.

We've invested in some great new businesses that have joined the portfolio. So, Audit Board, which is audit software. Doesn't sound that exciting, but we love it. External audit software Ivalua, which is a founder-owned French business.

We've also put more money to work in some businesses that are already in the portfolio, so Visma, which has been a long-term investment for HG. We put more money to work there.

We've put more to work in P&I, which is a German payroll software business performing very, very well for us. And IFS, which is a Swedish-headquartered enterprise resource planning (ERP) software business, with a global customer base. And again, we've put money to work in that, so we're very excited there.

So, it's been a nice mix of new businesses coming into the portfolio, and following on into some really strong performers for us.

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Sam Benstead: And what characteristics do you look for in an Hg investment?

Luke Finch: We're pretty myopic in our focus. We look for businesses that serve and manage critical workflows for their end customers. So, the end customer is typically small businesses, or up to some larger enterprises, but mainly small businesses.

We're typically doing the kind of boring, unglamorous stuff for them. So, it's your payroll, it's your accounts, it's you're invoicing, it's your tax. It might be compliance with local regulations.

It's the kind of unglamorous stuff that all businesses need to do, that you need to do every day, that you've typically got two or three people in your organisation working on, and it's not your core business.

It is the sort of stuff you have to do that's not serving your clients, and so we're trying to solve that pain point. Our companies are trying to solve the pain point for their customers. They sell on a subscription or recurring revenue basis. Then often, we're developing new product or buying in new product into those companies to then solve more and more pain points for your customer.

Sam Benstead: When we last spoke, at the end of 2022, the trust was on a 20% discount, which was quite rare at the time. How has the trust performed since then? You said it was a bargain, did it turn out to be so?

Luke Finch: Yeah, always a bit of a hostage to fortune on those. But thankfully, it's proven broadly right.

So, we were at about a 20% discount and now we're about a 3% discount, as of last night. I think when we were speaking, the share price was about £3.90 and now it's about £5.10, £5.15. So, a decent increase in share price.

I think over the last two and a half years, from the end of 2022, shares are up just over 50%, NAV's up just over 20%, so the discount's closed while NAV is also growing. So, that's what's delivered that share price performance.

Sam Benstead: And the trust dates back to the early 90s, so can we get some colour on the long-term record of the investment trust?

Luke Finch: The AIC have done some great analysis over the last few years looking at your ISA. What would it look like if you'd invested all your ISA since 1999, so going back 25 years now, in different investment companies, different investment trusts?

I think the maths is if you invest all your ISA for the last 25 years, that's a total investment of about £325,000 when you add it all up. I know the numbers changed over different years. If you'd stuck all that in HGT, it would be worth about £2.8 million. I don't know anyone who's done that, but it would be good. So, that's about eight times your money, that kind of internal rate of return compounding at 15%-plus.

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Sam Benstead: Software has had a great past 25 years, but what could the next 25 years look like?

Luke Finch: Past performance is no predictor of future success obviously, and I'm not an investment adviser, but I don't see why that would necessarily change. The need for software continues to increase, more and more workflows and business processes get “software-atised”.

If you think about the two core trends that we're backing across our portfolio, it's really that there will never be more people of working age in Western economies than there were last year or the year before that or the [year] before that. Working-age population peaked about three years ago.

That will be a dramatic trend for the rest of our working lives and beyond, particularly knowledge economy workers. Neither of us are wearing white shirts, but white-collar workers, they're more in demand than ever, and you can't just keep hiring more and more expensive people to cope with these workflows. So, what most of our businesses do is they enable your knowledge economy workers to be more effective, more efficient.

The other big trend that we back is really that despite what all governments everywhere in the world say, every year regulation does increase. It doesn't go down, and this bonfire of red tape never, never happens. They just keep heaping it on. Everywhere you look, you've got more compliance and more need to track data and be able to report data back to governments or regulators or your customers or whatever it is.

Software can remember things, can keep track of data much better than humans can with a pen and pencil or with Excel, or a database even. So, that sort of “software-atisation” of your data and your data management continues to continue.

So, those are the two trends that we're backing and we just see more and more opportunity to back them.

Sam Benstead: Luke, thanks very much for coming into the studio.

Luke Finch: Pleasure, thanks for having me.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel, where you can like, comment, and subscribe. See you next time.