Why our 20% trust discount is a bargain

Luke Finch, of private equity firm Hg, tells us how HgCapital Trust (LSE:HGT) is managed, and how their investment model works under higher interest rates. Finch also discusses the 20% discount on the trust, and more.

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider interview. Our guest today is Luke Finch of HgCapital, the private equity group, which manages HgCapital Trust. Luke, thanks very much for coming in.

Luke Finch of HgCapital Private Equity Group, which manages HgCapital Trust:Morning. Thanks for having me.

Sam Benstead: So, you invest in a basket of high-quality business-to-business software companies. Are you paying a premium for these types of stocks? And is there a comparison we can make to big benchmarks, perhaps the S&P 500, in terms of valuations that you're paying?

Luke Finch: Yeah, well, a premium to what? I think for comparable businesses listed in the US; we probably pay in line with what you'd need to pay to take those private. So, Intuit Inc (NASDAQ:INTU) or Microsoft Corp (NASDAQ:MSFT) with a 30% premium would be an equivalent valuation to some of the things we've bought recently. Ultimately, when we drill down to it and how we think is, we buy cash flows, we buy growing cash flows and EBITDA is an approximation to cash flow, but it's not actually that consistent across different industries because depreciation is very different in different industries, so in software, we don't really have any asset depreciation, so our EBITDA is very close to cash flow. What it means is typically we're buying businesses at 20 to 25 times forward cash flow, and if you look at other places you could buy cash flow growing strongly, I don't think we're paying a premium.

Sam Benstead: You're just investing in profitable companies then?

Luke Finch: Yes. 90% of our portfolio is highly profitable. We sometimes buy businesses that are on the journey to profitability, but where we can see that the core customers, old customers who've been buying the product for longer are highly profitable. The typical margin across our portfolio is mid-30% EBITDA margin, and similar on a cash flow basis.

Sam Benstead: So really high profit margins. What about that profit growth and revenue growth? What are you typically seeing there in your portfolio?

Luke Finch: Yes, I mean, if we look at HGT’s portfolio and the top 20 as a proxy for our whole portfolio, it's growing revenues at nearly 30% last 12 months and profits are nearly 30% as well. About half of that is organic growth, and the other half is M&A. M&A is a big part of our strategy across a lot of our businesses, so that's buying smaller companies, buying products to sell to your existing customers. It's a big value creation driver for us, and it adds a lot of value and innovation for the customers of our companies as well.

Sam Benstead: HgCapital Trust is part of Hg, the private equity firm. Do you normally take over companies completely? Do you take full ownership of companies? And when you own stocks, what do you do? Do you help them become better businesses?

Luke Finch: So, we try and take a majority, not necessarily the whole thing. Management or founders are often big investors alongside us. If we look at two of our biggest businesses, Access and Visma, management own between 10-30%-plus of those businesses and that's pretty widely distributed. So, that might be 200, 300, 400 people in that shareholding across the business. We think that's a powerful driver of engagement in returns and alignment. But, where we can, we will take control and then we'll support those businesses with a long-term view.

I think one of the powerful things about private equity is aligning long-term capital. So, we think in five-year horizons with management owning chunks of their businesses, with options to own more if they perform and with a clear plan over those five years. And so, businesses are thinking, how do we improve ourselves? Maybe that means investment over the next few years, so margins might be depressed but will grow stronger in years three, four, five. And they're not thinking quarter by quarter. How do I manage for my shareholders on a quarterly basis?

And I think that's one of the most powerful sorts of fundamental differences in private ownership versus public ownership. And then when we own our businesses, there's 50 of them in the portfolio, roughly, they can all learn from one another. We can learn from them. We can take best practice and help the portfolio learn about that. We have a team of nearly 65, I think 65 operators working at Hg who have run the European sales team of Microsoft or run cybersecurity at a large cybersecurity listed business. These people have run big divisions in big software companies, and they go in and they help our companies make change faster.

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Sam Benstead: Can you give some examples of when Hg has gone in and actually created a lot of value for your companies?

Luke Finch: Yes. I mean, let's take Visma as an example. We first invested in Visma way back in 2006. We de-listed it from the Oslo Stock Exchange. And we were a white knight, so we were invited in by the board because they were under a hostile public offer from Sage Group (The) (LSE:SGE) PLC in the UK. And Visma at the time was about €400 million (£353 million) of market cap enterprise value. Sage was, I don't know, €5-6 billion at the time. Fast forward to today, we've continued to back Visma with supportive capital, thinking in those five-year cycles. We're now coming up to our fourth five-year cycle with them, and the trust has been invested all the way through, and Visma's now €16-17 billion of enterprise value, and Sage, I haven't checked recently, but probably still somewhere in the €5-10 billion range.

So, what we've done with this is we've helped them with M&A. They've expanded out of Norway, across the Nordics and now into the Netherlands. They've innovated in product. They've been through a software as a service (SaaS) transition. So, I spoke earlier about the old revenue licence revenue model moving to SaaS, unlocking a lot of value. Visma is now the largest SaaS business in Europe by revenue, and that's because, the management team take almost all the credit there. We've helped them along the way, and we've been very supportive, and we've given them that time, and changing your product to SAS is a huge investment, it's €50 million of R&D and you don't get it right first time, so you probably have to spend more and do it for longer. But taking it off the glare of the public markets has allowed Visma to do that. And now as it's getting bigger and bigger, it's posting its best-ever organic growth as it scales.

Sam Benstead: So, you're investing in business-to-business software. Are there any areas within that sector which are particularly exciting now, and you've made some big acquisitions in?

Luke Finch: Our definition of exciting is maybe different to a lot of other people's definition of exciting. So, our definition of exciting is things that grow 8-12% organically, but very consistently where you have, 90-100% of your customers renewing every year, where you can add more and you sort of roll up, you snowball up, you compound up. We get very excited by that.

We don't get excited by things growing 100% a year in an infinite market that are going to change the world. Other people get excited by that, but we find that hard to judge and to make calls on. So, where we find our kind of excitement, the boring excitement, is tax software, accounting software, bookkeeping software, payroll software, compliance software, insurance software, operating systems for healthcare, the unglamorous stuff that's helping, frankly, expensive professionals be better at their job, comply better with regulations, understand their customers better, manage their data better. That's what gets us excited. So, we're not the most exciting dinner party guest, I'm afraid, when you're from Hg.

Sam Benstead: This is a private stock portfolio; you update the net asset value of the fund every three months. That's kept ticking higher this year, even as public markets have fallen and particularly software companies have fallen this year. So, what's that process and why is it resilient when public comparisons are struggling at the moment?

Luke Finch: Yeah, so we value every individual company in our portfolio, bottom up, line by line, and then the trust gets a valuation that reflects its ownership of each of those businesses. But there's a number of components that go into valuation for us. One is earnings growth. The second is then comparable listed businesses and comparable transactions over the last few years for those businesses. The third is exits we have, above book value. So, if we sort of unpick that, the comparables for our portfolio have come down and we've taken our comparables down with that. So, you've probably seen a 10-15% fall in our valuations from that effect. They haven't swung as wildly as some of the high growth, VC, really high growth tech stocks. They didn't march so far up the hill, and we haven't had to bring them so far back down, but they have come down. But then that's been offset by earnings growth.

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I said earlier that we had nearly 30% EBITDA growth over the last 12 months, and then we've had a number of exits above book value, so we've realised four or five investments this year on average, at close to a 30% uplift to the December book value, if you take December as maybe a high watermark in the public market. So, people see the value of our businesses, they're willing to pay for the value of those businesses. And I think one of the things I often say to our investors is that a lot of the uplift we get on exit is quite structural, because the rules tell us to value our businesses off of trailing earnings, LTM earnings, which we do, but because of the types of businesses we back with highly recurring revenue, often contracted, recurring revenue, we're almost always able to sell our businesses off at 12-month forward earnings number. People will buy off next year earnings because they can see at the start of every year 90-100% of that, in the bank, in the can. And if your businesses are growing at 30% and you switch from a historic earnings number, when you sell to a forward earnings number, you get a pop of value. And so that 30% uplift we had in 2020 to assets is very similar to a 20-year average. I think it's about 25-26% uplift over 20 years and hundreds of exits.

But nevertheless, it's on about a 20% discount, so investors are telling you that actually we think the real value is below what HgT says.

Well, the marginal seller of HGT is saying they're prepared to sell at that value. The buyers of our companies are telling us they're prepared to buy at 30% uplifts, so who's right?

Sam Benstead: So that could be an opportunity there?

Luke Finch: I think so, yeah.

Sam Benstead: And has the board been buying back shares, has it seen that opportunity?

Luke Finch: They did their first ever buyback in Q3. I mean, it was very small, I think was only £1 million or so pounds worth out of a £1.8 billion market cap. But it moved the price that day, it showed confidence. I mean, ultimately, we didn't really want to be buying back shares because this is a long-term compounding vehicle. But yes, I think the board believe that a discount that wide is wrong.

Sam Benstead: How do higher interest rates affect the private equity industry? This could be related to companies and valuations, but also raising money.

Luke Finch: If we take companies first, and our companies in particular, higher interest rates obviously affect your cost of funding. Typically, in our capital structures for our companies, it's 60-70% equity anyway and only 30% debt, so it's not a big component of what we do. But then if you can, if you can pass on inflation or rates to your customers because, you know, the product you deliver has value and they themselves need that, then a raising rate environment is good for our portfolio.

And I guess if, as I said earlier, the products we sell through our portfolio to their customers are about making businesses more efficient and helping them reduce costs, then I think a rising cost environment is actually a driver for more and more software adoption, and we're seeing that.

As regards to the whole industry for private equity, look, I think private equity has been going for 30, 40 years. I remember not so long ago having 6% as my cost of capital in all the models when I was an investment banker, sort of 15, 20 years ago, and people were still able to make good investments then. I think it's the last few years that have been an aberration. And I think having a more normal cost of money is good for the industry.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in the trust?

Luke Finch: I do. All the executives at Hg personally invest in our funds directly, so that's where the bulk of my investment has gone. But obviously I'm able to invest in the trust. Very rarely when it's open, but through tax-efficient wrappers, so I have my kids ISAs in there, my wife's pension in there, my ISAs in there. So, anything I can put in a wrapper I'll put in the trust, anything I can't I'll put directly into our funds.

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

Luke Finch: Pleasure.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel. Don't forget to like, comment, and subscribe. See you next time.