169. Investing in public and private equity

20 January 2022 (pre-recorded 12 January 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Chris Salih (CS): Hello and welcome to the Investing on the go podcast. I’m Chris Salih and today we are here to discuss the Schroder British Opportunities Trust (SBOT) with portfolio manager, Rory Bateman and UK small and mid-cap analyst Uzo Ekwue. Rory and Uzo work on the trust, which invests in both public and private equity, they work on the public side and are here to discuss that element of the portfolio. Thank you for joining us today.

Rory Bateman (RB): Good morning.

Uzo Ekwue (UE): Morning. Thank you.

[INTERVIEW]

[0:28]

CS: The trust was launched just over a year ago in response to the pandemic. Could you perhaps tell us a bit more about that and what opportunities you saw at the time?

RB: Yeah, look, the Schroder British Opportunities Trust really was, the genesis was around the time of the pandemic when we felt at that point in time, it was a pretty much a once in generation opportunity to buy really great quality UK small andmid-cap companies up to a market cap of £2 billion. On the public and the private side, trying to ensure we got into companies with lots of valuation upside, companies that weren’t distressed in terms of debt, but companies that needed fresh equity to be injected into those businesses for them to realise the full potential within their particular business model. So focused on UK businesses, really high growth potential, businesses that required fresh equity to maximise the potential growth.

[1:25]

CS: And when it comes to high growth companies that have benefited from the pandemic, you tend to think of things like Amazon and Zoom in the tech space. What type of company does the UK have to offer this space? And could you also perhaps give us a couple of examples just for the listeners?

UE: Yeah, sure. So I suppose you know, apart from obvious companies in areas like online food delivery and other types of e-commerce businesses that have done quite well, there are also these types of companies that have an indirect exposure to this space. So because they provide services to firms that need to adapt to the changing technological landscapes. So an example of this is a company called Ascential, which we own, and that’s really interesting company. You know, it provides data and analytics to global consumer brands, and it really helps them to embrace e-commerce and to understand the competitiveness of their products. And then they also have another business which they run events like the Money 2020 events, but the more exciting part of the business is really the data and analytic side of things. And over the last couple of years, you know, what you’ve really seen with them is dispose of this, you know, the non-core businesses in favour of this fast-growing area. And they raised equity last summer, which we participated in, and trading continues to be quite strong.

And then I think, you know, aside from that, whilst tech is often the, you know, spoken about theme, there are other areas that have done quite well during the pandemic. So if we were to look at, from a backward looking perspective, the earlier phase of the pandemic, we saw it coincide with lower economic growth and lower output. But then as that began to reverse in early 2021, we then saw a number of companies do well from, you know, the subsequent economic upswing. So, you know, we think about these companies being in the industrialisation theme. So where you saw suppliers, they began to manufacture more to meet excess demand. And then, you know, the combination of that strong demand and the supply chain issues and high commodity prices really saw them, or rather it recreated a higher inflationary environment and then it allowed them to have a lot of pricing power. So companies that we own there, for example, Volution and Luceco, for instance their share price did quite well. And then also because they’re exposed to the residential RMI (repair, maintenance and improvements) market and, you know, obviously, you know, we’ve seen over the last couple of years, people have been spending more on their homes, et cetera. And then also, you know, these companies have also been, they’ve had favorable tailwinds, regulatory, environmental, et cetera. So it really has been a bit of a mixed bag.

[4:04]

CS: Obviously the growth side is one part of the trust. The other sort of tranche is the undervalued UK companies element, that’s probably a large universe at the moment given the UK’s been unloved for a number of years. What do you look at for sort of in particular there? Is it just cheap? Or are there other elements as well, you look for?

RB: Well, look, I mean clearly I mentioned at the beginning, you know, the attractiveness of the UK market relative to many other places in the world because of the Brexit overhang over the last few years, people just have avoided the UK market, particularly international investors. So we felt, and we continue to feel that there’s a massive opportunity. But you’re quite right. There are a number of almost really value opportunities in the market, companies that are still growing. But valuations really are very attractive, I’ll hand over to Uzo, maybe to provide one or two examples.

UE: Yes. I think one example is probably a company that we think is, you know, unjustifiably lowly valued, and that’s One Savings Bank and we own that. And it’s a specialist buy to let lender and it’s basically benefiting from you know, larger more traditional high street banks, which are pulling away from the buy to let mortgage market. So, you know, we’ve seen, or rather we expect net loan growth in this business to be in the double digits. It’s cost to income ratio is less than 30%, so it’s quite efficiently run. But then when we look at it you know, it trades at just over one times price to book for a business that sort of through the cycle is generating 20% to 25% return on equity. So, you know, we obviously think that’s very, very low and the price to book should be a lot higher than that. And then to top it all off, it’s got lots of surplus capital on its balance sheets. And when you look at that relative to the market cap, we think that some of that could be paid away through special dividends in the future.

RB: So I guess just to follow on from that, I just want to reiterate, you know, we are not buying companies that are deeply distressed in terms of debt. That’s not what this fund is about. This is a growth business. We are interested in growth companies that require fresh equity in order to grow, not to pay down significant amounts of debt. So you won’t find deeply distressed companies in the fund. There are plenty of other players out there that do that. That’s not what this fund is about. I just want to make that point absolutely clear.

[6:19]

CS: Rory obviously you specifically mentioned the Brexit overhang, and obviously the UK has been unloved for some time. You’d like to think touch wood at some point that will change. Does the trust have some sort of a shelf life, or would you look to evolve it in a different scenario or environment?

RB: Well, look, I mean, one of the unique characteristics of this fund is our ability to invest in public and private companies. You know, we are targeting 50/50, we’ll come onto that I’m sure, you know, our ability to flex the weightings in the portfolio between public and private, depending on where we are in the cycle, depending on where the most attractive opportunities are, and that’s where we are working. We work very, very closely with our private equity guys. So we are working on what are the best opportunities out there in the marketplace for buying British, great British companies? And we don’t care whether they’re public or private. So we will use that flexibility to understand where the best opportunities are. And that may indeed mean that we’ve got more public at one point in time or more private in another point in time.

So, you know, I think that having that flexibility, having that unique fund structure, really does give us that flexibility and in terms of shelf life, that ability or that the strategy around buying companies that require fresh equity to grow, that’s never gonna stop, that will go on in perpetuity. So what we’ve gotta do is identify those companies that are coming through the private channel, companies that are gonna maybe eventually end up in the public space, buying those businesses nice and early, realising the value creation through their journey and then possibly and probably owning that company right through the IPO process until they become FTSE 100 constituents, hopefully at the end of the day. So that ability to buy companies right from the beginning in the private space right the way through to public space gives us huge amounts of flexibility, which is why this is an evergreen strategy.

[8:12]

CS: You mentioned the 50/50 there between public and private. Let’s dig a little deeper on that right now. What does the trust look like at the moment? Do you envisage it changing at any point? And is it sort of company dependent or market dependent, the sort of balance between public and private?

RB: Obviously we’ve been going a year. It takes time. It takes longer to invest in public sorry, private equity businesses than it does on the public side. So we got relatively quickly invested on the public side very quickly. So we were about 60%- 70% invested in public and what we are doing now ,which implies 30% on the private side, we’re gradually reducing some of the public names and investing the remainder of the cash into the private names as we go forward over the coming months. So by the end of 15, 18 months into the life of the fund, we’ll be at 50/50. And as I said before, in the previous response, it depends on where the best opportunities lie as to where we take that 50/50 split from here. So we’re well on track, as I’ve mentioned, we’ve got six private equity businesses in the fund at the moment, and they are all within the top 10 holdings of the fund. We would look to get another three or four into the fund and they will be, that compares to around 20 to 30 companies on the public side. So total portfolio holdings around 40, of which you’re gonna have end to 15 on the private side, 20 to 30 on the on the public side.

[9:33]

CS:  And just to take a step back. Could you maybe talk us through the pros and cons of private equity and also maybe just a little bit, the relationship between you and the private equity side in terms of the team and how that works, the dynamics behind the trust with the private equity side?

UE:  Yeah, sure. So I suppose where we’re sort of talking about returns, I’d say the really does depend on the stage that the company is at. So for example, the earlier stage venture capital deals. So, you know, companies at the seed or the series A stages where the companies are they’re usually unprofitable. The economics of the business is unproven. But you know, it can actually be quite rewarding from a returns perspective, but the industry loss ratio is quite high. And then in contrast, you might have later growth companies that have lower returns, but the industry loss ratio is actually lower than on the seed and series A stage.

RB: Just to add on that, I mean, look, the private equity space historically, because of the illiquidity premium, does generate higher returns. That is the, you know, that is a key part of the proposition. And we would expect that to continue. We have we have a business that we own Rapyd in the fund. As I mentioned before, we’ve already seen a hundred percent revaluation of that particular company within the portfolio. We’ve had a number we’ve had one or two other companies within the fund already within the first year have revaluations upwards. So, you know, you can see that the return profile from private equity is very strong. We would anticipate that to continue. And that is a key benefit of investing in private equity cause the return profiles tend to be higher.

UE: In terms of the negative, obviously there isn’t a liquid market for investors to sell, you know, at their leisure, in private companies. So they usually are locked in for quite a number of years. So that’s a drawback. And then we think another drawback is sort of, obviously private equity investors they’re usually for sellers at IPO, or at least until the lockup period expires. But I think what we’ve really tried to do with SBOT, so it’s a vehicle that, you know, obviously it benefits from both public and private. So we think that firstly, you know, the information that we gain from looking at companies whether or not they are public or not, really means that we can make the best investments in any given industry. Our strategy for this fund is less focused on early stage [inaudible] investments in favor of a bit more of the later stage stuff. So, you know, the likelihood of these businesses failing is much lower in our opinion, and, you know, SBOT, it is a permanent capital vehicle, but it’s publicly listed as well. So which means that there is an active secondary market for investors to buy and sell as they wish. And finally, because we can hold companies as they transition from being private to public, it then means that we’re not for sellers at IPO.

RB: You do obviously as Uzo has mentioned, you suffer from this illiquidity premium, but the beauty of an investment trust is clearly that it’s closed ended and the volatility and the share price is how you can buy and sell the shares. So it’s a real fantastic proposition in terms of that whole democratisation of private assets. We can get different clients into the portfolio and they’re able to buy and sell the shares, but retain that exposure to private equity, which is crucial part of the strategy.

[12:56]

In terms of Schroder’s capabilities in the private equity space. We’ve been exploring expansion into private equity over the last five years. We’re now running well over £50 billion in assets, in the private equity space. We have a global team. We have people in New York, in Asia and London. And we have a dedicated team of professionals on the Schroders British Opportunities Trust who look at the British businesses, of course, a couple of individuals: Tim Creed is obviously the head of private equity, and we’ve got Paul Lamacraft and Harry Raikes who are dedicated to this fund and other UK private equity businesses in terms of their overall broader suite of products. So it’s a very, very well resourced and obviously Uzo and I, and Tom Grady, we work together the six of us, primarily on this fund to get and we talk about the ideas, we compete ideas into the portfolio to decide on which is the best idea to get any into the portfolio, any point in time.

[13:57]

CS: And just lastly, what type of investor would you say the trust is suitable for?

RB: Well as I mentioned we, when we started marketing the fund, we weren’t sure in fact, what would be the client appetite and the client base interested in this type of fund, but increasingly private equity has become really a key part of the asset allocation process, not just for private individuals, but for institutions, pension funds and the like, so we decided very early on to say, look, we want this fund to be available to the broadest range of investors possible. We want from a retail investor perspective, the democratisation of private assets to be really valid and really relevant for our investors in this fund. So we’ve got privateinvestors, we’ve got private wealth managers, we’ve got institutions, pension funds. So we’ve got a very broad remit of clients and the beauty of the proposition in terms of what we’re trying to do in the diversity of the portfolio, and its ability to invest in both public and private means it is attractive to a number of investors. So we don’t just get the private sectors investors, we get public and private sectors investors being interested in it. So very, very open to any types of shareholder. And that is indeed is what we’ve got in the book.

CS: Uzo and Rory that’s great, thank you very much for joining us today.

UE: Thank you very much.

RB: Thank you.

CS: For our listeners, we’ve talked a lot about the public element of the trust today, and we will be discussing the private side at a later date in a future podcast. And if you’d like to learn more about the Schroder British Opportunities Trust, please visit fundcalibre.com and while you’re there, remember to subscribe to the Investing on the go podcast.