201. Why you can sleep more easily with private equity investments

7 July 2022 (pre-recorded 4 July 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] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. The Schroder British Opportunities Trust invests in both public and private equity. Loyal listeners may remember in January we discussed the public side of the portfolio on episode 169. Today our guests will be focusing on the private equity side of the portfolio as a complement to our previous interview. 

Chris Salih (CS): I’m Chris Salih and today we’re joined by investment directors Paul Lamacraft and Pav Sriharan, both of whom are here to talk about the role of private equity in the Schroders British Opportunities Trust (SBOT). Thank you joining us today.

Paul Lamacraft (PL): Thanks, nice to be here. 

Pav Sriharan (PS): Thanks for having us.

[INTERVIEW]

CS: So let’s start with private equity in general, and the fact that the Trust invests in it. Could you maybe explain to us what private equity does and how it differs from investing in the UK stock market and maybe talk through some of the pros and cons as well, please.

PL: Yeah, maybe I’ll just start by saying that really in its simplest form private equity investing is simply investing into private companies. So it’s relatively straightforward to understand as a concept. Private companies, obviously aren’t listed on the stock exchange, but can range in size from early stage companies, venture companies, up to growth companies, companies that are growing strongly that may not necessarily be profitable at that point in time. And then all the way up to what we term as buyout companies, which are profitable cash generative, strong, sustainable businesses. So you can invest across the whole spectrum. 

Within the British Opportunities Trust we focus in on growth and buyout businesses. So those slightly more mature businesses that are robust, growing strongly. And the majority of our investments are actually in the buyout space, which are profitable cash for generative businesses. 

But in the nutshell, that’s it. It’s investing into private companies. There’s obviously a number of complexities around doing it successfully. Fortunately we’ve been investing within the Schroders private equity team for over 25 years and across these different strategies, the adventure growth and buyout. So the complexities are fairly broad, I guess, sourcing, structuring, negotiating, and ultimately transforming the businesses. These private companies that we’re invested into is critical and then ultimately exiting them at the right time at the right price for the right return is a further complexity that brings the whole process together.

CS: Okay, we’ll go into all of that in more detail, but let’s just start with how you go about investing into private equity. You mentioned those three different avenues. Could you maybe go into each in a bit more detail for us?

PS: Yeah, sure. So as Paul said, we at Schroders Capital, we run about £15 billion in private equity strategies that span buyout, growth and venture. And we do this across a number of different investment types. Our primary investment types in what is known as transactional investment types, so secondaries direct and co-investments. We’ve got a number of different vehicles that allow investors access to private and each of these come with varying liquidity parameters and the most well established, both for us and in private in general is what’s known as a limited partnership structure in which investors lock up capital for anywhere, between a sort of 10 and 15 year period. 

What we’ve been seeing more recently, however, is the democratisation of private equity theme really play out and with that we’ve seen a lot of innovation come through in terms of creating structures that offer sort of semi liquid and liquid products that really open up the investor base for the private equity community. 

One of these structures is the investment trust that Paul and I work closer with in the UK and for us investment trusts are the perfect gateway to access private companies, you know, they are end-closed structures. So they’ve got the flexibility to hold illiquid investments such as private equity, and it allows the investors the ability to trade on the public stock exchange. 

To touch on some of the different strategies that Paul alluded to and we mentioned you know, venture capital is investing in innovation. So, you know, think of a Facebook, a Uber, long before listing these companies needed capital to allow them to get to the stage of life where they’re profitable and self-funding. And that’s sort of the really sort of early stage venture space. 

When you move into growth and buyout, which is the focus of the British Opportunities Trust, you know, in the growth space these are companies that are now, you know, they’ve found their product market fit, they’re revenue generating, they’re growing at very strong rates. Often times they can be profitable or unprofitable, but these are now becoming larger companies, emerging companies, where the risk of failure becomes a lot lower and that sort of moves nicely into sort of the buyout space where the company’s a lot more mature. And they’re working on transformational changes and growing through either organically and also through mergers and acquisitions and getting value patient through there. 

So typically as Paul mentioned, we’re looking at businesses in the Schroders British Opportunities Trust that are still growing. So significant growth rates from the revenue perspective, but are now coming or becoming profitable or very closely becoming profitable and also companies that are moving into different geographies, building out their product set. And that’s really the sort of the buyout space. And in the SBOT trust itself, we have invested in nine companies that span across both of these that are growing and we’re really excited about.

CS: Paul, I think you mentioned earlier about exit routes. Private equity obviously tends to have exit routes, could you maybe explain what these are please?

PL: Yeah. I mean, I guess we have to take it right back to the initial investment approach. So the way that we invest is we obviously spend a huge of time going through due diligence and understanding businesses, discussing with management teams, doing our reference calls, talking with our public markets team as well. So we can get that broader insight into an opportunity. But we can also draw off of the over 200 direct core investments that we’ve made historically or over the 5,000 portfolio companies that we’re invested in to be able to gain further insight and understanding in that due diligence exercise. 

But once we’re comfortable with the opportunity that we’re looking at, we also appraise the exit options, the exit opportunity for that business, if we are to invest in it. And the key here is being able to understand the requirements of the business going forward. The timeline that we would expect before we would seek a realisation. And then also to ensure that we have aligned investors around the table, so that the other investors we might be investing alongside all share a similar view as with the management that we’re targeting a 3, 5, 7 year hold on the investment. And then the key at that point is to not only understand what options we have around exit and really it’s about creating as many options as possible, but also to get a good understanding of what we would expect to realise in terms of valuation at that point in time. 

And when I talk about creating the exit options a number of private equity investors focus purely on single opportunities, single exit outcomes, which might be for example the IPO. And what we do is we try to create much more optionality around the ultimate exit so that we can be investing into businesses that may well IPO but may also be looking to be really strong as a trade acquisition. You could be looking at making an acquisition of the business in time, so attractive acquisition opportunities for trade players. And then also creating a further option, which is to be able to position these companies so that they can actually be bought by larger private equity manager in time to come. So it’s about creating as much options in the ultimate exit as we can. And we do a huge amount of that assessment at the day we actually invest right up front.

CS: I was going to ask is a lot of that done early stage? You have sort of like a flat plan of what you want that to look like when you first begin to invest in a company.

PL: Yeah. We have a broad outline of what we would expect to be the outcome in terms of the exit and like I say only around maybe 10% of private equity investments actually go on to IPO. So that doesn’t tend to be our pure focus. It’s about creating the strongest businesses that we can, transforming them, as Pav previously mentioned over our holding period so that they become really attractive either IPO candidates or trade acquisition candidates or financial sponsor, private equity candidates for them to purchase from later on down the line. And that transformation is really key to driving the returns because the way that we transform is we look to invest into businesses that we can professionalise that we can really scale up, that we can support in the product rollouts or the geographic rollouts or we can assist them with M&A.

And actually when we look back at a number of the different investments we’ve made in the private equity space in the British Opportunities Trust, the vast majority of those have already completed multiple transaction, multiple buttons to enable them to scale up further over time. And this is all part of that transformation process that increases the scale of the business increases the valuation of the business. As these businesses become larger, they attract higher valuation multiples over time and as they become more attractive to potential financials in the future. So there’s quite a huge of work that goes in up front in that that due diligence progress to really get a handle around where we expect to exit. What sort of return we would expect to achieve so that we can follow the progress of the business over the following 3, 5, 7 years. 

CS: Thank you. So I just wanna turn to COVID. Obviously the trust has been launched sort of in response to COVID, does that necessarily mean as COVID recedes the investment case ceases to be relevant, if COVID ever recedes. But maybe just talk us through that as part of the trust.

PL: Yeah, I think it’s a great question. And it’s one we have been asked a couple of times. The reason for launching the trust was so that we could be investing into supporting UK businesses, growing UK businesses, that could expand throughout the UK, could expand globally as well, but had operations within UK. 

During COVID clearly there was a significant amount of strain and uncertainty, which meant that some of these businesses may not be able to get the funding that they would require. Now while COVID has to some extent receded. And we never know if we’ve quite got it behind us yet, but it has certainly receded from the hay day a couple of years ago, we still think the uncertainty within the UK and globally is so significant that actually we continue to believe there’s a real need for support for UK growth companies and buyout companies.

So we’re facing a number of different issues as I’m sure your listeners will be very well aware in terms of inflation, in terms of supply chain shocks, it still seems to exacerbate around the world. We’ve got a number of challenges from a macro perspective, notwithstanding the tragedies in Ukraine. So there’s a number of different challenges that companies face. And for that reason, I think the relevance of the British Opportunities Trust remains absolutely vital right now. So yeah I think in short, absolutely it remains a key strategy for moving forward.

CS: And obviously ESG credentials have become sort of an important part of any investment. How do you factor ESG credentials into a private company? And do you find they’re more conscious and proactive towards sustainability?

PL: Yeah. Another good question. So ESG is again critical actually for the British Opportunities Trust. We engage with all of the private companies that we’re investing into. We require UN SDG alignment. So the Sustainable Development Goals, we require the businesses that we’re investing into are aligned with one or more of those. Now that’s obviously very useful, but some businesses haven’t quite got to that level where they’ve developed their ESG practices to that extent. So we’re also happy to invest into businesses where we can really help them deliver or develop their ESG framework going forward and all private companies that we talk to are aware of the importance of ESG today and absolutely going forward. So this is a sort of pushing on an open door to have these conversations. 

One great example of a business that we invested into, which is Graphcore, which is a UK high tech semiconductor business that’s developing next generation tools. This was a business that hadn’t quite formalised its UN SDG alignment. And so it was a business where we were actually looking to make the investment and undertaken our due diligence process. We could introduce our sustainability ESG teams and open up a dialogue with the Graphcore team to really help them shape their framework going forward. It was one of the key attributes that they saw of Schroders coming on to the register to support them in that regard going forward. 

So we take it very seriously, all the businesses that we’re invested into also see the value in it but I’m sure that’s the case for public companies as well. ESG just becomes a critical factor across the board in all honestly. But it’s definitely something hone in on very closely during due diligence. 

CS: Okay and you recently added Mintec to the portfolio and they’re a leading sort of global provider of food related commodity prices, forecast, and analytics to the food industry. I mean, given the higher cost of food prices, that’s quite timed at the moment around the world. Could you maybe tell us more about what they do and how a company like that fits in the portfolio?

PS: Yeah, sure. Great question. Look, we’re really excited about the addition of Mintec to the British Opportunities Trust portfolio. As you’ve stated, Mintec are the global leading price reporting agency for non-exchange traded food commodities. So think food products, ingredients, textiles, many others, they are servicing the largest industrial sector globally, which is the food sector. And just to give you context on size, that’s a $9 trillion market. And it’s about 10% of global GDP. 

What we really like about the company is they’re servicing sectors that are historically suffered from price transparency issues, and clearly this leads to inefficiency in negotiating and budgeting and the whole procurement process really for companies and they’re serving around 700 clients across food manufacturing and retail, and here think of blue chip names like Nestle, Unilever, Walmart, Tesco etc. 

In terms of why it fits our portfolio, as we’ve touched the genesis of the SBOT fund strategy is really growth. And on the PE side, that’s looking at the kind of growth to buyout stage businesses in terms of its life cycle, just to remind the audience. Mintec are a clear market leader and they’ve got very strong growth opportunities in, you know, what we believe is a greenfield market. And again, to provide some context and numbers, this is a target addressable market of 900 million. It’s largely unpenetrated and their market share is only 2.5%. And if you look at their clients, they have constant margin pressure and suffer from pricing dynamics and high volatility in the whole procurement process. So really what Mintec offers is a mission critical product. 

As you say, it’s a very timely investment because, you know, we’ve actually seen Mintec experience an increase in demand given what’s going on in Russian/Ukraine, and the volatility on the pricing side in terms of food commodity, but also supply shortages. From a business perspective, high recurring revenue, good profit margins, strong cashflow conversion, good pricing power and very good organic growth. So it ticks many boxes on our side. So, you know, a very timely investment, but looking at the business and fundamentals an isolation you know, it ticks as many boxes as we say. So we’re thrilled to have this addition to our portfolio.

CS: We talked about exit routes at the start. Would that be an example of perhaps the investment case changing from the point of investment to now? I mean, the world has changed, food prices are going up, we don’t know how long it’s gonna be. Would the exit route investment case change at any point already, or would it just be case of needing to be as flexible as possible with a company like that?

PS: No, I think flexibility is key. As Paul said, we spend a lot of time for companies an example know to give an example, you know, we don’t like companies that just want to go down the IPO or a public listing route, given the challenges if those markets are shut. So, you know, the ability to professionalise and industrialise the business allows you to have much more optionality at exit. 

And so, you know, there’s a multitude of options we believe for Mintec, be it selling upstream to larger private equity owners. And you’ve got a more diversified business and the ability to sell at higher multiples. Or actually this could be quite attractive to a strategic. So I think whilst very positive and timely from an investment perspective, and we should see that come through in the financials. I don’t think it changes the investment sort of exit thesis. And I think there is a lot of optionality for this company. 

PL: Another thing to add on Mintec, this is a cracking business as Pav’s obviously alluded to there but it’s also a business that we’ve been following for the last four or five years this was a business that was invested into, by one of our GPs, one of the GPs that we’ve supported for a good number of years. So we were able to follow and track the progress of that business for several years before actually having the opportunity this year, just to invest into ourselves. So at that point, you can see that it’s scaled, you can get that confidence around the business, the way that it’s been growing historically. And you can really feel as if you’re invested alongside some top quality investors with you. So that we can really get excited about the opportunity now that we know it even better than you might ordinarily do. If you just come into fresh investment without having that history, so’s a great opportunity for us really excited about it.

CS: And just lastly obviously we’ve got some listeners who perhaps have not invested in private before, or are looking to invest in private. Could you maybe just explain why now might be a good time or why they might want consider it as an investment now?

PL: Yeah, I thinking investing in private equity has been proven over the long term to be able to deliver some really great returns. Certainly in excess of those returns that we’re seeing in the public markets, but private equity also has reduced volatility. When you look at the opportunity in the public markets and you see the volatility that we’ve obviously experienced over the last few months, private equity tends to have a less daily priced volatility built into it. So the sentiment doesn’t fluctuate emotionally quite as much within private equity because private are generally marked on a quarterly basis. So you don’t get these expenses and fluctuations and therefore much less volatile and you can sleep more easily with private equity investments. I think in relation to the British Opportunities Trust, there’s also a discount at play in relation to an investment trust that feels unjustified and feels like a great opportunity to be aware of. So all in all, I think the long term returns from private equity, the lower volatility from private equity, all suggest to me that it’s an area that people should be really quiet closely looking at if not yet.

CS: That’s great, Paul, Pav, thank you very for joining us today.

PL: Brilliant. Thanks very much, indeed.

SW: The Schroder British Opportunities Trust is one of the few products to be launched in response to the pandemic. The trust seeks to tap into the unloved status of UK equities by targeting companies which have been in the eye of the storm, both through public and private equity investments. To learn more about the Schroder British Opportunities Trust visit our website fundcalibre.com and to hear more about the public side of the portfolio be sure to listen to episode 169. Don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

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 the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.