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1. Uncovering Trusts - HgT
70 Plays8 months ago
Today Milosz dives into HgT’s portfolio of leading, profitable, unquoted European mid-market businesses with an international footprint, offering mission-critical, low-spend software solutions to SMEs. He discusses how HgT’s portfolio fulfils the so-called ‘Rule of 40’ by delivering revenue and EBITDA growth of around 20–30% per annum at a margin above 25% across its top 20 holdings. Finally, he delves into the key underlying drivers of HgT’s healthy historical returns.
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About Uncovering Trusts:
Uncovering Trusts is a podcast run by Edison analysts, which is released every two weeks. Subscribe to hear analyst interviews on how investment trusts maximise returns while managing risks for investors.
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Edison is a content-led IR business. We believe quality investment content should inform all investors, not just brokers. Our mission: Engage and build bigger, better-informed investor audiences for our clients.
Edison covers 50+ investment trusts. Read about them here: https://www.edisongroup.com/equities/investment-companies/
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Transcript
Introduction and Host/Gues Introduction
00:00:06
Speaker
Welcome to Uncovering Trusts, a podcast by the Edison Group, a content-led IR business integrating analyst, content, digital targeting and investor engagement. Each episode will uncover the distinct features, latest developments of a selected investment company.
00:00:21
Speaker
Tune in to find interesting investment ideas and to stay on top of what's happening in the investment company sector. I'm your host, Neil Shah, Director of Content and Strategy, and today I am joined by Milos Pappes, Director of Investment Trust Content at the Edison Group, who will be talking about HD Capital Trust, or HCT. Milos, thanks for joining us today. Thanks for having me. So please can you start by providing a high-level introduction to HCT for those listed or less familiar with the fund?
Investment Focus and Strategy Discussion
00:00:50
Speaker
Sure, AGD invests in leading profitable unquoted European mid-market businesses with an international footprint offering mission-critical low-spend software solutions to SMEs. It currently holds a portfolio of close to 50 such holdings and provides high-quality exposure to the corporate digitalization trend. AGD sweet spotlights in the defensive tech growth companies operating in one of eight core end markets.
00:01:16
Speaker
Tax and accounting, European payroll, legal and compliance, automation and engineering, insurance, SME tech services, capital markets and wealth management IT, and finally, healthcare IT. I believe you call the trust the king of dull tech in one of your research notes. Yes, that's true. The tax sub-sectors AGT invests in may not sound as exciting as AI, which by the way, AGT uses to drive operational improvement of portfolio companies.
00:01:45
Speaker
or the metaverse, for instance. The trust does not invest in anything glamorous and there are no consumer brands in this portfolio. That said, its portfolio holdings benefit from a strong secular trend and offer a combination of a high share of recurring revenues based on software as a service subscription models and high customer retention. AGT has historically delivered revenue and EBITDA growth of around 20 to 30% per annum.
00:02:11
Speaker
at a margin above 25% across its top 20 holdings.
Valuation and Growth Metrics
00:02:16
Speaker
Therefore, it fulfills the so-called rule of 40, which is kind of a rule of thumb, but based on empirical evidence, saying that software stocks with combined revenue growth and EBITDA margins of 40% or more typically generate higher valuations. We have discussed this in our research note published in June last year. So there is nothing dull about the business prospect of AGT's portfolio companies or its returns.
00:02:42
Speaker
Thanks. That's very helpful. So how does HCD compare with some of the other listed private equity companies on the one hand and listed technology trusts on the other hand?
00:02:54
Speaker
HDTs are listed private equity trusts, but I believe it should not be looked only from that lens, but should also be considered a potential component of an investor's broader tech exposure.
Private Equity Trust Insights
00:03:05
Speaker
This is because many tech trusts or ETFs have their portfolios skewed to US big tech or the Magnificent Seven, as they are being called these days. It is also worth noting that the listed European software tech opportunity set is contracting due to M&A and take private transactions, for example, Aviva or Microfocus.
00:03:24
Speaker
Finally, better access to private capital means that companies across regions do not need to list to raise the funds required to drive growth. As a result, companies can stay private for longer and this allows private equity investors such as HGT to retain far more of the value created by these companies. And from what I understand, as a private equity manager, HGT also actively contributes to the value creation process.
00:03:52
Speaker
Correct, AG's vast tech expertise and value creation capabilities means that it may be perceived as a sort of tech conglomerate in an investment company wrapper. This comes from a combination of three strengths. Firstly, it's in-house team of operational experts, which includes more than 50 senior operational specialists, each supported by a network of trusted third-party associates and partners.
00:04:17
Speaker
Secondly, an extensive community consisting of key managers from its portfolio companies called HD Hive. And thirdly, intellectual property tools and group services on which its portfolio companies can rely. Okay. But as a tech conglomerate doesn't have a, a tech conglomerate doesn't have a predefined holding period for its businesses like a private equity fund. So what's HCT's approach here?
Investment Structure and Returns
00:04:47
Speaker
Yes, that's a fair point. However, while AGT makes new investments and exits each year, so constantly refreshing its portfolio and generating cash flow from realisation proceeds, it can also run winners for longer. This is thanks to a tiered suite of private funds managed by AGT, which AGT invests through, covering the small-cap military funds, the mid-cap genesis funds and the large-cap Saturn funds. A portfolio holding can therefore move up the fund structure as it grows,
00:05:17
Speaker
Examples of companies which were held by defense for more than the usual private equity holding period of around three to five years, Visma, a provider of mission critical business software to SMEs, and the public sector in the Benelux and Nordic regions, and Access Group, a provider of ERP and payroll solutions. Okay, that's interesting. Okay, so you've got longevity. Now, can you
00:05:39
Speaker
Tell us anything about the main drivers about for the returns generated by the trust. What are the contributions of the operational improvements fostered by HG? Let me start by highlighting that the trust's focus on software and tech enabled services companies provided, well, proved very beneficial to the trust's returns relative to other listed PE companies over the mid to long term horizon.
00:06:05
Speaker
The trust has also outperformed several of the UK listed tech trusts over the last five years, though was somewhat behind some of them over 10 years, which I believe was at least partly due to the stellar performance of big tech names to which several of the peers have had meaningful exposure. That said, investors should probably ask themselves the question if they want to exclusively bet on these names, which have become a quite crowded trade or hold a more diverse tech portfolio.
Market Trends and Risks
00:06:32
Speaker
Coming back to your question on the return attribution, AGG's 20-year growth IRR to end 2022 stood at a healthy 33%. Software sector growth combined with AGG's focus on strong players within selected clusters and positive operating leverage effects were the main contributor with around 15 percentage points, so close to half of the returns according to AGG.
00:06:58
Speaker
the trust's average portfolio leverage is likely higher than the average gearing across a listed tech portfolio, which is an inherent feature of most listed private equity trusts. Therefore, financing leverage added a further seven percentage points, so roughly one fifth, to HD's returns. HD's operating skills and M&A, that is buy and build strategy, were also important contributors with five percentage points and six percentage points respectively. Okay, that's a good thing. So we've got the attribution.
00:07:27
Speaker
The question that comes to mind is what extent is the market for business to business services offered by HCE portfolio companies already saturated? Would a new investor in the trust be late to the game? Yeah, this is a valid question given that the trust portfolio has benefited from the structural trend towards digitalization for many years now, which accelerated since the outbreak of the COVID-19 pandemic.
00:07:54
Speaker
That said, AGG's head of research recently examined IT spending patterns across countries and found that the share of software spending grows with the level of overall IT spending as a percentage of GDP. This suggests that the sector is not approaching saturation even in the developed economies. I believe this is first because even
00:08:14
Speaker
companies which have adopted one or more software-as-a-service solutions still have many more pieces of software that they otherwise have to buy or license upfront that could alternatively be delivered via the cloud, allowing them to be paid for as they are used and kept constantly updated. Moreover, more and more business processes are being automated across an expanding range of industries. And has the trend remained strongly in the recent inflation environment as well?
00:08:43
Speaker
In general, enterprises are likely to prioritize spending on software as a service to capture competitive advantages through increased productivity, automation, and other software-driven transformation initiatives. Demand for IT services should be supported by investments in organizational efficiency and optimization projects.
Performance and Realization of Investments
00:09:01
Speaker
These measures are aimed at offsetting the white-collar wage inflation and other cost inflation, among other things, so they play nicely into the inflationary environment.
00:09:10
Speaker
According to Gartner's forecasts released in January, global software and IT services spending will grow by 12.7% and 8.7% in 2024 respectively. That said, HGG has seen some pressure on sales to new customers as they become more reluctant to commit to new software and services in the challenging macro environment. However, this has been at least partly offset by cross and upselling to existing customers.
00:09:35
Speaker
This together with Bolton acquisitions resulted in strong revenue and EBITDA growth of 25 and 28% in 2023 respectively. This was achieved at the solid EBITDA margin, which over the 12 months and September 2023 reached 30%. Okay. And how about the trust portfolio valuations and realizations during the different macro environment in 2022 and 23?
00:10:01
Speaker
It's good that you bring this up. First, it is important to underline the trust's strong long-term track record of realising investments above previous carrying value. Between 2017 and 2022, for instance, the average uplift to carrying value at the end of the preceding years stood at 38%. Furthermore, there has been no disposal below previous carrying value across the trust portfolio over the last 10 years.
00:10:25
Speaker
HD normally underwrites a multiple contraction when acquiring its platform investments, so companies forming the base of the buy and build strategy. But actually the contraction did not materialize to a meaningful extent in the past. Even in the more demanding environment in 2022 and 2023, marked by low deal activity and pressure from higher interest rates, the trust was able to realize investments above previous carrying value.
00:10:50
Speaker
In 2023, the average uplift and 2022 carrying values was, well, robust at 25%. While the trust exit activity was quite muted in the first half of 2023, it picked up subsequently, bringing its total proceeds from realizations and refinancing to 343 million pounds in 2023. This includes 109 million from the full exit of the cloud-based transportation management software platform Transporion.
00:11:16
Speaker
an uplift of 18% to the last carrying value and 22 million from the full exit of Commify, a business messaging solutions provider to local enterprises at a 32% uplift to the end March 2023 carrying value. AGT's ability to deliver meaningful liquidity events in the tough environment should be put in the context of the decline in the global PE exit activity last year, which was down around 66% from the 2021 peak.
00:11:43
Speaker
AGT has announced four further transactions in December 2023 and January this year, which AGG expects to generate around £295 million of proceeds to AGT upon closure in 2024.
00:11:56
Speaker
though some of these proceeds will be reinvested in the same businesses. These include the onboarding of new investors into Visma through the AG Saturn funds, the full exit from GGW Group, which with part of the proceeds to be reinvested in the business, the partial realization of Iris generating net proceeds of 42 million to AGT, and the full exit from Argos Media.
00:12:19
Speaker
We know, well, I would say that the GGW group and Argos Media exits value the businesses at 40% and 7% uplift to the end September 2023 carrying value, respectively.
Interest Rates and Future Potential
00:12:32
Speaker
The IRIS deal values the business in line with the end September carrying value, but around 14% above the end 2022 carrying value. I believe that these realizations and the recently announced deals are a testament to the quality of the trust portfolio and its conservative valuation approach.
00:12:48
Speaker
In light of the sort of interest rate environment, can you shed some light on the impact of higher rates on the list of private equity trusts such as HCT? Sure. HCT's average net debt to EBITDA across its top 20 holdings stood at 7.4 times at the end of September, 2023. While this may look high in absolute terms at first glance, it is worth keeping in mind a couple of things.
00:13:17
Speaker
Firstly, AGT's net debt is a proportion of its overall capital structures, less than 30%. Secondly, its businesses display high earnings growth, around half of which comes from organic growth, while the net debt to EBITDA ratio I've just mentioned is based on last 12-month earnings. Finally, the underlying businesses are highly cash generative, which often allows for relatively swift deleveraging if necessary.
00:13:41
Speaker
Interest on 75% of the debt is hedged for two years on average and most of the debt is not coming due until 2027 to 2029. During last year's capital markets today, AGG highlighted that higher interest rates may reduce its prospective gross IRR by around 3 to 4 percentage points from the 33% IRR I mentioned before, so this still leaves a strong return generation potential.
00:14:06
Speaker
Melos, thank you very much. I mean, I think you've given us a great perspective on HG and, you know, white doll tech is actually really interesting to take a look at.
Closing Remarks and Additional Resources
00:14:14
Speaker
You've been listening to Uncovering Trust, a podcast by the Edison Group. If you want to find out more about HTT and other investment companies we cover, please visit www.ettersongroup.com. Thank you.