Has HGCapital Trust lost the midas touch?

Has HgCapital Trust (LON:HGT) , which used to be regularly voted private equity investment trust of the year, lost its way?

This week’s 2013 results were deeply disappointing. A 1.6% drop in NAV, compared with a 20 per cent rise in the FTSE All-Share, helps explain the shares’ substantial underperformance for the last year.

Nic Humphries, HGT’s manager, admits it was a “very frustrating year” and has trotted out various excuses ranging from the trust’s performance being hampered by high liquidity and the relative immaturity of its relatively young portfolio after several exits of profitable investments.

But the real embarrassment was HGT’s need to write down £15.5m on three problem investments – Lumesse, a HR software group, NetNames, an internet domain manager, and Teufel, a German loudspeaker company – plus sell off, for next to nothing, Americana, a UK clothing brand, which it has owned for seven years. Throw in a £4.2m write down for adverse currency movements, and a £4m hit on renewable energy, and HGT’s performance contrasts poorly with the rest of the private equity sector.

HGT’s speciality is mid-market buyouts with enterprise values of between £50m and £500m and lower mid-market buyouts in the TMT sector between £20m and £80m. It also invests in renewable power generating projects between €10m and €50m.

HGT says that these markets offer a high volume of companies with proven financial performance and strong market positions. Its target companies are small enough to provide opportunities for operational improvement, yet large enough to attract high
quality management and to offer multiple exit options across market cycles.

HGT, whose origins can be traced back to Mercury Private Equity, is the quoted investment trust arm of the £5.2bn HGCapital Group, one of the UK’s biggest private equity firms whose motto is to “support management to grow industry champions”.

HGCapital has 100 staff, offices in London and Munich, and was long regarded as the market leader in this niche area of the private equity market. Its long-term performance remains impressive. Since 1990 it has made 116 investments, and achieved 94 exits at an average 2.5x cost, and a 36% p.a. gross IRR.

The kindest interpretation is that 2013 was an embarrassing hiccup in an otherwise stellar career, and the trust’s net asset value will soon start increasing again at an above average rate. Revenues of its top 20 investments grew at an annual rate of 9% in 2013 whilst Ebitda grew by a similar amount.

HGT shares long traded at a surprisingly high premium to the quoted private equity sector because of the apparent skills of its investment managers.

However, its premium rating has taken a hammering over the last year. At a time when discounts have been shrinking at other quoted private equity trusts, HGT’s discount has widened to 12%, more than double its average for the past year.

Over one, three and five years HGT has now underperformed the market and one has to go back 10 years to find its shares handsomely outperforming the market – 16% pa compared with 8.8% pa for the FTSE All-Share.

HGT tries harder than most ITs to communicate with its shareholders. It has a glitzy website and information packed annual report, as well as issuing a video interview with its manager, plus a very full accompanying slide presentation, when it released its results on Monday. All very professional.

Nevertheless, it is hard to see what is going to trigger a re-rating of HGT’s shares in the near term. It is noticeable that HGT’s £11.81 net asset value would look even worse than it does, if the managers had not adjusted upwards the enterprise value/Ebitda valuation multiple from 10.2 times in 2011 to 11.6 times in 2013 to reflect the higher growth businesses it is investing in.

Another worrying footnote is that private equity doyen Ian Armitage, founder of HGCapital, who stepped down as chairman in November 2012, has trimmed his stake in HGT from 4.7% to 3.7% over the last year. Whether other HGT’s executives followed his lead is unclear since the latest annual report no longer splits out the percentage of HGT’s equity owned by staff. In 2012 staff owned 1.1m HGT shares, equal to 3.15%.

Mr Armitage appears to have transferred some of his loyalty to Strategic Equity Capital (SEC), a £94m investment trust specialising in quoted UK smaller companies. Since the Summer he has acquired a 5% stake in the company.

According to SEC’s latest report the weighted average of its portfolio of 18 UK small caps is valued at 9.5 times the consensus enterprise value/Ebitda multiple, and it has an average debt to Ebitda multiple of zero.

Whilst comparisons between the valuations of quoted small cap trusts and HGT’s unquoted private equity portfolio need to be treated with caution, SEC’s EV/Ebitda multiple of 9.5 times for its portfolio compares with HGT’s 11.6 times, and it has the added advantage of no net debt overall whilst the average net debt to Ebitda ratio for HGT’s top 20 companies is four times.

Note: The author is a long-term investor in HGT.