Adapting to a new landscape
Successful investing in the UK’s smaller businesses requires adopting attitudes and techniques similar to those in private equity investing, according to Tony Dalwood
At a glance
• The UK government has launched an initiative to tackle the failure of many British companies to realise their potential.
• Making a success of investing in smaller companies requires due diligence and techniques typical of private equity investors.
• Potential rewards are substantial.
• Smaller-company management teams are increasingly open to engagement with investors prepared to commit long term.
The growth of small and medium-sized companies (SMEs) in the UK is often constrained by poor availability of capital as well as the relatively short investment horizons. These weaknesses can often lead to promising UK companies either failing to fulfil their long-term potential or having to sell to larger, often foreign businesses.
The financing challenges faced by SMEs have made their way to the top of policymakers’ agendas. In his autumn statement to parliament the chancellor of the exchequer, Philip Hammond, announced he was beginning a Patient Capital Review to be chaired by Sir Damon Buffini, the former chief executive of private equity group Permira, to address the shortage of support for UK SMEs. Hammond also announced plans to pump £400m (€470m) into venture capital. The funds will come via the British Business Bank, a state-owned economic development bank, and are expected to unlock as much as £1bn for start-ups with ambitions to grow.
The government’s announcements acknowledge that the long-term investment culture in the UK can be improved and is lagging behind the likes of Germany and the US. Recent research from the Federation of Small Businesses highlighted how successful these countries have been in maintaining credit flows to small businesses.
The government recognises that positive initiatives to help increase the availability of patient capital to UK SMEs would deliver a welcome boost to the economy. Small companies are the lifeblood of the economy, so it is vital they have access to the capital they need to grow. According to a report by the Centre for Economics and Business Research, SMEs will contribute £217bn to the UK economy by 2020.
One particular concern is the barriers small companies – predominantly those listed on the Alternative Investment Market (AIM) – face in accessing long-term growth capital. Despite being listed they can suffer from being unable to access growth capital through stock markets and from a lack of interest from institutional investors.
Over the past decade several factors have converged to create market inefficiencies at the smaller end of public markets. The increasing regulatory burden makes it harder for pension funds, institutions and wealth managers to invest in smaller companies. Furthermore, shorter holding periods place a premium on the ability to sell shares in a company at short notice, while reduced sell-side capacity and research coverage restricts capital flow resulting in greater pricing dislocations and inefficiencies.
This has resulted in companies below £250m market capitalisation, and certainly those below £100m potentially, being overlooked by institutional investors and excluded from wealth managers’ central buy lists. Even AIM-specific portfolios and IHT (inheritance tax) funds tend to target the top end of the market.
Smaller companies have similar characteristics to private companies, such as significant founder/manager shareholding and low liquidity – in other words, they could be viewed as private companies with a quote. Therefore, to make a success of investing in this inefficient market, investors should be prepared to conduct thorough due diligence and use techniques typical of private-equity investors. They should also seek to invest for the long term (three to five years), be prepared to supply permanent capital to support longer term value creation, and actively engage with investee company management boards.
The rewards for doing this can be substantial. It is well documented that within UK equities, smaller companies have generated significant long-term outperformance, with further outperformance from small ‘value’ companies. The Numis Smaller Companies index (NSCI) Annual Review 2016, co-authored by London Business School professors Elroy Dimson and Paul Marsh, highlights that the NSCI ended 2015 with a return that was significantly ahead of the FTSE All-Share and the FTSE 100 indices. Indeed, the main UK benchmark used by institutional smaller-company investors, NSCI XIC, had a total return of +10.6% in 2015, compared with +1% for the FTSE All-Share index and -1.3% for the FTSE 100.
Factors creating inefficiencies at the smaller end of public markets include:
• Regulation : Following the financial crisis, regulation designed to make investing safer and more transparent has resulted in minimum institutional and wealth manager thresholds for market capitalisation rising above the AIM average of £73m and often above £100m. Some institutional investors have been even more stringent, with constraints often impeding a significant weighting to companies with a market capitalisation of below £250m;
• Liquidity: Markets are becoming increasingly impatient with reduced holding periods. Moreover, fund managers are judged on performance on a quarterly basis and can therefore be more concerned with short-term relative performance than long-term absolute performance. Fund inflows and outflows are also becoming increasingly volatile. Data from Morningstar show that investors withdrew more than £5.7bn following June’s Brexit vote. Market volatility may get worse before it gets better;
• Broker model: The traditional broker model is under significant pressure as the challenges pile up; indeed, as market volatility and regulation exacerbate falling commissions. Aside from challenging market conditions for small and mid-cap brokers, companies below £100m are typically only covered by their house broker. This lack of independent detailed analytical coverage makes it difficult for wealth managers and stockbrokers to buy off-list.
Ultimately there are significant opportunities on AIM, and smaller company management teams are more open to engagement with investors prepared to commit long-term capital.
Close Brothers’ latest Business Barometer highlights how UK SMEs need help. The survey revealed that 19% of business owners say there is too much red tape involved in accessing finance, with 14% lacking sufficient collateral to get the loans they want. The Patient Capital Review is a step in the right direction – it is crucial that small companies get the capital and constructive engagement they need to grow, and with the public markets failing them in some areas, they must look at alternative sources.
Tony Dalwood is the chief executive of Gresham House, a specialist investment management group