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IPE special report May 2018

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The European private equity buy-out market is booming in terms of capital raised and pension funds are increasingly looking to make an allocation to investment there. Yet the private equity buy-out market overlaps in capitalisation with the listed European small and mid cap marketplace and, indeed, the listed marketplace is not only a source of exits through IPOs, but is increasingly a source of deal flow.

Many of the factors that make European private equity buy-outs look attractive also apply to the listed small and mid cap markets, with the major distinction being that managers of listed equities do not have majority control and have no pretensions on the added value that they can bring to the management of the companies they invest in. So why invest in European listed small and mid-caps equities?

While there is some evidence that the ‘small cap effect' first mooted in the US of systematic outperformance also applies to Europe, what is also clear is that the small cap markets are likely to be far less efficient. As Neil Dunn of Munros Capital Management explains: "Firstly, there are 6,000 companies and covering them all is very labour intensive which means that to screen it properly you have to employ a lot of people.

"Secondly, you have capacity constraints; to do it properly around €2bn is the limit, which means that while the big fund managers will say they have a European small cap capacity, they aren't going to allocate their best five or six fund managers to the area." While Dunn's views may be controversial, the team at Munros, which was spun off recently from Kempen, has focused purely on European small and mid caps since 1994.

To cover the 6% market weight of the small cap segment, two general approaches are possible, suggests Piers Hillier of West LB Mellon Asset Management: "Either, investors add a handful of selected stocks up to this percentage share to the overall portfolio or they buy a specialised portfolio to cover this weight. We believe that investing in a broadly based portfolio offers a far more risk-efficient approach than merely adding a few smaller company stocks to a large cap equity portfolio. Specialised management increases outperformance potential, especially as these companies are not as extensively covered by sell side researchers," as the chart shows. European small companies are fundamentally different from those in the US and Japan. Dunn argues that "in any US city you will find a bunch of good small cap managers and their process will always be the same: identify a promising company with a good product and business plan at a very early stage and then stick with it as it expands around the US. The US market is the only market where you can do this because it's huge and seamless."

In contrast, in Japan he adds that "small caps are largely there to support large caps. For example, if a small auto supplier is about to go bust an automaker might arrange a loan for it with the bank. It might be technically insolvent and just kept alive for the benefit of the automaker."

Europe again is very different: "The US model won't work over here. In Europe we are not one big merged consumer and business market. No one has told the British consumer or businessman that he must behave like an Italian or French consumer or businessman. Europe still has a huge number of very different local markets. For a European small company this means their growth profile will differ from the US small company. They will have their strong growth phase when they are operating domestically. When it comes to translating their product or process into other markets the failure rate is enormous. Think Marks& Spencer in France.

"What that means for us is that we have a shorter time period in which to make our return than would be the case in the US. In our experience if you do find a very successful small company that has been growing for a long time it is taken over, either by a larger company or a private equity group. In the first quarter of 2005 we lost 25% of all our holdings to takeover activity."

Jan Berg from the asset management business of Credit Suisse in Zurich says that "currently small and mid-cap stocks are trading at a premium to large stocks because they are showing greater earnings improvement".

Hillier adds: "European equity earnings look set to rise by 6-8% over the next 12 months according to the analytical consensus. We expect earnings growth for small caps to be significantly ahead of this. Support also comes from debt financing being relatively cheap, hence the significant cash inflows into private equity funds looking for a leveraged return. In addition, corporate management is also playing the private equity game through cash M&A and share buy backs. With this kind of demand support we would expect additional returns above earnings forecasts as the equity risk premium (earnings yield minus the bund yield) narrows from its current 400bps."

But Berg sees some dangers: "We are finding it more difficult to identify good companies at reasonable prices, they are getting quite expensive. Small and mid cap stocks are now trading at premiums to large caps when historically they have traded at a discount because of liquidity issues. Small and mid caps valuations are now at a four year high." He goes on to warn that "a key risk to the asset class is that the premium will fall. Small and mid caps have far less liquidity than large caps, which is why historically they have traded at a discount. If small and mid cap earnings momentum were to slow, investors might want to exit the asset class, which given the relative illiquidity, would cause an increase in volatility. We don't believe that 2007 and 2008 will be good economic years, so consequently we are cautious."

Michael Hughes of JP Morgan Asset Management (JPMAM) also argues that "there is a prevailing view among investors that small caps have been outperforming for too long and are now expensive relative to large caps. Certainly they are more expensive than they were five years ago when the small cap outperformance cycle began but it is worth remembering that at times small caps have traded at a premium to large caps as a result of their faster EPS growth and we don't have a problem with that."

Taking a view on small cap valuations relative to large cap seems a natural thing to do, but Dunn argues that "the biggest mistake people make with regard to this asset class is to look at the position of small caps relative to large caps and try to guess which side they should be on. That is missing the point; the whole investment basis of European small cap is inefficiency." He goes on to argue "we only have evidence of the valuations of European small caps relative to large caps back to 1989 when HSBC produced the first index. However the evidence so far follows a very similar trend to that seen in the US since 1926. If you look at the whole experience of small cap versus large caps in index terms between 1989 and 2001, small caps have underperformed in every single year. People who had invested seriously in small caps have been coming out of the asset class throughout that period and in so doing making it even more inefficient.

"There are various excuses expressed for small cap performance, such as the impact of globalisation, but it is all nonsense. Every single year since we started focusing solely on small caps, since 1994, we have outperformed the large cap index." Dunn's argument is that in Europe, the small/large cap relationship is "not a fundamental relationship, it's a stock market risk evasion/risk taking relationship. So don't use fundamentals as a guide post for asset allocation, use the inefficiency as your guidepost!"

It is also worth pointing out that looking at the performances of small cap indices can be very misleading since successful small cap companies either move out of the index or are taken over!

The impact of private equity activity in the European equity marketplace is clearly a factor that active small cap managers have to react to. As Credit Suisse's Berg explains: "Private equity is a theme we are playing at the moment. We search the universe for the stock characteristics that private equity investors might find attractive. For example, for the last year we have certainly incorporated strong balance sheets and cash flow into our screening. We have been quite successful; there have been a couple of companies where we have identified that have attracted private equity interest. Every portfolio manager in Europe has been surprised at some of the prices that private equity groups have been prepared to pay!"

His own view is that "the margins private equity groups currently generate will fall in the long term. It might take a couple of years but I think it will become much harder for these groups to generate above average performance. As an example, it's getting a lot harder for private equity groups to IPO portfolio companies. Public market investors are getting more cautious and looking more closely at the multiples. IPOs from private equity groups typically come with high debt levels, which reduce potential dividend payments. After a while performance will return to a normalised level."

Dunn also injects a note of caution with regard to European private equity: "I am always nervous when in any investment market the general trend leads to a vast expansion in activities. That's never happened in the small cap market. When I see what has happened to private equity, I feel the expansion of liquidity has outpaced the generation of opportunities. It's a bit like an IPO boom, the first wave of companies are usually of high quality and come at an attractive price. Once the boom moves into the second phase it's about lower quality companies and much higher prices."

Private equity firms will argue that their ability to add value may enable the best firms at least to maintain a return advantage over listed equities. The issue for investors however, is gaining access to the best firms, which is also a problem for investment in listed small caps, with many firms closed to new investment through capacity constraints.

 

The key issue for any small and mid cap manager is how to have a disciplined process that can sift through 6,000 or more companies to arrive at investable portfolios in a cost effective way. One approach is that of Dimensional Fund Advisors (DFA) who adopt a passive approach by essentially buying every stock they can get hold of at acceptable prices, almost acting as a buyer of last resort. Without having to engage in artificial turnover generated through having to track closely to an external index, such an approach can give a low cost exposure to the whole asset class.

DFA's Garret Quigley also points out that their approach gives rise to very low turnover of around 10% annually for core portfolios, and 20-25% for small cap value portfolios. As capacity constraints are determined by the turnover the strategy entails, DFA is also able to have a higher capacity for their funds.

Clearly, every firms needs to use some quantitative screening. The initial step can be quite straightforward, as Dunn explains: "Of the 6,000 companies in our universe roughly half don't meet our criteria of liquidity."

Quantitative driven firms, such as Axa Rosenberg, have achieved success in recent years through adopting a consistent approach to analysing all the companies in the universe through a break down of published data. Screening by any firm invariably focuses on similar sets of variables such as earnings revisions, P/E ratios, etc.

JPMAM sees that "there are certain specific characteristics of companies which are associated with long-term outperformance: value, momentum (stocks which have been outperforming tend to outperform in the future), broker estimate revisions (stocks which have received upgrades tend to go on receiving further upgrades)." They use these in an approach they dub "behavioural finance" because "our view is that each and every one of these styles outperforms due to the collective impact of human psychology on the market. Value works over time (though not all the time) because people find it very difficult to go out and buy a whole load of stocks that no one else wants. Managers tend to build similar portfolios because if they underperform everyone will be exposed, it's a herd mentality."

Dunn though, sees serious
problems in trying to extract information from historic small cap data: "Screening on historical financial data is far from optimal. We see the optimum holding period for a stock as being about three years but the fact of the matter is that small companies change constantly and they change substantially. If you get a list of successful companies over the last three years, usually you are also looking at a list of companies that will be very unsuccessful over the next three years. The only screen process that therefore works is a manual one. Whether you have €50m under management or €500m you need five or six people."

Many firms, including JPMAM, Munros and West LB Mellon try and combine quantitative screening with a thorough fundamental analysis based on, as Munros' Dunn puts it, "the standard four boxes you see in everyone's process chart: financial analysis, business analysis, valuation analysis, management assessment". What is often controversial is the extent that company visits can add value to the process. Dunn does see value: "We use visits to companies to build up a picture, we meet over 500 companies per year. When we see them we are also building up a picture of what the visibility of earnings is inside that company. If the management tells you that they have nine months' visibility, what value should I put on my estimate of their earnings two years ahead? We need to know that so we can put a discount on our estimate."

The European marketplace is more difficult than the US for small and mid cap companies to thrive in given the huge difficulties in transferring business models across countries. Investors in the sector may therefore be best served by awarding mandates to firms with dedicated and significant high-calibre resources to the sector, who are best placed to identify the companies best able to overcome the challenges, using ideas and methodologies that may not be that dissimilar to those seen in European private equity buy-out firms.

The problem may be, as in private equity, finding high-calibre firms with capacity to spare.

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