Weekly Commentary: 02/09/19

It’s a bi-polar world

Printing money hoping that will engineer inflation has in the past resulted in inflation, but it hasn’t worked. As central banks increase their balance sheets the hope was that banks use the reserves to create money to increase their lending, but that only happens when banks wish to lend and borrowers wish to borrow. At the same time as the government has been increasing reserves they have introduced an extra bank tax rate and increased the bank reserving requirements thus discouraging the banks from lending. It’s a bit like telling the kids to go and play in the garden while removing the toys. Neither do consumers appear to want to spend a lot more.

We do however seem to want to invest more. The lower interest rates that come with QE have served to increase asset prices such that there are some very dangerous valuations around at the moment (check with the Unicorns for details). And now, with weak economies in Europe we are faced with negative interest rates. Which means it costs us to hold cash, which puts us in a bit of a tight spot. We don’t want to hold cash in the bank and the alternative is to invest in overvalued stocks thus ensuring a potential negative return over the next few years until earnings catch up with valuations. There is, as far as I can see, only one safe answer.

The Mattress. It will soon be cheaper to hold money under the mattress than to hold it in a bank account. The mattress doesn’t charge me for holding it, although there could conceivably be some wear and tear involved. If negative rates haven’t had the expected multiplier effect of increasing bank lending and consumer spending it seems unlikely that negative rates will change this. Unfortunately I don’t know any quoted mattress manufacturers but perhaps the obliging brokers will IPO one soon.

So, some 40 years after Margaret Thatcher came to power with her new weapon of monetary policy, the government seems to be returning to the pre-Thatcher world of using fiscal policy and throwing deficit caution to the wind to get us through the withdrawal from European trade agreements.

Anecdotal evidence of our own prime minister increasing health service spending while talking of tax cuts. I think his words were “rocket boosters” to “turbo charge” the economy. It sounds better than “fiscal stimulus”. It looks like we are in for a spending party to get us through Brexit.

So far we have tax cuts for high earners, hospital building programme, new railway line to link northern cities, a fund for deprived towns and restoring funding for schools.


This could very possibly create some feel good consumer spending which has been missing from this cycle. Wage growth has lagged inflation and structural change means that many are in declining industries. But this fiscal spending will increase the deficit rather like private equity uses leverage.

Against that backdrop I find myself wondering if the economy may enjoy a post Brexit bounce as the travelling proves worse than the arriving. The private equity techniques of high leverage and reducing profitability as debt is loaded on can make a lot of money for equity holders but not in a sustainable way. So perhaps the same techniques may have a similar impact on our economy. The one last spike as we spend tomorrows’ earnings today aided by a slew of cheap money fuelled by negative interest rates.

Over recent years structural growth companies have been chased by an increasing amount of money while traditional companies have increasingly been ignored. This is evident in the outperformance of the FTSE 350 Low yield index (purple line) against the FTSE 350 High Yield index (black line).

Just as the economy is about to have a fiscal boost the traditional mature businesses have underperformed materially providing fertile ground for private equity to eye some rich pickings.

Investment Approach

As the economy reaches a bi-polar world when there is a negative return for holding cash in bank accounts while growth stocks are overvalued investors need to avoid these positions if they are to avoid negative returns. Cash under the mattress may be better than cash in the bank. While neglected brands and reliable revenue streams are also likely to produce returns. Private Equity is a useful catalyst for producing those returns.

Private Equity

Private Equity funds are awash with Capital. Despite a strong pace of investment since 2014 uninvested capital in private equity funds globally has been rising since 2012 and according to Bain & Co reached $2 trillion by December 2018. They calculate that at the current run rate the dry powder held in buyout funds represents 3 years of investment.

It seems that just as value emerges in the stock market the private equity funding availability reaches new highs at the same time as the economy receives a fiscal boost. It doesn’t take a rocket scientist to work out what happens next.

Track Record

Private equity methodology involves buying unwanted companies by the stock market. They then load them up with debt, strip out the assets and cut the cost base. Generally within a 3 year period they will sell the business onto some-one else on an EBITDA multiple. The potential bid by Tilney for Smith & Williamson is a good example of the differences between the private equity approach and traditional investing.

Tilney, the wealth manager, is owned by the private equity house Permira and today has 38% underlying operating margins, far in excess of Rathbone at 29% and Brewin at 25%. This is a result of the higher revenue yield on the customer assets at 97 basis points vs 79 basis points at Brewin and 76 basis points at Rathbone combined with lower staff costs. Looking at the balance sheet it has net debt of £345m with negative net tangible assets of £25m. Rathbone on the other hand, in the quoted arena, has £226m net tangible assets and Brewin Dolphin has net tangible assets of £188m.

SharePad Tilney SmithWilliamson Brewin Rathbone comparison table 1
Source: Companies House, RNS, Sharepad

It seems likely that the enticing returns from private equity may well force Rathbone and Brewin to either become more aggressive acquirors or they may well fall prey to private equity. From a shareholders point of view both these results are generally financially positive. The social benefit is less clear – private equity strategies have been described as “pump and dump” operations.

Pump and Dump

If we take a look at the track record of previous private equity exits onto public markets it may be described as “mixed”. While the average performance is +359% in absolute terms this is skewed by exceptional performances from Fevertree and Worldpay. If we stripped these two out the average performance would be -5% over a period when the FT All Share index increased 5%. It seems that – perhaps as we may expect with leveraged companies – the performance is highly geared both ways. Private Equity may take the view that shares can only go down 100% while that thesis doesn’t sit comfortably when we are investing our savings on a long-term view.

SharePad Top performance since IPO Just Group Fevertree
Source: RNS, Sharepad

Much more productive for the UK Investor is to consider the stocks where private equity may be the predator. There are few more pleasurable feelings than coming to the screen, cup of fresh coffee in hand, for the 7am rat run of RNS announcement than to find our largest holding has received a bid.

Ideally suited to private equity leverage are businesses with recurring or reliable revenues, or strong brands. All of the businesses in the table above fit into that camp. There are two struggling businesses fitting that description that come to mind.

Ted Baker

Share Price 915p

Mkt cap £408m


Ray Kelvin started his first store in 1980 in Glasgow opened further stores in Manchester and Nottingham. In 1990 Ted Baker opened a store in Covent Garden, Soho and Leeds. Kelvin subsequently bought the company outright from part-owners Goldberg and Sons. Ted Baker Woman was launched in 1995 and the company came to market in 1997. Now the company is a global lifestyle brand encompassing clothing, grooming, sports-wear, watches and electrical goods. It is the ability to use this brand in multiple products that could well attract private equity to the business. The founder was forced to resign earlier this year following a series of profit warnings and allegations of “forced hugging, but he still owns 35% of the company. In July this year the newspapers reported that Kelvin had made “discreet enquiries about taking the company private”.


Last year to January 2019 the company reported £461m revenue from retail sales, £156m from wholesale and £22.1m of licensing revenue. Profits were down 14% to £63m on account of competitive discounting in the retail sector, consumer uncertainty and the challenges facing their trading partners. Weather was also included (as is a customary) on the list of retailer excuses. E-commerce revenues grew 18% to £98m, some 31% of the retail revenue in the UK, while in US ecommerce is 16% of retail revenue. It seems to me that the scalability of this ecommerce revenue and the licensing revenues could well be attractive to private equity.

Balance Sheet

The net debt was £123.8m at the year end and on top of this the company has something in excess of £50m of annual lease commitments which will come onto the balance sheet in the current period. This will result in an increase in assets and liabilities of c.£187m. The company also owns the freehold of its head office, named the “Ugly Brown Building” which it acquired in 2017 for £58m.


Forecast anticipate a reduction in profit this year followed by a recovery in the year to January 2021.

Source: Sharepad


Market Valuation – On the January 2020 numbers, which are anticipated to be the trough year, the shares trade on a PE of 10.3X and yield 5% from a dividend that is almost twice covered by earnings.

Private Equity Valuation – Private equity will not look at current profitability to justify their price. Typically, they will calculate the potentially profitability with a new strategy and calculate the price by discounting the profits at the (very high) rate of return they require. It is the potential from the licensing income alongside the e-commerce growth that will turn the business into a capital light, high ROE growth business.

It is possible to envisage the £22m of licensing income becoming £100m over 3 years while e-commerce could grow to 30% of total sales from the current 26% adding perhaps another £20m of revenue. So, if we added perhaps £100m revenues to last year’s £617m we get c£720m revenue. At the forecast 12.7% EBITDA margin this would produce £90m of profit, but if private equity were able to cut 10% off the cost base this would add another £50m to the profits. So, it is not difficult to envisage profits above £100m before we start putting exotic leverage into the business. Typically this would be worth 8-10 EBITDA which is £800-£1bn of value, which compares to today’s £424m markets cap with £123m net debt mitigated by £58m of freehold property.


I am happy with the valuation that there is enough room for private equity to bid at a significant premium to the current share price and still enjoy strong returns. We have a brand, licensing income and a disaffected ex CEO (and 35% shareholder) who is reported to have held discussions with private equity. This is looking likely to me to fall prey to private equity. And until that happens we have a 5% dividend yield which is almost twice covered. I like that.

Just Group

Share Price 43p

Mkt cap £446m

Source: Sharepad


Just Group is the result of the merger between Just Retirement and Partnership Group who were innovators in the annuities market whereby they were able to provide better value annuities for retirees with impaired health using their statistical longevity data. Unfortunately, soon after their November 2013 IPO the government introduced pension freedoms which caused the annuity market to halve. Since then they have entered the care home plan insurance market, retirement mortgages and used their balance sheet for acquiring defined benefit pension schemes from companies who wish to remove this risk from their balance sheet. As the company expanded into retirement mortgages the regulator then tightened the rules requiring them to hold more assets against the retirement mortgages causing a rescue placing in March this year to strengthen the balance sheet at 80p per share since when the shares have close to halved.


For the year to December 2018 60% of the gross revenue was from the DB pension schemes, 36% from the annuities business and 3% from the car home plans.


Little progress is expected in profitability over the next couple of years which may have been a contributor to investors losing interest in the stock.


While this type of business is not a typical one for private equity to get involved in they do occasionally. Cinven are the private equity firm that brought the company to market in 2013 at 225p/share. However the valuation of these more esoteric companies can become extreme as this one appears to be.

Book Value

As an insurer it will normally be valued relative to asset value. At December 2018 the net asset value “NAV” was £1.66bn and the net tangible assets were £1.49bn. The ROE this year is a lowly 7% so we may expect it to trade at a discount to NAV. If our cost of capital was 10% it may trade at a 30% discount. However, in this case it trades at a 73% discount to net asset value.

So, if private equity bought this business they could have two options:

  • Firstly, if they stop taking new business, the capital requirement reduces enormously which enables them to release a large part of the capital held. If that was 35% less capital then they could get their money back within one year of ownership leaving them with £1.2bn of assets that will come back to them in cash as the policies expire over perhaps 15 years.
  • Secondly, they could run the business until the new divisions have built to the extent that they generate sufficient capital to be self-sustaining, which the company believes is in 2021, and then find a new buyer around the net asset value level.


This is an industry that private equity are reluctant to be involved, though it does happen. I am perplexed as to why the company itself doesn’t simply close to new business to release value. If they don’t it may be private equity of another insurer who could bid for it to release capital. Usually when the available rewards are clear free markets ensure that value comes out.


In this bi-polar world we don’t want to hold money on the bank or to invest in highly rated growth stocks. The two strategies which are likely to produce better returns are holding cash under the mattress or perhaps looking at investing in neglected brands or recurring income companies that may be attractive to private equity. Both Just Group and ted Baker are good examples of these types of company.

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