Two private equity trusts: one to buy, one to avoid

The recent $800m fund-raise by Revolut valued the loss-making digital bank, which was founded just six years ago, at $33bn.

That’s six times its valuation in early 2020. It’s a stark reminder of the euphoria surrounding tech-related private equity valuations.

Few ordinary investors will have benefited either directly or indirectly (unless you happened to be one of those who bought and held when the bank initially raised money through crowdfunding sites).

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However, they may have benefited from the huge (but lesser) surges in valuations of other tech-related private equity businesses via two listed funds which floated three years ago: Augmentum Fintech and Chrysalis.

Is now a good time to invest in these trusts, or should you take profits? Let’s have a look.

Augmentum Fintech: a buying opportunity for sceptics

Augmentum Fintech (LSE: AUGM) initially looked rather too esoteric for private investors. But it has subsequently more than justified the confidence of those who subscribed the initial £94m.

The trust has returned nearly 45% and has issued additional equity to double in size. The recent 15% drop in the share price provides a great opportunity for the sceptics to jump aboard.

Augmentum Capital was founded in 2010 by Tim Levene, backed by Lord Rothschild. He and his co-founders have an impressive 20-plus year record not just as management consultants but as entrepreneurs, notably having built Betfair into a global business.

Paul Volcker, former chairman of the US Federal Reserve, said in 2009 that “the most important innovation that I have seen in the past 20 years is the ATM” – but Levene and his team realised that internet technology would have a massive impact on all corners of the financial services sector.

AUGM seeks a portfolio that is diversified both by the market it serves and by the maturity of its companies, which could stretch from venture capital to listed. Levene says, as do others, that “leading fintechs are electing to remain private, leaving public market investors with limited opportunity to participate in exceptional returns.”

For example, payments company Stripe is now valued at $95bn against an initial funding valuation of $100m while Swedish-based lender Klarna is valued at $31bn against an initial valuation of $11m. Being early to invest can reap enormous returns.

There are 21 investments in the portfolio, the largest being £32.6m in investment platform Interactive Investor. Around 17% of the portfolio is in early stage investments, 18% in mid, and 55% in late stage, with 10% as a cash buffer for unexpected opportunities.

The portfolio is pan-European but half is in the UK, reflecting UK leadership in the sector rather than manager bias. “Significant businesses are being built in Scandinavia and the Netherlands and then globalised”, says Levene to reinforce the point.

One holding, Dext, was sold after about a year, generating an annual rate of return of 31%. The buyer was HGT, which suggests that there was much more to go for – but Levene says that influence over the company was limited and he wanted to show that “realisations are an important part of the story.”

AUGM targets a 20% annualised rate of return and has achieved 19% so far. This is impressive for a portfolio that is immature, presumably conservatively valued, and with little benefit from uplift on disposals.

The pipeline of opportunities is “very significant”, with £920m live and £144m being actively pursued. Hence AUGM has recently raised another £55m from investors, which accounts for the drop in the share price.

Competition mainly comes from larger investors, such as HGT and Draper Esprit, but they invest at a later stage in a broader universe. The rapid growth and evolution of the fintech sector is shown by global funding in the first quarter of this year of $29bn, which exceeded the totals for the whole of 2016 and 2017.

The pandemic has accelerated the adoption of technology – 74% of UK consumers are now using less cash and 20% of daily trading volume on the US stockmarket is now accounted for by retail investors.

Levene points out that 12% of the UK population has downloaded an online banking app for the first time during lockdown. There are still nearly 10,000 bank branches in the UK, down from over 20,000 in the mid 1980s, but most of them are now smaller and emptier.

The move of financial services online and the disintermediation of salesmen posing as advisers has much further to go, aided by technology and innovation that Volcker couldn’t have imagined just 12 years ago. While the sector giants of yesterday struggle to adapt and compete, Levene and his team are finding the entrepreneurs cutting the ground from beneath their feet.

Chrysalis: buyer beware

Chrysalis (LSE: CHRY) has been an extraordinary success story. It raised £100m at flotation at £1 a share to invest in “crossover” opportunities. Its share price is now 240p, 10% below a recent high, and its market value, after several further equity issues, is £1.3bn.

The last published net asset value (as of 31 March) is only 206p. But a flurry of good news, such as the recent flotation of Wise, makes it inevitable that the next quarterly number will be significantly higher.

The inspiration for the trust came from Richard Watts and Nick Williamson, managers of Merian’s (now part of Jupiter) small and mid-cap funds. They recognised that a growing proportion of their performance was coming from newly listed companies such as Boohoo, Fever Tree and Blue Prism – yet these companies were staying private for longer, resulting in more of the benefit of early-stage growth accruing to private equity investors.

Like Baillie Gifford and others, they realised that the solution was to invest in these companies when they were unlisted and hold them through flotation – “crossover” investing. This they could not do in their open-ended funds.

Unlike conventional private equity managers, crossover investors do not seek to control, manage or advise the companies they invest in – they simply tag along for the ride, providing passive equity to private companies intending to float in 2-5 years’ time.

Chrysalis expects to continue holding its private equity investments after flotation but doesn’t buy listed equities. Given the speed of its investment after the trust’s launch, it clearly had a shopping list ready, investing 65% of the money raised within three months.

This has brought early success. Shares in The Hut Group (an e-commerce company – “we build brands”) soared after its September 2020 flotation, while Wise (formerly Transferwise), which provides online money transfers, floated a few weeks ago. It is now valued at £9.5bn compared with a £4bn valuation in July last year.

Klarna (online payments offering credit to buyers) is expected to float soon. CHRY has just increased its investment in Starling, the online challenger bank. Wefox, the insurance technology start-up, has recently raised $650m at a $3bn valuation, almost double that in December 2019. You & Mr Jones, “the world’s first global brandtech company” (providing digital and mobile technology for marketers) raised $260m in January to value it at $1.3bn.

These six companies account for nearly 70% of the portfolio and Watts & Williamson report strong progress in all of them. With the intention of issuing further equity, they have indicated a pipeline of 13 opportunities requiring over £1bn in total as well as £250m of follow-on opportunities, including the recent £35m in Starling.

The focus is on tech-enabled disrupters rapidly scaling their businesses at the expense of established companies. Early scepticism that they had the network to give access to the best opportunities has been confounded. So what can possibly go wrong?

The potential drawbacks

Watts & Williamson have not had a crisis or setback in any investment and, without managerial control or private equity experience, it is impossible to know how they would react to a problem; everybody learns more from their mistakes than from their successes. CHRY’s investments are large, over 15% of the portfolio in at least two cases, so it is vulnerable to problems. Scottish Mortgage’s exposure to Wise and You & Mr Jones is much smaller.

Tom Slater, manager of Baillie Gifford’s Scottish Mortgage Trust, has expressed concern that the aggressive pace of recent flotations is encouraging companies to list too early in their development. They should be thinking longer term and building resilience into their business models.

The prospect of early flotations may be encouraging crossover investors to overpay, encouraging over-confidence by company managements. Older investors will remember the TMT (technology media and telecoms) bubble of the late 1990s in which companies progressed from start-up to FTSE 100 (or their overseas equivalent) at break-neck speed, supported by impressive financial and business progress, only to then implode.

Could history repeat itself?

Banking is a mature, highly competitive industry. Does Starling (or Metro, Resolut and Monzo) really have a sustainable edge? They have a proven ability to gain customers but will the services they offer be sufficiently profitable?

The Hut Group resembles an online Woolworths rather than a haven of quality brands. What does Klarna do that Visa, Mastercard or Apple Pay don’t? The tech boom has fostered many great businesses, but life will be tougher for the next generation.

Caveat emptor.