An unwelcome merger deal for the Honeycomb Investment Trust

The Honeycomb Investment Trust (LSE: HONY) is a fund which invests in debt. It came through the pandemic with an excellent record in terms of defaults. Until recently it has provided investors with an 8%-plus dividend yield, backed by a broad portfolio of debt: everything from small business loans to consumer credit. If a fund promises more than 7.5% a year in dividends, I make it a rule to scrutinise it closely, but Honeycomb passed my test.

However, last month it announced something unusual.

Honeycomb is run by fund manager Pollen Street Capital, a private debt specialist. While there was some controversy surrounding its involvement in a lending fund called P2P Global Investments, Pollen Street has a good record and has appealed to adventurous types looking for yield.

An unusual reverse merger

But Pollen Street clearly felt something was missing. Honeycomb traded on a 6% discount to net asset value, which made raising extra capital harder, while Pollen Street had, by December, amassed a pipeline of £1.5bn in loans. How to square the circle of an asset manager hungry to grow its balance sheet with a stockmarket unwilling to put more money into the main listed fund? The answer came last month. Honeycomb will acquire Pollen Street in an all-share deal that values the investment manager at around £285m. More than half of Honeycomb’s shareholder register has backed the deal, which is due to complete next quarter.

Matt Hose of investment bank Jefferies notes that this £285m price tag represents a valuation equivalent to about 10% of Pollen Street’s £3bn assets under management (AUM), although if that £3bn includes Honeycomb’s existing £600m-odd of assets, which it seems to, it’s more like 12%. That falls to 6%-8% based on the group’s medium-term aim to grow AUM to £4bn-£5bn. Hose thinks this represents a “broadly fair” valuation; in my view, it seems a tad expensive.

A very different company

The new entity will look and feel very different, in effect becoming an operating business with a big balance sheet attached. Moreover, Hose notes that the dividend will be cut from today’s 80p to 63p in 2022 and 64p in 2023. Suddenly wealth managers and private investors who thought they were investing in a pure-play alternative-income dividend vehicle are in effect forced into an operating business with much greater risk, though arguably more upside. Unfortunately there is no tender to take out investors who might be unhappy with the deal – I would strongly suggest private investors lobby for one.

Here’s what I’d rather see

A handful of funds either wholly own their fund manager or a stake in it (Lindsell Train is a classic example). Over the next year I suspect we’ll see more examples of managers reversing into their funds in this sector – Hose notes that some are struggling to grow, and so moving the fund manager into the fund vehicle offers the “potential to capture current high market valuations” for asset managers. But while I can see how in the equities sector adding the fund manager stake adds upside leverage, in the alternatives sector most investors want simpler, less risky, income-based options. Adding the fund manager just increases risk and gets in the way of that income focus. 

A preferable alternative to reverse mergers would be more merger and acquisition deals. If public markets won’t fund growth, and thus effectively undervalue alternative assets, what’s to stop private equity firms from snapping them up? We’ve already seen one fund, GCP, taken over in this way. I think we’ll see a sharp rise in such activity in two sectors in particular – renewables and energy infrastructure, plus real estate investment trusts – as the fund-raising pipeline for many listed funds closes due to market volatility.