This specialist software fund is still cheap

Private equity trusts have produced some of the best returns in recent years, but investors remain sceptical. The average fall in shares in the first quarter was 9% and the average discount to net asset value (NAV) grew from 15% to 21%.

The £2bn HgCapital Trust (LSE: HGT) is top of the performance table with a five-year return of 233%. Growth in NAV has compounded at 20% for the last ten years, yet the shares trade on a 7.5% discount.

Hg was one of the few trusts to sail through the financial crisis unharmed. Its strong financial position then enabled it to buy businesses while competitors were forced sellers. It sold underperforming, peripheral investments to focus on its core speciality, software and services, investing mostly via the $30bn of funds run by Hg. Sales at its top-20 portfolio companies in the last five years have grown by 22% and cash flow by 28%.

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However, these businesses look richly valued on a multiple of 27.4 times cash flow, well above the 20.5 for the S&P 500 software & services sector. With many investors believing the technology sector is still highly priced, this valuation premium accounts for some of the scepticism. Investors worry that it’s too good to last.

A greater focus on profits

David Toms, Hg’s director of research, puts this into context. The value-to-sales of loss-making firms has halved in the last year, he says, but that of profitable firms is only down 4%. “Unprofitable companies were growing sales much faster, but growth for growth’s sake has been hit hard.” A year ago, unprofitable companies were valued at very similar levels to profitable ones, but now they have reverted to their historic valuation discount.

The software sector now trades on 18 times cash flow, compared with 14 for non-software, yet the valuation relative to free cash flow is similar at 28 and 27. This reflects the low capital requirements of software.

Twenty years ago, software companies were selling large packages, making sales lumpy and vulnerable to delays and postponements. Now, sales are by annual subscription, making them more predictable. Software sales growth in 2022 was 11%, compared with 6% for non-software. Hg focuses on businesses with “consistency and replicability of performance,” says Nic Humphries, Hg’s senior partner. He expects “software sales to continue to grow at 2.5 times the rate of GDP”.

Hg concentrates on mission-critical business-to-business software. It does not invest in start-ups: “we track businesses on average for five years before investing”. While it does not rule out unprofitable businesses, a clear path to significant margins is essential. Portfolio businesses are highly profitable, generating an average 35% margin of cash flow to sales.

High-quality management

The manager’s continued ability to find new investments at attractive prices was shown by two acquisitions in early April, costing Hg a combined £114m. This still leaves £318m of liquid resources available for future purchases, assuming no disposals. The fact that disposals in 2021 were at an average uplift of 40% to book value confirms that the portfolio valuation, far from being extravagant, is modest.

The management of the portfolio is labour intensive and the managers are well rewarded for success. As for all listed private equity trusts, the total expense ratio is high (1.4% in 2021). This makes most private wealth managers reluctant to invest in the sector and so it trades at generous discounts to net asset values that are both conservative and out of date. Therein lies the opportunity for private investors concerned only with performance.