Trust commentaryQ4 2022
2022 was a tough year for public equity markets, especially UK small and mid (“SMID”) caps. Amidst a backdrop of rising inflation, increased rates and geopolitical troubles, the market favoured more international, larger UK companies. Both banking and oil sectors, largely represented in the FTSE 100, saw robust share price returns in aggregate, boosted by trade conducted in US dollars which translated favourably to their sterling earnings. Meanwhile, UK SMID caps came under pressure due to the greater sensitivity of their valuations to rising interest rates. This naturally impacted the performance of the portfolio’s public equity allocation, as we invest in fast-growing SMID businesses.
While private equity (“PE”) valuations held up better than that of public markets in 2022, the asset class was not immune to global economic headwinds, inflation and increased interest rates. Fundraising in Europe was at its lowest since 2014 in terms of capital raised and portfolio exits dropped to their lowest value in nine years as a result, in large part due to decreased appetite for public listings. Meanwhile, less freely available capital and higher interest costs has meant debt will cost a lot more and leverage levels, which have helped boost returns in the recent past, will be lower. With all of that said, we are pleased with how our private equity holdings performed, in aggregate, in 2022.
With this context, it may come as a surprise that we are excited as investors. This is principally for two reasons. Firstly, we believe now represents an incredibly opportune moment for us as long-term, active investors to make high quality, growth investments across selective areas of the public and private equity markets in the UK. Secondly, we employ an investment process that focuses on characteristics that we believe will enable our portfolio companies to withstand and even thrive in the current challenging economic environment.
As mentioned earlier, the underperformance of publicly listed UK SMIDs (typically a faster growing and more domestically focussed area of the market) was stark in 2022. Our philosophy when investing in public markets is to identify and capture mispricings - i.e. opportunities where we do not believe that the market is discounting the long-term growth or cash generation potential that a company holds. As such 2022’s retreat in share prices (which was driven by weaker macroeconomic sentiment) provided us with an opportunity to increase our existing positions in companies such as City Pub Group and Sosandar.
The sell-off in UK SMIDs in 2022 was indiscriminate, and not discerning between the “good” and “less good” companies. As such this led to inbound M&A activity from corporates and private equity investors, who bid for some of our holdings (i.e. Euromoney, EMIS Group and Ideagen), to the benefit of the trust’s performance.
Despite the market backdrop, our approach is to remain steadfast and calm. We believe that when there is expectation of an economic recovery and market sentiment sustainably improves, small and mid-caps should be the first to re-rate in response. Furthermore, our analysis shows that such market underperformance in the past by UK SMID caps has usually been followed by outperformance over three- to five-year periods relative to large cap companies in the FTSE 100. This combined dynamic provides us with confidence that the valuations of our public holdings will recover.
Turning to private equity markets, with leverage and rising multiples unlikely to propel returns in the near term, there could be a sweet spot for strategies focussed on strong financial performance: revenue growth and profit margin improvement. For example, expansion of product lines, geographic footprint, and professionalising management to improve profit margins. This is all easier to do among small- and medium-sized companies. This is typically harder to achieve at larger companies, which have often been through several rounds of private equity or institutional ownership. For example, portfolio company EasyPark, a leading parking tech company that helps drivers find and manage parking spaces and charge their electrical vehicles, has evolved as a company in terms of product offering, maturity in the marketplace and thorough geographical expansion – the company now helps drivers in over 25 countries and more than 3,200 cities. Buy and build strategies are also positioned to do well, with opportunities to buy smaller companies with the intention to improve profitability and sell at higher multiples in the future. One example in this regard is the portfolio’s holding in Waterlogic, a leading designer, manufacturer, distributor and service provider of purified drinking water dispensers. The company embarked on a successful buy and build strategy from 2015 onwards and completed a merger with Culligan International (an innovative brand in consumer-focused, sustainable water solutions) in 2022, which benefitted the portfolio. Meanwhile, an investor’s ability to access deals, whether direct or co-investments, with or through the very best investment partners is paramount. We would argue even more so now. In Europe, the number of first-time funds hit record lows in 2022, suggesting that investors are prioritising experience and track records at times of uncertainty, making these partners potentially even harder to access. We are well positioned here, as our private equity team has established a formidable network in the UK (as well as globally) over the course of 20 years, with relationships with hard-to-access investment partners.
We invest in growing companies that have a number of attractive characteristics that we believe should allow them to withstand this tough economic environment and prosper. Whilst the macroeconomic environment will ebb and flow, our core focus is to invest in high quality companies that have strong balance sheets and that can sustainably compound their earnings over the long run. These are typically companies that have considerable pricing power, market leadership (or an opportunity to gain scale via consolidation), attractive unit economics and strong management teams. Our investments are typically profitable, but where we have invested in loss making companies, there is a clear pathway to profitability, with a strong runway of cash.
Several of our holdings, whether they are public or private, exhibit characteristics that should result in stable revenues in an economic downturn. This typically includes one or more of low customer churn, strong net revenue retention and high recurring revenues.
Finally, our differentiated public-private equity strategy enables us to continue to invest without boundaries, whilst providing access to a broader investable universe to the benefit of shareholders. We believe this differentiates Schroder British Opportunities Trust from other investment trusts and provides us with an advantage when seeking out attractive investment opportunities.
The key risks that are specific to the Company
- The Company’s strategy is to invest, initially, in companies impacted by the Covid-19 crisis in the approximately £50 million to £2 billion equity value range. These companies may not have the financial strength, diversity and resources which larger companies may have and there may be a higher risk that these companies will find it more difficult to operate during the Covid-19 crisis, as well as in periods of economic slowdown and recession. The risk of bankruptcy of such companies is also generally higher. Therefore, investment in such companies could be riskier than investments in larger companies and the deterioration in the financial condition or bankruptcy of such companies may result in greater volatility in the Company’s net asset value (“NAV”) and may materially and adversely affect the performance of the Company and returns to Shareholders.
- The long-term impacts of Covid-19 are unknown, rapidly-evolving and may be materially more severe and/or more permanent than anticipated. It is difficult to accurately predict the effects these factors may have on the investee companies within the Company’s portfolio and on the Company. The Company may invest in investee companies which do not meet the target returns anticipated by the Portfolio Managers (being Schroder Investment Management Limited and Schroder Adveq Management AG (the “Portfolio Managers”)) due to the Portfolio Managers underestimating or failing to accurately predict or foresee the time scale, severity and/or impacts of the Covid-19 crisis, which could result in a material adverse impact on the performance of the Company, the NAV and the returns to Shareholders.
- Private equity investments are difficult to value. Information from underlying investee companies may be delayed, missing or restricted which would lead to valuations being made on incomplete information.
- It is difficult to accurately time the exit of private equity investments. Exits will take time and the Portfolio Managers may have very little influence on any decisions around the timing on exits. Realisations of private equity investments may not occur on a regular straight line basis. Should an exit of a private equity investment be effected in such manner or time frame which is not compatible with the Company’s investment horizon, this could result in a material adverse impact on the Company’s NAV and on the return to Shareholders.
- There may not necessarily be a liquid market for shares in investee companies in the approximately £50 million to £2 billion equity value range even if their shares are publicly traded.
- The AIFM, the Portfolio Managers and their affiliates will provide services to other clients, which could compete directly or indirectly with the activities of the Company and may be subject to conflicts of interest in respect of their activities on behalf of the Company.
- The Company may not meet its investment objective and returns of the Company are not guaranteed.
- The Company has a fixed life and in the event that no alternative proposals are put forward to Shareholders and approved by Shareholders ahead of the winding-up date, a winding-up resolution will be proposed at the winding-up date to voluntarily liquidate the Company. This could mean that certain investments, in particular, private equity investments, may not be able to be realised at an optimal price, or that the realisation of such investments may take longer than anticipated (as it could take several years after the commencement of the winding-up of the Company until all of the Company’s private equity investments could be disposed of and any final distribution of proceeds made to Shareholders).
- The Company has no employees and the Directors have all been appointed on a non-executive basis. Therefore, the Company is reliant upon the performance of third party service providers for its executive function. Failure by any of these or any other service provider to carry out its obligations to the Company in accordance with the terms of its appointment, together with a failure by the Company to enforce such terms, could have a materially detrimental impact on the operation of the Company.
- Failure by the Company to maintain investment trust status, or changes in taxation legislation or practice, could result in the Company not being able to benefit from the current exemption for investment trusts from UK tax on chargeable gains and could affect the Company's ability to provide returns to Shareholders.
- Changes in tax legislation or practices or laws or regulations governing the Company's operations (in particular, the Listing Rules, the Prospectus Regulation, the Prospectus Regulation Rules, the Disclosure Guidance and Transparency Rules, the Market Abuse Regulation, the AIFMD and the PRIIPs Regulation) may adversely affect the Company's business.
Key risks specific to the securities:
- The Company has a total return strategy and therefore may not pay dividends to Shareholders.
- The value of the Shares can fluctuate and may go down as well as up and an investor may not get back the amount invested. The market price of the Shares, like shares in all investment trusts, may fluctuate independently of their underlying Net Asset Value and may trade at a discount or premium at different times, depending on factors such as supply and demand for the Shares, market conditions and general investor sentiment.
- There can be no guarantee that a liquid market in the Shares will exist. Accordingly, Shareholders may be unable to realise their Shares at the quoted market price or at all.
- The Company may issue new equity in the future pursuant to the Placing Programme or otherwise. Where statutory pre-emption rights are disapplied, any additional equity financing will be dilutive to those Shareholders who cannot, or choose not to, participate in such financing
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Past Performance is not a guide to future performance and may not be repeated.
This information is a marketing communication. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions.
The Company's Portfolio Managers, Schroder Investment Management Limited and Schroder Adveq Management AG, have expressed their own views and opinions in this announcement and these may change.
This announcement may contain "forward-looking" information, such as forecasts or projections. Please note that any such information is not a guarantee of any future performance and there is no assurance that any forecast or projection will be realised.
Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registration No 4191730 England. Authorised and regulated by the Financial Conduct Authority