Investors who want to gain exposure to companies at their highest-growth stage should buy in in the years leading up to their IPO, according to Richard Watts, manager of the Merian Chrysalis investment trust.
Merian Chrysalis, launched in November last year, invests in later-stage private companies with long-term growth potential. It currently has nine holdings, which Watts said have a weighted average revenue growth of more than 50 per cent.
“The reason I give that number is because I want people to make a connection that these companies are growing very, very rapidly, far faster than the companies that are listed on the stock market,” he said.
Watts was inspired to start the Merian Chrysalis investment trust after assessing the performance of the stocks he bought at IPO for his Merian UK Mid Cap fund and comparing revenue growth in the years before and after floatation.
Performance of fund vs sector & benchmark over 10yrs
Source: FE Analytics
He found the average growth rate in the year of IPO was about 30 per cent, which fell to 25 per cent the following year and 20 per cent the next.
While these are clearly attractive rates of growth, they are well below the average rates of 50 to 60 per cent per annuum they recorded in the two years before IPO.
“To put it quite simply, these companies are essentially timing their exit from the private market into the listed world as the amalgamate growth often starts to slow,” said Watts.
“So if you only participate at IPO you'll capture these companies a bit later on in that growth story, but there's less value to create subsequently. We’ve had huge success [on Merian UK Mid Cap] investing in the likes of JustEat and Boohoo and Fever-Tree. [We thought] what if we could step back and capture more growth? And that’s what Chrysalis does.”
Watts is keen to point out this trust does not just throw money at any old start-up – he typically invests in companies a few years before IPO, at a stage when they are not ready to list but need some liquidity so early stage investors can realise some of their gains. The manager added this is not just about wanting to maximise growth potential, either – with more companies choosing to stay private for longer, the number of opportunities open to small- and mid-cap managers is declining.
For example, he pointed out that the average age of exit for a company in 2011 or 2012 was five or six years, which had risen to 11 years by the end of 2018.
“To put it another way, essentially in the 10 years or so since the credit crunch, the average annual number of IPOs in the UK has been about 90,” he explained.
“In the 10 years leading up to the credit crunch, it was about 200. The replacement rate, so how many IPOs you need a year for the number of stocks present in the stock market to stay constant, is about 150 to 160.
“So in very simple terms, the stock market in the UK is shrinking.”
Watts said there are a number of reasons for this trend. Many of the start-ups he meets have been established by a founder or group of founders that like being able to make decisions that will benefit the business in the long term, as opposed to hitting short-term profit targets that a stock market listing demands. At the same time, he said that with the growth of tech-enabled capital, the private market has become a lot more sophisticated in recent years.
Regardless of the reasons, he said that anyone who shuns unquoted stocks may have to wait another five years to invest in a company compared with in 2012, adding: “There's a huge amount of value creation that is staying within the private market and therefore being lost to the public market.”
The gating of Neil Woodford’s flagship LF Woodford Equity Income fund back in the summer led to concerns about the use of unquoted holdings within funds. However, Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC), said this is where investment trusts prove their worth.
“Using an investment company to invest in unquoted companies gives investors access to a professionally managed, diversified portfolio of private companies not normally available to individual investors,” she explained.
“But investing in these hard-to-sell assets is high-risk and requires a long-term mindset. The closed-ended investment company structure frees up the manager from having to worry about inflows and outflows, while at the same time giving investors a chance to sell when they want to via the stock market. In contrast, open-ended funds that invest in illiquid assets can come unstuck when investors want their money back.”
Data from FE Analytics shows Merian Chrysalis has made 28.5 per cent since launch in November 2018, compared with losses of 11.78 per cent from its IT Growth Capital sector.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
However, investors should note the concentrated nature of the portfolio, with top holding Starling Bank accounting for 49 per cent of assets as at the end of August.
It has ongoing charges of 0.85 per cent and is on a premium of 19.65 per cent.