A highly unusual small company

On January 15, 2021January 15, 2021 By Shrey Srivastava2 Comments

The small company investment mantra: ‘Tell investors we’re going to change the world and hope for the best’.

Of course, I am being facetious but there is a real point there – changing the world and generating sustainable cash flow are apples and oranges. The dream obviously is for both to engage in a positive feedback loop that makes laissez-faire capitalists weak at the knees. As we know all too well though, often all management presents to investors is a blank chequebook and a sleazy smile.

This is a particular problem because of the nature of many small firms.

There is often a single innovator behind them. He or she serves as CEO in addition to leading scientific or technical efforts. This centralisation of control can be fantastic for company direction but often fails given that innovators, in my (albeit limited) experience, tend to not be as adept at capital allocation as a veteran executive.

This brings me on to my main point: talking about one of my latest investments – DeepVerge (LON: DVRG) – and how excited I am about the business model.

What DeepVerge and its transformative CEO Gerard Brandon have done is take historically mismanaged businesses – with huge data and intellectual property moats – and bring them together under one roof. This has all happened within the last few years. As such, the market in my view values DVRG like a startup even though its subsidiaries have been in operation for more than 10 years.

On to those subsidiaries then, and there are a few. We’ll start with Labskin, which has produced ‘the only commercially available lab-grown, full thickness human skin model with entirely human collagen production for cruelty free skin testing.’ This overcomes three key obstacles:

Eliminating often unethical testing of products on animals, but also humans.
Overcoming logistical and time issues regarding procurement of clinical trial subjects.
Reducing human error in clinical skin trials.

As one can imagine, this is very much in the nouveau ESG mould. What’s more is that Labskin are augmenting their offering through offering personalised skincare packages – available to consumers this year. Essentially a swab is taken of one’s skin and sent to DeepVerge. They then get back with a personalised skincare plan based on that individual’s genetic makeup. The below slide from DeepVerge’s December 2020 investor presentation sums it up well.

You may be wondering: how does Labskin do all this? Couldn’t a larger competitor usurp them? It’s certainly a very valid concern and one I’ve written about before. Fortunately, their aforementioned moat is so vast that that concern is greatly diminished. According to DeepVerge, Labskin have 13 years of data and have written 30+ research articles. Naturally, this is not something that a company can usurp without large sums of money and – even more elusive – time. This is precisely why according to the December 2020 investor presentation Labskin are testing products for 18 (!) of the top 20 largest global cosmetics companies.

So Labskin may be about to enter a market worth $189.3bn in 2025 with a personalised, unique skincare offering, in addition to revolutionising how the industry thinks about clinical skin trials. What (in my opinion) tops even this?

Modern Water Group (MWG), which DeepVerge in fact secured 100% ownership of today.

MWG are attempting to modernise the water monitoring industry. At present, the convention is to take a sample, send it to a lab and then wait typically a few days for the outcome. MWG, using artificial intelligence from the Rinocloud subsidiary and predictive analytics, now aim to a) identify and b) predict virus clusters in wastewater in real time. The technology thus enables proactive pandemic/epidemic management based on likely outbreak centers. It is only too easy to imagine how this could have helped ameliorate the effects of the Covid-19 pandemic in the UK. The November 2020 wastewater monitoring summary for SAGE says as much.

Why are MWG the team to change the way we monitor wastewater? Well, they’ve got a bit of a reputation. Over 100 patents, 30 years of brand recognition for the ‘Microtox’ product, and 700+ scientific research articles are a few of the highlights. Oh – and they have more than 3000 units installed in more than 60 countries. Huge amounts of data, cutting edge algorithms and a fantastic patent portfolio; now that is what you call a moat! It is a matter now of retrofitting existing units with AI capabilities for live water monitoring and prediction of pathogen clusters. That is before we even get on to installing new units in (for example) China and India, the former of which has set aside over $270bn to combat water pollution according to DeepVerge. They have contacts and knowhow in these places that is unachievable without years spent selling a premium offering.

**A slide from the DeepVerge December 2020 investor presentation**, **on their water monitoring services**

Finally, a brief snippet on their potential cruise ship offering. The below DVRG slide again does a good job of articulating the potential market size for this offering. It involves a patented breathalyser licensed from PulmoBioMed for the Microtox BT breath test and a Microtox PD, AI-driven wastewater pathogen detection system. In short, this would be instrumental in protecting cruises not only from coronavirus outbreaks, but also any other outbreaks (remember the norovirus panic anyone)?

Of course you would be right in thinking that Microtox BT has other applications. The passage below from this article explains its potential in opening large venues here:

‘The Company believes Microtox BT has the potential to enable instant real-time testing of people within the community. This could be capable of providing daily triaging of everyone who may or may not demonstrate levels of infection. To “open the economy”, Integumen (now DeepVerge) has incorporated a 24-hour Digital Health Pass that indicates if the person tests positive or negative for infection. Matched with blockchain secure date and time stamp of the test, the company believes Microtox BT and the Digital Health Pass using “one second” QR Code scanners could potentially contribute to enabling the economy to re-open with personalised go/no go entry into venues such as work, events, social locations, public transport and airports.’

The combination of all these businesses, tied together under the DeepVerge moniker, has the potential to yield some truly explosive growth. In fact, it already is. Revenues were up more than 300% in 2020 to £4.4m, and guidance is for 2021 to be another year of revenue more than doubling at £10m. DVRG, based on even capturing a small sliver of the addressable markets above, could generate hundreds of millions of pounds in revenues – at high net profit margins – by the end of the decade. Any more specific guidance is bound to be wrong with how fast the company is growing.

The market capitalisation at today’s close is £55.45m. To put that into context, at a 15x PE ratio it is pricing in the equivalent of c. £3.7m in annual net profit, in perpetuity. Based on the above I for one think that DVRG has scope to outperform significantly on this in the coming years. Even if their £3m funding facility does not prove enough for their financing needs, assuming even 100% dilution the company is significantly undervalued in my view. There are multiple ‘shots on goal’ from subsidiaries with huge moats. If they manage to capture a significant portion of any of their addressable markets, the share price quite clearly can see a re-rate.

Thankfully, the directors agree with me, with a combined 15.03% shareholding in the company. This includes over 5% held by Gerard Brandon himself. As of the end of last year, Helium Rising Stars Fund also held 6.55%.

In summary, DeepVerge to me is an investment worth making on multiple accounts:

Multiple innovative products
Huge addressable markets
Significant moats with data and patent advantages
Respected brand – rare for a small-cap

Of course, every investment has risks, not least a small cap but the risk/reward is asymmetric in my view – and it is why I have confidence in DeepVerge to deliver. An early adopter of the AI-as-a-service business model and a highly unusual small company, DVRG is one of those that really can do good for the world and potentially help out some of its shareholders a great deal.

Disclaimer: All content provided on Shrey’s Notepad is for informational purposes only. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

The owner of Shrey’s Notepad will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, financial or otherwise, injuries, or damages from the display or use of this information.This article does not constitute financial advice in any way, shape or form.

Surviving in the age of monopoly

On December 2, 2020December 5, 2020 By Shrey Srivastava2 Comments

To say that we live in an era of giants would be stating the obvious.

Large companies have been growing larger since before today’s generation can remember. This is naturally to the chagrin of academics and progressive policymakers alike; one of many recent angry articles reads “Britain is over-tolerant of monopolies.” Whether this is true or not, change is probably as likely to come as Donald Trump is to remain silent after he leaves the White House. The facts are on the table: power, financial or otherwise, is concentrating in the hands of a few at the top. From Amazon hoovering up 49% of the US ecommerce market in 2018 to Uber gaining a mammoth 55% of the UK ride hailing and taxi market, large firms dominating markets has become an indomitable maxim.

The point of this piece is not to opine on the various drawbacks and positives of today’s market structures, but to identify where this shift to the top leaves an investor interested in smaller companies. What moat can be relied on when the Alphabets and Apples can plough seemingly unlimited cash and technical expertise into a sector? Which nails can remain intact when giants have infinite multi-purpose hammers?

Let’s go through some of the options.

Cash/Balance Sheet: No. The giants will certainly have more cash than the minnows. Even if upstarts can somehow outspend their competition, the resultant dilution and/or leverage would considerably weaken the investment case. Examples like Amazon famously bullying Diapers.com into submission are notoriously difficult to ignore, not only because they have recently become commonplace.

Contacts/Distribution Channels: This is a common so-called ‘differentiator’ touted by firms who, to me, do not really have many others. Large conglomerates are involved in many, many markets. They thus have deep and broad relationships across the spectrum. To me, distribution is but a temporary hurdle to overcome. It’s not “sticky” enough to be a durable defence. Superior contacts only persist so far as the product is superior or of comparable quality.

Brand Reputation: As with the previous factor, this will only persist so long as one actually has a superior, or at least similar quality product. BlackBerry used to have a great reputation for phones; good luck finding anyone who uses a BlackBerry now. Without product, the company’s ‘moat’ isn’t so much a moat as a ticking time bomb.

This brings me to the question: how can you maintain quality and thus market position as a small firm vis-a-vis your mammoth competition?

I see two ways, the first of which is relatively obvious and the second of which has become a key additional component of my investment process.

Patents/Intellectual Property: It’s hard for a large firm to compete on price when they don’t have a good product. A good way to ensure you have the best product (until it is replicated using another method) are patents.

Arm Holdings, which was taken over for $31.4bn in 2016 by SoftBank, had this. In fact, over 4500 of these (either granted or pending). That is a huge part of why it survived. Defensible intellectual property is more than a speed bump to giants, it is a closed road altogether. This is because they must start again at point A, and redesign the wheel just to get on the same level as the company with patented technology. One of my favourite holdings, a pharma company without pharma risk, 4d Pharma (LON:DDDD), has over 950 patents, the largest number in its sector. A robust defence indeed. But in my mind, not the only one.

Data: In my mind, the fifth factor of production. It could be easily argued that data is just as important as established factors like land, labour or capital (without enterprise, we wouldn’t have the whole shebang). Large companies cannot hold a candle to this, no matter how significant the cash and resources invested are. This is because data is a tangible manifestation of the time invested in a project. Small companies may have an abundance, because they got there first. Instead of or in conjunction with an intellectual property estate, this is a must to brave harsh waters. Again, two of my relatively large holdings provide good examples of where data can be useful:

Seeing Machines (LON: SEE): SEE‘s Guardian tech has logged over 5 billion kilometres of naturalistic driving data from its various customers. This is a hugely important resource to optimise their Human Factors technology: understanding from a driver’s facial expressions and movements whether they are drowsy, distracted or intoxicated. You just can’t be as accurate if you don’t have enough data to go on. This veritable moat helps them save lives: as the CEO Paul McGlone likes to say, “everyone deserves to get home safely”. In addition to this, it’s a huge reason a larger competitor can’t just swoop in and take a significant percentage of the global driver monitoring market.

DeepVerge (LON: DVRG): This is a company that has many different revenue streams, but for the purposes of this article Labskin is most relevant. It is “the only commercially available lab-grown, full thickness human skin model with entirely human collagen production for cruelty free skin testing.” In the words of CEO Gerard Brandon at an investor presentation, it is “ring-fenced by 13 years of data collection”. As with Seeing Machines, this is not something that someone can wake up someday and do. Optimising the technology needs real world application, which Labskin have done plenty. This is what cements it as not only a market leader now, but in the future too.

Let’s be honest with ourselves: the avenues for small companies to compete are closing. This presents significant challenges to an investor focusing on these upstarts. It is now imperative for them to crystallise their first-mover advantage; patents work, but so, crucially, does data. This is why, to me, data is hugely underlooked and just as hugely valuable to the investment case for small companies.

Without it (or patents), you are at a large competitor’s mercy. With it, you can get that rare one up on today’s Goliaths.

Diversifying into pharma

On September 15, 2020September 15, 2020 By Shrey Srivastava6 Comments

It’s not often that I’ll buy a share that’s up over 400% from where it was just 6 months ago. It’s even rarer that I’ll speculate in pharmaceutical companies, so notorious for having success or failure contingent on a lone trial. On first glance, I would be sorely against spending hard-earned money on such a company, let alone an AIM-listed one.

But if even the best of us can eat our words, who am I to not U-turn every so often?

As part of my move into smaller companies with more asymmetric risk-reward ratios, I’ve been searching for undervalued businesses that could grow into the type of company lauded as an AIM success story. On this quest I’ve taken a deeper look into 4d Pharma (LON: DDDD), a company that, while certainly on the up, has not yet hit the stratosphere like I hope for. Let me be clear: a look at the financials alone does nothing to back up my statement. For a company with an almost £200m market cap, paltry revenues of £0.21m in the financial year to 31 December 2019 do not give my theory much credence. Let me show you what does.

DDDD (what a mouthful!)’s USP is that it specialises in the use of non-engineered single strains of bacteria, originally isolated from the gut microbiome of healthy human donors. Strains of bacteria are then chosen to treat particular diseases, ranging from cancer to COVID-19. The benefits of this “Live Biotherapeutics” approach are perhaps best explained by the CEO himself:

“Live Biotherapeutics as a new class of drug have a number of advantages over traditional therapies. As living bacteria, LBPs produce multiple products, proteins and metabolites, and as a result have ‘poly-pharmacy’ effects, able to hit more than one target simultaneously. For this reason, Live Biotherapeutics may be able to address multi-component diseases where previous approaches have failed. This includes Parkinson’s disease, cancer and immune-mediated diseases.

The perfect drug is both safe and effective; Live Biotherapeutics, by definition, are expected to meet the safety criteria, and we are currently demonstrating efficacy through our clinical trials. This safety profile significantly accelerates the development pathway, allowing us to go from discovery to clinical proof of concept in as little as four years, much faster than traditional drug types.”

It reminds me somewhat of stem cell treatment, which can be modified to treat a wide variety of ailments. From this, 4D appears the Swiss Army Knife of pharmaceuticals. Although, who would invest based on the words of a small-cap CEO? (without substantial proof of concept backing them!) Of course, we as even vaguely prudent investors need more than that.

I now direct you to their prospective treatments, of which there are no less than 16. If any one of these pass any of the regulatory hoops all the way to Phase 3, the current £187m market cap is a mere fraction of fair value. Take the Irritable Bowel Syndrome (IBS) treatment, currently in a Phase II trial. With the market for IBS treatment set to reach $1.5 billion by 2023, and with no treatment as of now tackling the problem’s source, we can easily see the potential. Combined with their so-called largest intellectual property estate in the microbiome sector, with granted patents in the US, across Europe and globally, with over 400 patents, this could be a future source of recurring cash flow for 4D.

What’s more, investors are circling, just not so much in the UK. 4D competitor Seres Therapeutics currently boasts a $2.48 billion market capitalisation, a potential sign of what to come if even one of the 16 therapeutics listed above receives regulatory approval.

Finally, from a balance sheet perspective, the fact that a July equity placing raised just over £7m to strengthen the company’s liquidity position mitigates the risk of further placings in the near term. If a fund raise does occur in the future, in my opinion it likely will be accompanied by a potentially transformative piece of news that can send the market capitalisation into the billions (if it isn’t there already! With risk diversified across treatments in an innovative new sector, I find the investment to be a potential multi-bagger (even if I wish I got in a little earlier). Let’s see if my entry price of around 125p a share looks downright cheap in the future!

I currently hold shares in 4d Pharma (LON: DDDD).

Trash to cash?

On August 13, 2020August 14, 2020 By Shrey SrivastavaLeave a comment

Would you invest in a company that could turn trash to cash?

I have to make two apologies straight away here, the first of which is to my British readers for the Americanism, and the second of which is for generalising. Of course it would depend on whether another company could do it more cheaply, profit margins, and so on and so forth. The broad point stands strong, though: at first glance, it sounds like a business model with legs.

Recently, I’ve come about a company that does just this: EQTEC (LON: EQT). The Irish minnow specialises in gasification, a process that converts biomass to combustible gas, namely producer gas, or syngas. This is itself a fuel and can be used for a variety of applications, generating, for example, heat energy in the industrial sector. To me, the share price has a significant way to go from here on a relative value basis (compared to rivals such as PowerHouse Energy) and also of its own accord. This is because it has secured multiple projects and because its technology is proven to work and is already operational.

Their projects include one at Billingham, where it partnered with the energy company COBRA for the 25 MW £150-180m project. This looks to be a headline cash cow in the future. There also exists a proposed “1.18 MW net biomass gasification power plant project in Gratens, France”. All of this, of course, is in addition to their numerous Spanish projects, including Movialsa, that have already run for over 111,000 hours without major issue. Despite these developments, the market capitalisation remains at a measly £33.37m as of 13 August 2020!

Of course there has to be a reason for pessimists to justify the low valuation, and in this case it is the financials (mostly). The company is still loss-making, which may turn off some prudent investors. What I would say in response is that a recent equity placing to the tune of £10m leaves the company fully funded. Moreover, Align Research projects the company to reach profitability in FY2021, with a €5.39m pre-tax profit.

A caveat to this is that should the company not reach this optimistic projection, we as (hopefully!) diligent investors should not fret. This is, of course, so long as the company continues to expand its list of potential projects and memorandums of understanding, with significant signs of converting these leads to hard cash. I, personally, can stomach free cash flow a few more years into the future so long as it is worth the wait. After all, the world’s central banks seem determined on keeping that risk free rate as low as possible, so future cash flows are still highly appetising.

At a broader level the global waste-to-energy market is projected to grow by $12.26b from 2020 to 2024. Covid-19 is poised to turn the wheels of ESG revolution, which brings companies like EQTEC all the more to the forefront globally. Though the sector is growing and, in my opinion, will grow for a long time into the future, investors haven’t yet been too keen to agree with my prognosis. PowerHouse Energy, a waste-to-energy company with, to be kind, many fewer projects in action, is currently valued at a lofty £121.27m on the Alternative Investment Market. I believe EQTEC’s proven technology, strong deal flow, and cash at hand position it to close this valuation gap, and to grow as the market grows. It’s why I topped up on my initial position a few months ago.

Though I initially purchased at 0.18p, which looks like a downright steal today, it is my firm belief that EQTEC has much further to go, and for a 3-5 year investment (at least!) it presents an extremely strong investment opportunity. You don’t often see a green tech company’s potential pre-tax profit five years down the line exceed its current market capitalisation.

Of course, tailwind risks do include further dilutive equity issuance (although if this is to fund more projects you might even be grateful for it). In addition, EQTEC partners with China Energy for the Billingham project. If you’re of the persuasion that Western governments will rip off the China band-aid (or, to be more accurate, the full limb), you may have your reservations about this. EQTEC is also facing a lawsuit from Aries Clean Energy LLC in the US for patent infringement (though EQTEC has denied this in the strongest possible terms and I, personally, find it an opportunistic and baseless claim).

If you find yourself disappointed by the line of risks, it’s the reason why I’m remaining cautious with this investment (it doesn’t take up nearly as large a share of my portfolio as Seeing Machines, for example). AIM investing is a rollercoaster and it’s inevitable that you’ll sit through a few peaks and troughs trying to find the diamonds in the rough. But with EQTEC, a company that quite literally is the future, I’m willing to endure them.

Disclaimer:

All content provided on Shrey’s Notepad is for informational purposes only. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

I currently hold shares in EQTEC (LON: EQT).

Blue Prism and the rise of robotic process automation

On January 24, 2020August 14, 2020 By Shrey Srivastava7 Comments

One company that caught my attention recently is Blue Prism (LON: PRSM). Listed on the Alternative Investment Market (AIM), it creates robotic process automation (RPA) software. This essentially automates manual data entry, which is both low return and high risk to a firm. I invested in the company (on a virtual portfolio) at 877p a share, and since then it’s returned around 80%, with (in my opinion, at least) further potential to grow. Much of this return has come over the past two days, where the share price has gone up around 30% off the back of impressive FY2019 results. Major highlights include 83% higher revenue, allaying concerns that the business could not scale significantly enough to justify its valuation.

RPA is of course an industry that is in vogue, however beyond the media hype there is a significant reason why the sector, including companies such as UiPath and Automation Anywhere, is so highly touted. The market for RPA is set to reach $3.11bn by 2025, at a CAGR of 31.1%. Businesses from small shops to the largest multinationals could see significant efficiency gains from implementing such technology, and moreso save on the salaries of individuals employed for such a function. It fills a gaping lacuna in the centre of firms’ back office functions, doing so in a way that is both cost effective and that minimises errors.

It comes as no surprise, then, that PRSM’s revenues would see an uptick. However, in addition to this, I find a number of green flags in its most recent report. In addition to customers rising by more than two thirds to 1,677, its customer retention rate sat at 96%. This implies to me that a large proportion of revenue is “sticky”, and the products offered are clearly satisfying clients. Hence the fact that losses more than trebled to £80.7m, from £26m the previous financial year, is not a significant factor given the investment undertaken through the year.

Initially, I invested in Blue Prism as it traded on around 10 times the year’s expected revenue. Compared to its peers UiPath and Automation Anywhere in the same industry (based on estimates as these companies are private and venture-capital backed), their sales multiples are 25 to 30-times, a massive premium to Blue Prism. Analysts at Shore Capital, having done similar calculations, came to an even bolder conclusion: ‘Taking the average of the recent private equity valuations for UiPath and Automation Anywhere implies a short-term fair value for Blue Prism of $2.4bn (or £27 per share).” I see no reason for this to have changed in light of the recent rise in share price (although am eager to hear opinions to the contrary!)

Given that the business assuages a fundamental need across industries, the company should definitely continue to increase revenues (and, eventually, profits), with contained variation due to the business cycle. If I am right (hopefully!) then over a number of years revenue will continue to grow at a fast clip as the company matures and ventures into profitability.

An interesting question, however, is the impact of RPA on the economy in general. There is no doubt in my mind that the technology has the potential to make redundant the most vulnerable in society. With the continuing trend of automation this threat was always going to get larger as we move into the 20s. Hence, for policymakers, a challenge is faced on a level not really seen since the Industrial Revolution. To me, the solution lies in state-funded re-training programs to make the labour market more flexible. In addition, a universal basic income as proposed by Andrew Yang in the Democratic primaries makes a great deal of sense to me as automation progresses, because primarily it gives workers the flexibility to retrain and prepare themselves for the long-term.

Overall, then, to me Blue Prism is a solid investment in a truly exciting growth company. Robotic process automation is a great example of creative destruction, however in a broader sense policymakers need to consider certain impacts of this technology. Questioning themselves on how to avoid a sustained rise in the unemployment rate may lead to some off-the-beaten-track initiatives, which have the potential to safeguard the most vulnerable while ensuring firms continue to increase efficiency and the economy continues to grow.

Disclaimer:

This article does not constitute financial advice in any way, shape or form.

I currently hold shares in Blue Prism (LON: PRSM).

The reasoning behind Blackstone’s move from partnership to corporation

On December 16, 2019August 14, 2020 By Shrey SrivastavaLeave a comment

April saw the behemoth private equity group Blackstone announce a dramatic, yet not unprecedented, change in its legal structure. While previously a publicly traded partnership, the corporation, from July 1, is precisely that in US legality: a corporation! The move follows the same shift in structure from rivals KKR & Co Inc and Ares Management Corp last year [1]. Not surprisingly, as with most financial changes occurring in the US right now, the shift has a lot to do with changes implemented by the Trump administration.

Since Blackstone went public in 2007, it persisted with the now disowned partnership structure. In a nutshell, this structure means that Blackstone’s performance fees were not charged as corporate income. This allowed them to save money that would have otherwise been taxed. The change which occurred now, however, is that when the Trump administration reduced the corporation tax rate from 35% to 21%, the benefits of this scheme dwindled. [2] Moreso, the structure presents inherent complexity for investors year-on-year (with a 30-page file having to be filed by investors to the IRS every year). Major stock index trackers and mutual funds have thus refrained from adding Blackstone to their holdings.

Given that passive funds comprise around $10tn of market capitalisation [3], the argument Blackstone and its legendary founder Stephen Schwarzman present is that given diminished tax consequences of the switch, and the fact that a pop in the share price would be likely, the time has come to switch structure. Schwarzman himself came out stating that the number of potential buyers of Blackstone stock would double with the change, in which case the appreciation in share price would more than compensate for increased tax payable. Investors no longer have to navigate as dense a mountain of legal paraphernalia to invest in Blackstone, thus, in theory, bringing their shares closer to fundamental, or intrinsic, value.

So, what happened?

To put it simply, investors loved the news. [2] In its best trading performance since January of 2016, shares surged in the group to $38.62/share, an uptick of 7.5% from the previous trading day. While the rise in share price was almost definitely driven in part by sound results (with a record $126 billion raised by the firm), the technical veracity of Schwarzman’s argument definitely resonated with investors. Even as of 20 July, Blackstone’s share price sits at $45.63, a noticeable uptick from the April announcement.

However, while Blackstone’s performance has mirrored KKR’s at least in the short term, it is also true that KKR saw a decrease in its share price to around its original price point in the December 2018 market rout. While Blackstone are right to be optimistic, it is necessary to tread weary of history when analysing the long-term impact of such a move. A probable benefit in terms of attracting funding at lower cost (in terms of equity) will only be realised with sustained adoption of the shares by passive funds.

A drawback of the move, also, is that it occurred in response to a current US administration whose personnel seem to be operating on a proverbial merry-go-round and whose grasp to power is at best tenuous approaching the 2020 election cycle. Should, for instance, a Democrat president be elected, and the corporation tax decrease was reversed, it would be extremely difficult (in terms of the legal work required) and expensive (in terms of a decrease in share price) to shift back to a public limited partnership structure. Such short-termism may prove costly in a future which is by definition unknowable and whose trajectory varies wildly from one day to the next. Blackstone’s estimates of an ultimate dilution of earnings of around 13% [3] will almost certainly prove inaccurate in the future, and the tax impact of the change in structure may well have been understated.

To conclude, the recent change in legal structure has solidified a change which has been in the works in the private equity for a while now. Apollo Global Management in May also followed Blackstone and KKR by changing structure [5], strengthening the domination of the “corporation” moniker in the industry. As with so many responses to Trumpian aggression, the response may prove far-fetched in future once it has been realised just how much of an outlier this current administration’s tax policy is. If this move is an example of the group counting their chickens before they’ve hatched, their strategic position in the industry is unlikely to be in much danger. As this has been an industry-wide change, we would be likely to see regret in many major private equity funds, not only Blackstone. For this reason, this change, while expected, is interesting precisely because no one can tell whether it is the right decision or not at this point. As with so many things, that can only be answered by time.

I’m currently running the LSE Alternative Investments Conference Finance Review, where this article first appeared on. Sign up now at lseaic.com/finance-review!

Bibliography

[1] Reuters (2019). Blackstone to switch from a partnership to a corporation. [online] Available at: https://www.reuters.com/article/us-blackstone-group-results/blackstone-to-switch-from-a-partnership-to-a-corporation-idUSKCN1RU196 [Accessed 20 Jul. 2019].

[2] CNBC. (2019). Blackstone is converting to a corporation from a publicly traded partnership. [online] Available at: https://www.cnbc.com/2019/04/18/blackstone-is-converting-to-a-corporation-from-a-publicly-traded-partnership-effective-july-1.html [Accessed 20 Jul. 2019].

[3] Ft.com. (2019). Blackstone to shift from partnership to a corporation | Financial Times. [online] Available at: https://www.ft.com/content/1eb7afcc-61ca-11e9-a27a-fdd51850994c [Accessed 20 Jul. 2019].

[4] Nytimes.com. (2019). Blackstone Will Ditch Partnership Structure to Draw More Investors. [online] Available at: https://www.nytimes.com/2019/04/18/business/dealbook/blackstone-corporate-structure.html [Accessed 20 Jul. 2019].

[5] Ft.com. (2019). Apollo to ditch partnership status and become a corporation | Financial Times. [online] Available at: https://www.ft.com/content/77c022ea-6ccc-11e9-a9a5-351eeaef6d84 [Accessed 20 Jul. 2019].

No deal may be likelier than we think

On August 28, 2019 By Shrey Srivastava2 Comments

Featured Image Credits: Ala z on Wikimedia Commons

A serious disruption of the free flow of commercially valuable data between Europe and the UK.

£13 (around $16) more to be spent each week per household on food in the UK.

A £100bn loss to the EU economy.

Regardless of your opinion on whether the above is waffle or a genuine threat of a no-deal Brexit, it seems pretty logical for both sides of the UK-EU negotiating table to see this as an avoidable scenario. Unfortunately the world, and most certainly geopolitics, is not exactly replete with magnanimity. Whilst public perception of politicians as a swarm of Machiavellis can be seen as a tad harsh, politicians, like regular people, in general tend to act in their own self-interest. Numerous groups, though, across the UK are unceasing in their attempts to stamp out a no-deal Brexit from the list of potential outcomes of the negotiation. However, previous attempts have fallen flat and so for the moment the blocking of no-deal from potentiality seems unlikely. Given this probability the potentially destructive no-deal black hole is coming closer and closer to Europe. This is not because it wouldn’t hurt both sides greatly but because if either side is seen to be the one to give ground, it could have dramatic implications.

First, a brief description of the issue: the Irish backstop.

To maintain the seamless transfer of goods, services and people across the border separating Northern Ireland and the Republic of Ireland, the agreement reached between the May administration and the EU involved a so-called “backstop” in the region. In this case, Northern Ireland would have to comply with some rules of the EU single market, thereby necessitating the whole UK acquiescing to the EU rules. Given one of the major concerns for the UK populous in the very beginning was the claimed iron fist of the EU strangling the great British will to be free, the deal is hardly likely to curry favour with them. But forget the public, it didn’t even make it past the politicians, even after four tries! This is the essential bone of contention here.

Let’s firstly look at this from the UK perspective. PM Johnson already knows he cannot even consider bringing any deal with a backstop involved to the House of Commons, lest it be rejected for a hysterical fifth time. He now has two alternatives: a no-deal and an alternative to the current backstop arrangement which is acceptable to both the Commons (so the deal can actually pass) and the public (unless he wants to become May 2.0 and plunge the Conservatives into a deeper rut). He could, of course, revoke Article 50 altogether, but unless he wants to be known as the man who caused civil unrest, he’s going to stay well clear of that route. Now although both parties have indicated a willingness to explore alternatives to the traditional backstop (for example, the technology-driven border mechanism frequently espoused by many UK MPs), there has been precious little detail on the matter. As of now there remains no workable solution to the border issue and so the only option left on the table for Johnson is a no-deal.

What about for the EU? A backstop certainly isn’t the preferable outcome for them either, given the many benefits to the Republic, and thus the EU economy, of free trade between themselves and Northern Ireland. If there is no backstop (and no alternative arrangement) and the EU agrees to no hard border on the island of Ireland, they are essentially allowing the UK access to the EU single market without the UK “giving” anything in return, for example, through membership of the customs union. This sets a dangerous precedent because the EU has numerous times said that it will not give the UK such preferential treatment. Countries like Norway and Switzerland have had to give substantial ground with regards to contributions to the EU’s budget and accepting the free movement of workers.

Now, don’t get me wrong; politicians are commonly hypocritical and go back on their word often, and I’m not for a moment suggesting that EU politicians such as European Council President Tusk aren’t capable of this. The issue is that this issue is extremely high profile and contentious. If the EU secedes this issue to a country that is, even slightly, anti-EU, it is capable of reigniting anti-EU moments driven by politicians such as Geert Wilders in the Netherlands and Marine le Pen in France. Once these movements are bolstered, the very fabric of the EU is under existential threat. If this sounds sensational, ask yourself this: how many people would have predicted Brexit in 2010? Hence the EU cannot be seen to give the UK any sort of preference in this negotiation, otherwise it opens up a Pandora’s box of potential difficulties for the bloc.

It’s clear to see then, that taking an elementary game theoretical stance on the matter a clear Nash equilibrium is the UK crashing out of the EU with no deal. While not the optimal solution, given what is at stake for both parties it seems the most likely outcome unless a viable alternative to the Irish backstop is found.

While this presents a rather melancholy view, it seems to me as if it’s pretty realistic. The market may have to price in much greater odds for a no-deal than 50% soon.

For the Fed, where’s the worry?

On July 22, 2019 By Shrey SrivastavaLeave a comment

Featured Image Credits: Dan Smith and “Dontworry” on Wikimedia Commons.

The past month or so, US equities have been zealously barreling towards past highs, buoyed by the most exceptional and exquisite of all financial drugs: forward guidance.

Mostly, however, the markets’ high originated far abroad in Europe; Portugal, to be precise. Mario Draghi’s dovish tone convinced investors of the ECB’s ability to use both the rates and quantitative easing mechanism to bolster growth. Given in the past decade or so that global developed-market rates tend to move synchronously with each other, the march upward of US equities wasn’t exactly surprising either.

Nothing in this saga after Draghi’s recent speech has come as all too unexpected, including Jerome Powell’s warnings on the global economic outlook. The proverbial sea of central bank governors is teeming with doves, eager to cut interest rates as soon as the slightest threat of a slowdown or (God forbid!) a recession rears its ugly head. It seems to make sense; who wants the music to stop?

Until you realise what the current US federal funds rate is.

2.5%.

One question springs up instantly from this: where’s the wiggle room? If things do go topsy turvy and then some, what can Powell do? You could say he could use quantitative easing. When you’re one of the biggest global players, though, and your best maneuver is a policy that’s efficacy is doubtful at best, you might indeed find yourself asking how you put yourself in that position.

Is it really worth exhausting your best shot on somewhat reduced growth from a large boom in the economic cycle? Yes, there are the fears of a trade war with China. Yes, concerns regarding Iran persist. And yes, we have no idea what Trump’s fellifluous self could conjure up at any moment. There are a lot of tailwind risks to the US and global economy right now, but my take is they don’t necessitate cutting interest rates by the expected 0.5%. Especially not when in the first quarter of 2019, the US grew at a more than healthy clip of 3.1% annualised.

We’re about a decade on from the Great Recession, a time where an investment banking behemoth collapsed, credit froze over and consumer confidence sunk faster than Rory Stewart’s hope of being Prime Minister. That (or at least something close to that) is when you suck the last drops of juice from the interest rate mechanism. In my opinion, a time where economic stimulus in the form of, for example, cuts in corporation tax have (perhaps unsustainably) bolstered growth is not a good time.

Recent dovishness has led the US two-year yield to drop to as low as 1.82%, and cuts in interest rate could potentially inflate further already huge equity valuations. A dollar of an American company’s earnings has gone from setting you back around $15 to setting you back $22 or $31, depending on the data which you use. When Netflix shares dropped significantly on the back of decreased US subscribers, it may have indeed been a sign that valuations are becoming increasingly optimistic (and perhaps superfluous). Not to preempt any sort of bubbles which may be occurring in equity and broader asset markets, but signs such as this don’t really point towards much else. As any five-year-old child will tell you, inflate too much and the bubble goes “pop!”. And when the bubble affects millions of people’s livelihoods and could pose a huge threat to pensions everywhere, you really don’t want to inflate too much.

While Powell brings about legitimate concerns regarding slowing global trade and inflation, I question the need for any substantive change in policy at the present moment. Growth was frequently demeaned as laggard in the years following the 2008 recession, and it seems when economic growth finally picked up meaningfully, he thought it would continue for far longer than it did. Moreso, forward guidance can backfire, in signalling to investors that there’s some sort of grave boogeyman ready to jolt the US economy any time soon. In fact, this is simply not the case. Powell should save his best for when we’re far nearer to the trough of an economic cycle, when growth is closer to 0% than 3%, and the US labour market isn’t adding nearly as many as 224,000 jobs in June. Otherwise, he might find himself out of ammo, just when he needs it the most.

So Trump is a hypocrite: what’s new?

On June 20, 2019 By Shrey SrivastavaLeave a comment

Featured Image credits: The White House

Not to say that we in the UK don’t have our own share of clownish politicians, but the phrase “hypocritical Donald” isn’t exactly an oxymoron. How about the fact that he’s pro-life and yet not disclosing how many abortions he’s paid for (hint: he should be saying zero). Or what about when he criticised Obama for playing golf while in office before playing even more golf himself in the same time period while in office? Regardless of all these, though, I’m here to talk about quite a recent example of hypocrisy from the 73-year-old’s Twitter. The tweet, from yesterday, read:

“German DAX way up due to stimulus remarks from Mario Draghi. Very unfair to the United States!”

Where to begin with this? Trump’s rationale (presumably, at least; do we ever really know?) is that Draghi’s statements that the European Central Bank (ECB) could enact stimulus measures (including cutting policy rates further) in the future adds further negative pressure on the euro. This in turn makes US manufacturing uncompetitive with respect to that of Europe, and thus has the potential to depress the US economy through reducing exports and increasing imports. This is because the dollar appreciating vis-a-vis the euro makes exports from the US more expensive for foreign buyers, and makes imports into the US less expensive for US buyers.

While this train of thought is logical, it ignores the myriad of other reasons why the ECB would try and cut rates. Growth in the Eurozone has been flagging, due to, among other factors, the risk of a disruptive Brexit and a global trade war; OECD projections state growth as most likely around 1% for the year. While I’m not denying that a part of Mr Draghi’s army of reasons to act this way would be to add downwards pressure to the euro, Occam’s razor suggests that the currency argument isn’t the primary reason why Draghi is considering such action. Moreso, it’s not as if what the ECB is doing is unconventional; monetary authorities have been using interest rates as a tool to manage the economic cycle for decades.

However, it is also true that Trump never explicitly said that the intention was to depreciate the euro; he merely said it was unfair to the United States. Does this absolve him of any blame for the statement?

I don’t think so, for the following reason: Trump has repeatedly maintained his opposition to the mildly hawkish tone of the Chairman of the Federal Reserve, Jerome Powell, with respect to interest rates. If it’s so unfair that the ECB may cut rates in case of future economic stagnation, then why is it not also unfair for the Federal Reserve to cut their interest rates instead of raising them? The world Trump lives in, where interest rates are a primary tool of exchange rate warfare, is a world where there is every action is an act of hostility. If Trump really believes his own tweet, he should expect a barrage of European criticism once he inevitably again tries to persuade Powell to halt his hawkish tone on rates.

It’s not as if Draghi is actually cutting rates right now either; his point is that they remain a tool in case Eurozone growth slows even further, a perfectly rational position to take. Draghi’s speech was somewhat reminiscent of his “whatever it takes” speech in 2012, which is widely credited for saving the euro. If Trump means that even suggesting that interest rates should be used to curb a potential recession (or decrease in growth) is unfair, he means that a central banker looking out for the interests of those he or she governs (as Draghi did in 2012) is unfair as well. In this case, one has to ask: isn’t all this “America First” nonsense that Trump keeps spouting wildly unfair as well?

The fact I’ve read so deeply into what is probably an off-the-cuff tweet from one of the most volatile Presidents in US history is a carry-forward from previous administrations. A tweet (or any sort of official statement from the President) used to be taken seriously by all, and was almost always well crafted and thought out. It speaks volumes about Trump that more and more, his tweets are beginning to look like jokes, and the markets his personal see-saws to tip up and down as he wishes. I suppose Trump being a hypocrite isn’t exactly a groundbreaking observation, but the blatant ignorance that comes with a tweet such as this is something that I felt I had to comment on.

Metro Bank and the challenges facing it

On June 10, 2019June 11, 2019 By Shrey SrivastavaLeave a comment

Featured image licensed under the Creative Commons Attribution-Share Alike 4.0 International license. Image author: Philafrenzy

As is often easy to forget, humanity never really progresses in a straight line. From unpredictable conflict to unexpected technological advancement, the road of history is far fuller with roundabouts and U-turns than we often feel in the modern day. That is why when the Financial Services Authority granted Metro Bank its license just over 9 years ago, some degree of apprehension would be appropriate regarding its future growth path. This would prove to be well-placed, as just a few months ago Metro was embroiled in an accounting scandal that rocked the firm to its very foundations.

The issue arose in Metro’s miscategorisation of some loans in its commercial loan portfolio. Many commercial property loans and loans to buy-to-letters were deemed as less risky than they actually were, when they should have been among the bank’s risk weighted assets. Around 10% of Metro’s loan book was affected. The significance of this cannot be understated; it implies that Metro had far lower capital ratios than initially thought, and so the firm was more prone to default risk. Even at the end of March, the company’s tier 1 capital ratio sat at 12.1%, only a tenth of a percentage point above the company’s self-imposed guidelines. The events triggered a 75% decrease in share price within a few months of the announcement of the miscategorisation. Metro’s share price currently sits at around £6.30 a share, having dropped to lows of £4.75.

The question, now, is what will become of the challenger bank, now that the dust of the cataclysm that befell them is somewhat settling on the horizon. Metro did indeed raise £375m in equity finance in the span of three hours to help them meet regulatory requirements, however to say the company has been unaffected would be a gross understatement. Deposits at the firm fell by 4% in the first quarter of 2019 to £15,095,000,000, and for a business in an industry that is so reliant on customer sentiment, that spells worrying news indeed. Although the raising of capital may assuage some of this fund outflow, it may take quite a while before the firm can recapture the confidence (and thus, the funds) of the public in the way in which it once did. Whether it is able to do this is soon to be seen, and if it does (as we can see from when its next quarterly results come out) we may be more confident of a turnaround.

Moreso, although a pioneering entrepreneur in his own right, Vernon Hill (the co-founder of Metro) does not exactly have a squeaky clean resumé. He has often been criticised for using Metro Bank funds to pay family members, and the recent fiasco will help convince no-one of his abilities to manage shareholder capital. Having already just recently survived a shareholder revolt, the 73-year-old is not the most popular man in any room. How he navigates this personal mini-crisis of investor confidence and whether he can convince existing shareholders that he is the man to lead the company into the future is a key issue to be wary of before investing in the firm. It should be noted that only 12% of shareholders opposed his re-election as chairman, indicating that this issue may not be as significant a factor to consider as the one that preceded it. However, in the event of another gaffe this would again come into the limelight, almost definitely with far more severity.

Finally, an existential issue to bring up relates to Metro’s customer service. The bank was set up to challenge existing paradigms of how retail banking “should” be in the UK. For an organisation like this you’d expect it to have pretty good customer service (at least in comparison to its rivals). This makes it all the more surprising that Metro Bank, along with Barclays, ranked lowest of all lenders on customer service and the propositions they offer. This issue is so serious because it fundamentally challenges the notion that Metro are executing their disruptive business model with any degree of success. Vernon Hill would be the first to tell you that acquiring fans is more important than making profits in the short run, however it’d be hard for him to be able to do either when customer service threatens both acquisition and retention of depositors. This is a key indicator of whether the bank can reverse its fortunes in the future; its customer service ratings will be a key barometer of whether it can successfully execute its business model in the long-term.

Overall, then, the loan misclassification fiasco at arguably the UK’s most prominent challenger bank has damaged its credibility with shareholders and depositors alike. The three factors described above, namely total deposit numbers, Vernon Hill, and customer service ratings are in my opinion the three biggest issues to consider when debating investment in the firm. At this critical juncture in Metro Bank’s history, all is to play for, however that can be as much a curse as a blessing.

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