Description

There have been 18 VIC write-ups on the main US-listed alternative asset managers and their funds over the years. These write-ups have been followed by strong share price performance for AAA, KKR and Blackstone which are now trading at more reasonable valuation. I assume here that readers are quite familiar with their business model.

Mercuria Investment is a boutique Japanese Private Equity firm modelled on these industry leaders. The company’s current market cap is fully covered by cash and co-investments in its own funds, resulting in a highly profitable business trading at negative or negligible Enterprise Value. Without even assuming that management is able to grow Assets under Management (AuM) from the current US$1.8bn as they intend to, the upside seems substantial with limited downside.

Background

Mercuria was established in 2005 by the current CEO Toshihiro Toyoshima with the backing of the Development Bank of Japan (DBJ) where he used to work. Itochu became the second institutional investor in 2015. Their respective holdings currently stand at 24% and 14%. DBJ is an investor in most of the funds and both provide strong institutional legitimacy. Varecs Partners, a boutique Japanese fund which we highly respect, is the third investor with a 6.25% stake which it acquired last year from a former cornerstone investor.

The majority of Mercuria’s management and performance fees are generated via its Japanese private equity fund and a HK-listed REIT invested in a Grade-A office property in central Beijing.

The IR contact is professional and helpful and can arrange a call with the CEO & Founder. As you would expect in their line of business, both speak excellent English.

https://www.mercuria.jp/english/

Private Equity and Venture – The crown jewels

We estimate that their initial US$200M private equity fund has returned an IRR of about 20% since its launch 10 years ago. The investment team focuses on small and mid-caps Japanese private businesses which would benefit from Mercuria’s experience and network in the broader Asian markets. The number of Japanese founders in their 70s who are looking for help with succession or expansion is well-documented and explains the reasonable entry valuation for deals. As a result of both the favorable market dynamics and their strong track record, we think that Mercuria is looking at raising a larger follow-up fund which we expect to generate strong institutional interest.

Mercuria has additional investments in a  successful venture fund and in addition holds a 25% stake in Enex Infrastructure Investment (9286.JP), a Tokyo-listed infrastructure fund, which is in early stage of its development.

Real Estate - A messy fight

HK-listed Spring REIT principally manages a Grade-A office tower in central Beijing with constantly high occupancy rate, mainly from international corporates. The prime office market in Beijing has been a great place to be invested and it tells a lot about Mercuria’s network in the region that it was able to invest in such a prized asset at the time.

Admittedly, Mercuria does not have as good a track record as a steward of this public vehicle, which is reflected in the REIT trading at a steep 50% discount to such a quality asset, a record for HK-listed REITs with assets in China. The best way to understand in excruciating detail their poor record so far is to read the latest presentation sent to the Board of Spring by local Private Equity firm PAG together with their own financial disclosure and presentations.

https://savespring.hk/

It is difficult to argue against the main points raised by PAG, but Spring seems to have been able to survive the campaign and will keep earning its annual $9M fees-based income stream, 75% of which are paid in units of the REIT. Fortunately, it is likely to have no impact on the team’s reputation in Japan. If the Board were to take some of the suggested steps to close the discount, their investment in the fund worth $45M  at current valuation would rerate accordingly. In the meantime, it looks like the REIT will remain firmly under their control.  

Ironically, Asia-based investors may remember that PAG itself was on the receiving end of a similar campaign by minority shareholders back in 2015 for its own London-listed Chinese private equity fund, ARCH.

Good businesses at negative Enterprise Value – You can still find them in Japan?

Compared to its market cap of $127M, Mercuria’s co-investments in its funds are worth $70-80M at current valuations, and $125M at full NAV for Spring. Cash adds up to $20mm. Spring REIT’s earnings have been very stable while the ones from the Private Equity and Venture funds are understandably much more volatile.

If we assume that the company rerates at 5x EV/EBIT on 2021 forward operating profit of JPY 1.5bn, as management guided for this year, no re-valuation gain from existing investments and taking co-investments at current valuation, we estimate that an investment would compound at 22% a year over the next two years.

If one adjusts the enterprise value to reflect NAV valuation, it either offers an extra margin of safety or would drive a correspondingly higher IRR.

Longer-term, management updated its long-term plan this summer with a target AUM of US$5bn and JPY2bn of average annual net income by 2025. While we wait for these developments, the company distributes a dividend yield of 2.5%.

Risks

The private equity and venture earnings are highly dependent on realizations which are themselves dependent on favorable M&A and equity market conditions. The 60% earnings drop in 2020 is a good and timely illustration of the volatile nature of the business. Their different investment lines also depend on a copious access of leverage.

There is a key-man risk with the CEO and Founder who is the figurehead for the firm and seems instrumental to its institutional investors relationships.

Catalyst

We understand that the company has been slow to publicize the attractive investment returns generated by its private equity and venture funds for fear of running afoul of strict Japanese guidelines on the promotion of financial products to non-professional investors. The publication of these returns would be a positive catalyst for the share price, as would be news on the fundraising progress for its second private equity fund. The amount raised would give a good indication on the credibility of management's target AuM by 2025.

An improvement in capital allocation and defter handling of minority shareholders at Spring REIT would be another (welcome) catalyst and should be relatively simple to implement.