Description

Warning: Low liquidity security

Thesis

SDC is a thinly-traded recent spin where the classic smaller cap spin from larger entity has created a favorable entry point. SDC is a “permanent capital vehicle,” i.e. effectively a holding company/closed end fund model, which owns a portfolio of modest-risk securities trading at a 40% discount to NAV with minimal leverage. We believe shares offer an attractive investment where we stand to lose little if wrong and make a great deal if correct.

SDC’s parent company is Peregrine Group, the oldest hedge fund management company in South Africa. In mid-2017, Peregrine decided to spinout its excess cash and securities portfolio to create a permanent capital vehicle. Peregrine’s reasoning was two-fold: the mark-to-market of the securities portfolio added unnecessary volatility to Peregrine’s earnings and insiders wanted a higher rate of return on their investments. It’s worth noting Peregrine insiders are significant shareholders. Due to the small spin from larger cap company dynamic, along with the general lack of coverage in South African small caps, SDC is currently trading at a 40% discount to its NAV.

Given the sizeable discount to NAV, the investment hinges on 1) NAV accuracy and 2) SDC’s investment returns outlook. On NAV accuracy, the portfolio consists of diversified European real estate investments, particularly Stenprop REIT (STP SJ), and investments in Peregrine’s funds, particularly long/short equity, fixed income, and global macro. The funds are in generally easily-marked securities and Peregrine has a strong reputation as honest, high-quality investors. On return outlook, the vehicle is managed by Peregrine’s founder, Sean Melnick, under a reasonable management contract targeting a greater than 15% rate of return, which compares to the South Africa prime rate of ~10%. Sean Melnick is a well-known entrepreneur and investor in South Africa. While he could prove a bad capital allocator, the substantial discount implies limited fundamental long-term risk (down 40% is really, really bad investment performance…) and he historically has been a capable manager.

We believe the combination of a recent spinoff, low leverage, and steep discount to NAV create an attractive entry point. Assuming a 10% IRR on SDC's investment portfolio (below the management company's hurdle) and an exit at 0.9x NAV in one year, we believe shares offer >50% upside (~Rs 5.50/share exit).

Note: We realize SDC may trade at a larger than 10% discount given liquidity, but if SDC is at all successful in its investments, we would continue to hold shares at a >10% discount to NAV, assuming leverage remains minimal.

Catalysts

·       Spin Dynamics – Given little coverage, low liquidity, and recent spin, we believe shares are exhibiting “classic” spinoff selling pressure from Peregrine shareholders. As their selling abates and more investors learn of the story, we believe SDC could reweight.

·       South African Macro – The SA market has recently bounced following the departure of Zuma. If the macro picture turns more positive, new money could enter the market.

Risks

·       Currency – While the majority of SDC’s investments are outside of SA, the shares are listed in ZAR, a notoriously volatile currency

·       Real Estate and Interest Rates – Half of SDC’s current investments are in real estate, mainly in Europe, which could fall in value if global rates head higher

·       Nala Investment – SDC has an investment in a Black Economic Empowerment investment vehicle, which owned a stake in CIL SJ, whose shares have fallen 80% in the last 12 months. The investment is marked on SDC’s books at a small negative value. It is our understanding that the investment should be a zero at worst, but IR will not confirm the debt is non-recourse. At worst, SDC would be on the hook for their ~ZAR56MM share of the loan (~4-5% of NAV).

NAV

SDC’s Portfolio

SDC’s portfolio is mainly cash, hedge fund investments made into Peregrine’s funds and real estate, largely an investment in the publicly traded Stenprop REIT, another related asset manager. Normally an NAV based largely on investments in related parties would raise a red flag; however, in the case of an investment management company reinvesting in the funds it manages, we think the investments make sense. (We imagine many managers on this board explicitly pitch to investors that they reinvest their profits in the fund.)

The hedge fund investments are mainly in Peregrine’s equity long/short, fixed income, and global macro fund of funds. We view these as lower-risk/lower-reward investment categories, despite the South African focus, and would expect a diversified portfolio of these investments to largely track South African equity and fixed income returns but with lower beta. Peregrine has a long track record of success in South Africa and the various funds’ tear sheets can be viewed on their website (https://www.peregrine.co.za/). While we am not expecting heroics from these investments, at a 40% discount to NAV, we are comfortable in the risk/reward and use the marks from the last NAV update.

The real estate investments are direct real estate investments in the US and Europe and Stenprop, a publicly listed REIT in South Africa. The direct investments (and the non-STP listed RE) are ~8% of NAV and we mark at book value at last NAV date. STP SJ is ~30% of NAV and is itself an interesting investment story. Stenprop is a portfolio of office, mixed use, and industrial property in Mainland Europe and the UK trading at an ~20% discount to NAV and ~8% dividend yield. Further, the company is applying for UK REIT status and plans to relist on the LSE to make its stock more noticeable to its logical investor base. While the stock is arguably over-levered, with an LTV of 50% versus peers between 20-40%, again the 40% discount to NAV in SDC’s shares provides substantial cushion. In the NAV calculation above, we mark STP SJ at last sale.

Investment Strategy

SDC’s stated investment strategy is to gradually divest its current investments and pivot towards a portfolio of a few concentrated investments, typically in private equity or micro-cap public equities, where SDC management can have an impact on the business.

Per the Pre-Listing Statement:

“The current portfolio composition is effectively an inherited one, being assets held by Sandown Capital and the surplus assets unbundled from the Peregrine group. Whilst the board are comfortable that the current portfolio of hedge funds, direct property and listed property units as well as a funding stake into a South African corporate through a black economic empowerment vehicle, is capable of generating acceptable long-term growth in NAV per share, it is anticipated that the current portfolio will, over the next few years and in a stable, measured manner as divestment opportunities arise, be realigned with the intention being to seek out fresh opportunities across a wider investment landscape, encompassing listed as well as unlisted opportunities.

The geographical split of Sandown Capital’s investment portfolio, on a net asset value basis, is currently 30% South Africa and 70% invested internationally. It is envisaged that the majority of new opportunities will continue to be international focused.

Shareholders should be aware that strategically there is a preference for investing in a few, high conviction opportunities rather than building a more diversified portfolio. In principle, Sandown Capital would prefer to be a meaningful cornerstone investor, actively engaging with management and adding strategic value rather than be a holder of passive investment stakes. The deployment of permanent capital is seen as a clear advantage in the pursuit of this strategy.”

We have a favorable view of this strategy – we ourselves run a concentrated investment fund – and Melnick’s history as an successful entrepreneur and investor is documented below. 

Sean Melnick

Any investment in a “permanent capital vehicle” is highly dependent upon the investment manager. While a 40% discount would be attractive even in mediocre hands, we believe SDC has a competent manager in Sean Melnick. Melnick founded Peregrine Capital in his mid-twenties after a working at Investec and Liberty Asset Management, two well-known SA financial institutions. After only a few years of existence, he took the unusual step of listing Peregrine, capitalizing on the emerging markets stock boom in the late 1990s. After listing at Rs2.50, shares surged to Rs28, a USD $1B value, despite less than a million in trailing revenues, and Melnick became enormously wealthy. Inevitably, the stock crashed, creating major headwinds for Peregrine’s business. (How do you motivate a 25-year-old analyst who just made US$3MM to work long hours when his base salary is US $40k?) However, rather than retiring to a beach, Melnick stuck with the business through the decline and gradually built the company into the largest hedge fund in South Africa, and the stock eventually recovered. He retired from his CEO role in 2006, remained chairman at Peregrine, and has pursued various investment opportunities. While his track record is not perfect (whose is…), we take comfort in investing alongside someone who has had the opportunity to “take the money and run” but has stuck by investors and done the right thing.

For more info on Melnick, here are two interviews:

https://www.youtube.com/watch?v=Gy2qPZK0fxI&t=723s

https://www.moneyweb.co.za/archive/sean-melnick-executive-chairman-peregrine-holdin-2/

Manager Contract

SDC is a third-party managed vehicle. Melnick’s contract is structured as an effective ~1% management fee (minimum of ~£1MM) with a 10% performance fee subject to a 15% hurdle rate. Of note, for purposes of management company fees, the NAV will be adjusted for any issuance/buyback of SDC shares, thus Melnick is not incentivized to do deals regardless of merit to boost compensation AND Melnick is incentivized to buyback stock at a discount. In our view, the contract is reasonable and provides the proper incentives without the more prominent conflict of interest incentives that often plague third-party management.

Insider Buying

In January, the two management professionals at Sandown, Melnick and CFO Jelley, both made significant insider purchases, with Melnick acquiring roughly 5-6% of shares outstanding.

Other Info

Sandown Pre-Listing Statement: http://sandowncapital.com/News/Article/4

Catalyst

·       Spin Dynamics – Given little coverage, low liquidity, and recent spin, we believe shares are exhibiting “classic” spinoff selling pressure from Peregrine shareholders. As their selling abates and more investors learn of the story, we believe SDC could reweight.

·       South African Macro – The SA market has recently bounced following the departure of Zuma. If the macro picture turns more positive, new money could enter the market.