Investing In Unlisted Companies

In this section I have provided some commentary on investing in companies whose shares are not listed on the Australian or other major stock exchange but are ‘well established’ and generating a respectable return on shareholder funds.

Although In writing this commentary I have in mind profitable privately owned businesses that have a turnover of over $50 million, a similar approach could be taken in relation to a business with a much lower annual turnover – such as a local nursery, café, restaurant, butcher or baker or even a professional services firm.  The commentary does however not relate to ‘start-ups’ or other early stage businesses and nor does it include mining exploration businesses or biotechnology R&D businesses. These are invariably much riskier propositions for investors.

The expected return on investment depends on the nature of the instrument, whether it is ordinary shares on the one side of the risk equation, a senior secured bond on the other side or sits somewhere in between.

Ordinary Shares

I will start by providing some commentary on the return one should expect from an investment in the ordinary shares of such a company.

An indication of the expected return can be gleaned from the prices at which such businesses sell. I understand that businesses with a sustainable EBIT (earnings before interest and tax) of about $2 million sell for an EBIT multiple of around 4 times, whereas businesses with an enterprise value of about $10 million sell for an EBIT multiple of about 7 times.  Assuming 50% of the purchase price is funded with debt at a cost of 6% pa and a 30% tax rate, the price represents a pre-tax equivalent return on the equity of 44% pa in the case of the business selling on a 4 times EBIT multiple and 22.3% pa in the case of the business selling on a 7 time multiple.

The private equity firms and high net worth family investment companies generally say they are targeting a return from any investment of around 25% per annum, which sounds reasonable given that they target the larger private companies and so expect buy on a 5 to 7 times EBIT multiple. This return expectation is however determined on the basis that the sell-out multiple is assumed to be the same as buy-in multiple.  The reality is that they expect the sell-out multiple to be much higher than the buy-in multiple, resulting in a target return of over 40% pa.

While these are attractive potential returns I would as a minority shareholder struggle in most cases to get comfortable with having no control over management or the exit event and in some cases even getting copies of the financial statements. Private equity firms and high net worth family investment companies generally overcome this concern by purchasing a controlling interest in the business. The company’s constitution (shareholders agreement) could be changed to provide some protection to minority shareholders but even so I would not want to take on the risk of expending time, effort and cost enforcing compliance.  So unfortunately that rules me out – of taking a minority holding in the ordinary shares of an unlisted business.

The return one could expect on the other side of the risk equation, a senior secured bond, depends on whether one (as the investor) is in effect competing against the banking sector. If the banks are willing to provide the loan required, the all-in rate would generally be 4% to 7% pa. If the banks are not willing to provide the loan, it could be that the risk is too high. It could also be that the borrower’s shareholders might not be willing to provide personal guarantees and mortgage their real estate as security for the loan. Banks also decline to lend where the borrower is in an industry that does not meet their social conscious commitments.  These borrowers need to pay a premium to secure the required loan from the non-bank sector. In the current market the return I would expect as a prospective lender would be 10-15% pa. The opportunities however to earn such a return on a senior secured loan to a mid-size profitable business are somewhat limited. I do come across them from time to time but unfortunately not often.

Whereas the prospect of finding suitable opportunities to invest in the ordinary shares of an unlisted business (as a minority holder) or to invest in senior bonds paying above 10% per annum is rather remote, the potential exists to earn high returns-for-risk on hybrid instruments.

Hybrid Instruments

Many businesses have a need from time to time for hybrid capital, capital that does not require an issue of additional ordinary share and is not a senior loan or leasing facility provided by one or more banks.  The investment could be to fund the additional working capital needed to support a higher level of sales or extending credit terms to retain a large customer or it could be to fund additional (new or used) equipment, the purchase of another business or for expanding the size of its footprint (factory, office or shop size).

Many mid-sized businesses (with a turnover of at least $50 million pa) have identified worthwhile projects, ones that would enable them to increase profits and shareholder value. These could be to increase the business’ production capacity and efficiency or its product quality or reduce its cost of production. Such projects are often rejected or put on hold due to funding constraints. On the one hand the banking sector typically does not provide loans for speculative projects and requires the borrower to adhere to gearing and other covenants and are reluctant to provide loans where the interest capitalizes. In effect the banks lend against the strength of proven net cash flows, rather than on potential cash flows. As a result the banks are often not willing to provide a loan against the project economics or if they do, they often are not willing to provide all the capital required by the business. On the other hand the owners of the unlisted businesses are generally not willing to dilute their shareholdings. In these cases the business is left with a funding shortfall and not realizing there are other sources of capital often decide not to pursue projects that would if pursued materially increase profits. The funding solution lies in the issue of a hybrid instrument.

The expected return on investment depends on the nature of the instrument and the associated risk profile. If it is akin to a short term (12 to 18 month) subordinated loan I would be expected to earn a return of 12%-15% pa. On a longer term subordinated loan I would expect 15% to 20% per annum. If more like ‘equity’ I would expect a return of 25% to 30% pa.  My preference is an investment that gives me a minimum return of 12% to 15% per annum and a high level of confidence that (through a warrant or other ‘profit sharing’ arrangement) my total return will be in the order of 20% to 25% per annum.

These returns are achievable on many business acquisitions as well as on many projects. Although many projects have a payback period of less than 4 years consider do the math on a project with a 4 year payback period and say a 10-year economic life. Consider two scenarios. One is where the investor provides a loan to cover the entire project and commissioning cost (for say 12 months) after which the business refinances the loan with a bank.  The other scenario the investor only funds the shortfall, the balance of the project and commissioning cost not funded by the bank.  In both cases one would have reasonable justification for requiring 20% to 25% per annum.

Expected Risk:

If structured (as I would suggest) as a subordinated loan or redeemable preference share the risk profile should be much lower than an investment in the ordinary shares of a ‘blue-chip’ company listed on the ASX or other major stock exchange. That is because the company will have a contractual obligation to repay the capital invested and pay at least the stated minimum return. One will only not get one required return if the company is unable to pay the amounts due in full and on time. This is quite different from an investment in the ordinary shares of a blue chip company, where one’s return is affected by changes in market sentiment.

The benefit of this level of certainty around the return on investment (and return of capital) is however offset to some extent by the company (the borrower) probably being of a higher risk than applies to an investment in the shares of a ‘blue-chip’ company. I would mitigate this risk by requiring a high level of confidence that the company will be able to meet its payment obligations in full and on time.  I would also want to rank ahead of executive directors, not only as regards their ordinary shares and dividends but also in relation to salary increases, performance bonuses and share buybacks.

Problems to Overcome:

While I argue that an investment in a hybrid security of a well-established and profitable mid-size business has the potential to deliver a high return-for-risk (in this case a high return in return for a comparably low risk), there are some problems for the prospective investor to overcome.

One of the problems – and a rather major one – is how do you find opportunities to invest in these hybrid securities. There is no formal market and there is no ‘industry’ selling or otherwise promoting them. One is unlikely to receive such opportunities from stockbrokers – as their objective is to encourage their clients to invest in listed securities (preferably those with the highest market capitalization) and to trade frequently.  One is also unlikely to receive them from wealth managers and financial planners, whose corporate arrangements and insurance basically preclude them from recommending unlisted investments, particularly those issued by companies whose ordinary shares are also unlisted.

In the event that one does find these opportunities, who does one approach for advice as to whether or not they ‘stack-up’? The stockbroking fraternity would be of no help. Not only would their training, business structures and insurance preclude them from providing advice, they would have a vested interest in persuading one not to consider such an investment. Wealth managers are in a similar position, so also of no help. Their focus is generally to sell insurance and investments in managed funds. The accounting profession is unfortunately also of little assistance. Although they are well placed to interpret financial statements, they are generally not trained or educated in assessing investments and generally do not have the insurances and licenses needed to provide such advice. Many (if not most) accounting firms offer a financial planning or wealth management service and so suffer the same limitations.

Another obstacle facing a prospective investor is getting a prudent level of portfolio diversification. Just as I would caution against investing in only one or just a few ‘blue chip’ shares I would caution against investing in only one or just a few hybrid securities. The amount one would expect to be required to invest in any hybrid investment would generally be a lot higher than the minimum one would need to pay in order to invest in a blue chip shares. This unfortunately puts a direct investment in hybrid securities beyond the reach of most private investors. I am also not aware of any managed fund in Australia targeting unlisted hybrid instruments, so private investors are also not able to get an indirect exposure (through a managed fund)to these hybrid securities. Both ‘doors’ are closed for them.

In Conclusion

While investments in hybrid securities can offer the potential for high returns relative to risk, they are unfortunately beyond the capacity of most private investors. This may change if and when a managed fund is established to invest in such hybrid instruments.

Prepared by: Mark Morris