Constructive engagement with listed smaller companies: A ‘Value’ alternative to Private Equity?

We recently made a presentation at the LVIC Value Investor conference in London (password provided at the end of the article) on the theme of how ‘constructive engagement’ on smaller listed companies can accelerate returns and reduce risk.

We have been investing with the same investment philosophy and process since the QCF (Lux) – Argonaut fund was launched 19 years ago. We focus our efforts on the least efficient part of the market: the ‘grey area’ of European micro caps where mis-pricings abound and where our fundamental research approach enables us to accumulate a portfolio of ‘good’ companies acquired at ‘great’ prices. Experience, focus and an open (contrarian) mind have given us a competitive edge in this area.

Our investment approach has always been based on travelling around Europe to find unloved companies trading at low valuations in out-of-favour corners of the market, then continuing in-depth research to increase our conviction and position weighting. There is then inevitably a period of waiting (and monitoring) for our investment thesis to play out, which often takes several years. Our investment process already felt half-way between that of “Listed” and “Private Equity” with frequent visits to company sites and very regular direct contact with the top management. Even if we do not carry out formal Due Diligence, our research process has always been ‘Primary’ rather than ‘Secondary’. Our target companies were listed, but often were not covered (or poorly covered) by broker research, so we have always always done our idea sourcing and research inhouse.

As the fund increased in size, we found ourselves ever more regularly holding between 5 and 10% of the capital of a company and our interactions with management became progressively more ‘engaged’. With a larger equity stake, we became longer term shareholders and management even started to consult our opinions on communication and strategic options for the business.

Once we are fully invested in a target company, we tend to put our ‘broker’ hat on and ‘reverse-broke’ the share to the investment community and encourage research analysts to initiate coverage of our orphan stocks. By the time the market becomes excited by a new name, we start to gently offer out blocks of our shares to take profits.

Over the near 20-year period that we have been running the fund, the “Private” Equity sector has also been developing very fast with very substantial inflows. Strong performance had led to great enthusiasm for the Private Equity ‘magic’ that was really creating impressive returns. The funds raised money faster than they were able to invest it and the Private Equity industry now has ‘dry powder’ of USD 3.4 trillion waiting to be invested. This compares to dry powder of USD 0.5 trillion at the same time as the Argonaut fund was launched in 2003. The increasingly larger Private Equity funds have since been queueing up together at competitive auctions to bid for targets whose valuations have been driven ever higher. Over this period, the valuation multiples in the mid-market have risen from circa 6x Ebitda to over 11x now.

The classic Private Equity value creation model is driven by investing in good companies at attractive valuations, improving operational performance, incentivising management to streamline the business, applying leverage, pursuing a longer-term strategy and ultimately exiting at a higher multiple via a stock market listing. The model remains intact apart from the purchase price valuations of Private Equity which are now higher than those of their listed peers, making market exits unattractive.

Looking over the 19 years since launch, the valuation multiples of the Argonaut fund have remained in a similar range and are still at 1.2x book value and a PE ratio of 13x this year’s net profits and 11x next year. With listed equities trading at a discount to Private Equity, it begs the question: ‘Can we reproduce part of the Private Equity value creation model through Constructive Engagement on under-valued smaller listed companies where we control a 5-10% stake?’

We have always kept a close relationship with management of the companies where we are invested, but we also note that, with the onset of ESG lobbying, they are now even more open to hear the views of shareholders. We have also found ourselves discussing more with other shareholders to have a louder voice and increasingly direct discussions with board members. Our engagement has always been ‘constructive’ and we shun the ‘Activist’ word as we want to preserve our positive reputation across European micro-cap corporate spheres as the long term investors who arrive at a contrarian time and make positive suggestions for improvement. This keeps the doors of our European universe open.

6 areas of best practice

Our approach has been to label our engagement as ‘Encouraging Best Practice’, which underlines the positive nature of our process, and we set 6 areas of best practice we focus our energies on:

  1. Communication and engagement with the stock market and investors
  2. Operational improvements – benchmarking by subdivision
  3. Sustainability / ESG policy
  4. Governance / Management incentivisation
  5. Asset Allocation – acquisitions, consolidation, asset sales, debt reduction…
  6. Dividend policy

There are a host of measures a Private Equity firm with full control can implement, but obviously the influence of minority investors is on a different scale. Nevertheless, this influence can be significant, particularly when minority shareholders join forces in pushing for change. One of the first and easiest areas where we have tended to work concerns the communication and engagement with the stock market. We want to assist the company in enabling the market to see the hidden value we have identified. We don’t pretend to have the authority to teach the management team how to run their business, but we have found that reminding them what their best peers generate in terms of operating profit margin in each of their subdivisions has been a powerful driver for positive change in terms of operating efficiency and strategic capital allocation. We have often invested in undervalued companies, with hidden assets that were difficult to understand because there were too many businesses, with the idea that a more streamlined and focused business would be better valued by the stock market.

Since the launch of the Argonaut fund in 2003, we have been encouraging smaller companies to become more efficient, to streamline, to participate in sector consolidation, to focus their business and to pay dividends… or simply to communicate more openly with the stock market. We are often invested in listed family-owned companies, so are used to businesses that might not be optimally managed. This often means that there is room for self-help and improvement by the company management which ensures another driver for the share price.  Our constructive engagement can add further value to this positive change… and ultimately helps with our exit strategy.


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