5 key lessons on investing in emerging companies

Following the strong run in equity markets in the second half of 2020, finding publicly listed growth companies trading at reasonable valuations has become increasingly difficult. But for those hunting outside public markets, the opportunity set looks very different. 

Jonathan Pearce from CVC Emerging Companies says the companies they’re considering typically grow revenues at 20% a year or more, while sensible valuations are a necessary precondition for inclusion in the fund. He points to the example of Cleanspace Holdings (ASX: CSX), which he invested in at 36 cents a share before it eventually listed at a price of $4.41.

In this Fund Manager Q&A, Pearce shares five key lessons on investing in emerging companies and explains the key drivers of returns. Delving into his portfolio, he also reveals two companies that might be set for Australian IPOs in 2021.

Could you give a brief introduction to emerging companies?

Emerging companies refer to those in the growth and expansion stages. Growth and expansion stage companies are those requiring additional capital prior to an ultimate liquidity event. The liquidity event could be an IPO on the ASX, a trade sale or a sale to private equity. The companies we typically come across are fast-growing, with yearly revenue growth of more than 20%). They also usually have strong founder ownership and leadership seeking a capital partner able to help them through the liquidity process, which is typically within six to 36 months from the time of investment.

What has been the experience in your first fund, and what are some of the lessons that you’ve picked up since the fund launched?

Many companies looking for capital fit within our mandate. We look at more than 200 companies a year, and will generally invest in less than 10 of them. We’ve learnt some good lessons, both from companies we’ve invested in and those we haven’t. A few key lessons have included:

1. Having a strict focus on post-commercialisation, expansion-stage companies as opposed to early-stage companies not only removes a lot of early-stage risk from the portfolio but helped free up a lot of our time in assessing opportunities.
2. Having a slightly more mature business is generally better. The bigger the company from a revenue perspective, the more likely they are to have some buffer for an operational “speed bump”, unfortunately, the reverse is also true.
3. Founders who have large share ownership tend to be the best partners – they care the most about the company and will sweat the “little things” with key operational issues likely to keep them up at night.
4. Growth companies can react quickly, and they implement new business initiatives if there is an opportunity or a requirement to diversify, whereas larger competitors will struggle to make changes quickly and fail to compete on this basis.
5. Always check the history of management both on Google and more broadly from contacts or references – understanding the people you’re investing in is by far the most important component. Bad management can wreck good businesses very quickly!

What are the key drivers of returns?

Performance in the company is a key driver. The ability to negotiate preferred terms in an investment is very important for protecting downside and ensuring that the returns are maximised through the exit event. But ultimately, unless the company performs, returns will be capped.

Alignment with the founders on all the above is also very important and drives returns – it’s critical we are aligned from the start.

The other key driver of returns is how the stock market is performing – it is a great source of liquidity for good quality growth companies and guides valuation on entry and exit.

What are some of the most important selection criteria when investing at this stage?

The first checkpoint is management. Do not pass go if they are no good! Put very simply, if we don’t like management or our background checks don’t satisfy us then we won’t invest.

Following that, a few of the key inclusions are:

• Strong growth,
• A well-managed balance sheet and a set of financials that we can understand,
• A growth strategy that makes sense (with a vision beyond six to 12 months),
• A supportive team around key management, and
• A sensible valuation with a clear understanding of the exit.

The IPO market was shut for the first half of 2020, what are you seeing now and how do you manage the vagaries of the IPO window?

The window was shut in the first half but was well and truly open in the second. We see this continuing for a time but are still cautious about some of the IPOs that are coming to market. The good companies will continue to be listed but the poorer quality will struggle as investors and the ASX provide a reasonably good filter.

What happens when things don’t go to plan?

When things don’t go to plan, it typically creates a large distraction for the Fund. So fast, well-considered and early action is critical. An exit may be the first response, if we are able to exit. If that's not possible, then we tend to get more involved in the investment than we have been previously. So far, we haven’t needed to get too involved in the investee companies for Fund I. Having aligned management helps.

What is an example of a successful investment that you have been involved in?

Cleanspace Holdings Ltd was a cornerstone asset for Fund I. They manufacture personal respirators to protect users from the environment around them. Their respirators are used in industrial, mining and healthcare and have experienced unprecedented demand since the onset of Covid-19 for their healthcare respirators. We invested at $0.36/share in Fund I and the company listed on the ASX at a price of $4.41/share and now trades at more than $7/share.

The management team have a strong history in respiratory devices, and we continue to believe that Cleanspace has a long growth and expansion path ahead of it. It has been a very successful investment for Fund I.

What is a company that is likely to list in 2021 that is a great example of the investments the team at CVC make?

We made four investments in the December quarter and while all are exciting, Studiosity is a standout for us. It is an online software provider to the education sector with a strong, aligned board and management team. We are hopeful they’ll IPO on the ASX in the coming 12 months and continue to grow strongly.

Node1 is a smaller investment in the Fund that we made in 2020 and is growing at a remarkable rate. It is a WA-based telco with a very experienced board and management who are driving their growth. If the company continues to grow at current rates, it can either IPO or would be highly sought by a trade buyer.

What is the rationale behind the launch of your second Emerging Companies Fund?

Fund I has returned more than 120% in under two years and is almost fully invested. We do not reinvest capital; we return capital to our unitholders and have returned almost 30% of our capital to date. We have almost run out of investable capital in Fund I and the opportunities keep coming, so we are raising a second Fund to continue investing in a sector we are passionate about.

Under-researched, under-valued, under-owned

The CVC Emerging Companies Fund II has been established to invest in high quality, primarily unlisted growth and expansion stage companies in order to generate superior returns for investors. CVC Emerging Companies Fund I has to date delivered strong returns, and while past performance is not an indication of future performance, CVC Emerging Companies Fund II will be managed in the same manner as Fund I. The Fund is now open for investment. Find out more here