Stock markets serve a dual purpose. They provide savers with returns on their investments over time, and they filter capital to companies best positioned to earn those returns.
Historically, yields have captured the most attention from investors. Yet today, more and more, savers also want to make a difference with their money. Providing follow-on capital to growing businesses is a great way to do this.
One of the most satisfying parts of my job as a fund manager is watching a small business grow into a mid-sized business, knowing the role our investors’ money has played in that transformation. Together we can help businesses create more jobs, make more profits and hopefully pay more taxes.
The success of a business is largely due to careful management and good products or services. Yet even the best policies, practices and ideas can go to waste without capital.
Make your money count
The biggest groups in the FTSE 100 rarely come to market for money. These companies can often borrow relatively cheaply if they do not generate cash from their own operations. The greatest demand for follow-on capital is seen in the early stage and small cap space.
Investing at an early stage can be particularly risky. The Aim market still harbors dangers, but it’s a happy hunting ground for savvy stockpickers and home to many fast-growing companies that need help. Just over half of our portfolio – a UK multi-cap fund – is made up of Aim shares.
The smallest listed company has a market cap of less than £1m; the largest of around £3.5bn at the end of January 2022. Somewhere between these extremes are another 770 companies, many of which will want to raise equity to fund their growth.
Last year, more than £9.5bn was raised by companies in the junior equity market. There have been 66 IPOs, but perhaps most interestingly around two-thirds of that £9.5bn was follow-on activity – £6.31bn from 297 capital raises .
Make the best use of money
K3 Capital is a Bolton-based business services company which covers mergers and acquisitions, restructuring and tax advisory services. We have held its shares since 2019 and have supported several capital increases. In July last year, he raised £10m to fund the acquisition of a complementary M&A and tax advisory business.
Since going public in July 2017, when K3 had a market capitalization of £40m, a strategy of raising equity for smart acquisitions has helped the company grow into a much more substantial and diverse business. It now employs over 500 people and its market capitalization has grown to around £230m.
Scottish homebuilder Springfield Properties raised capital by issuing shares in 2017 at 106p and in December 2021 at 140p. He used the money to buy land and opportunistically bought up smaller private homebuilders. As a result, it is now widespread throughout Scotland and has a large land reserve.
Early-stage small businesses often have very low revenues and need capital to take advantage of orders when they come in. One example is Surface Transforms, which makes next-generation brakes for cars. It first raised funds to prove the effectiveness of its products to car manufacturers. More recently, it has started winning orders from well-known electric vehicle manufacturers. In February 2021, it raised nearly £18m to build capacity to meet those orders.
Sometimes investors are solicited for less positive reasons. At one point in the spring of 2020 I was pricing several capital raises a week as Covid wreaked havoc on the UK economy. It was brutal, but often buying more shares seemed like the right choice.
Companies we supported included Hollywood Bowl, a chain of bowling alleys and the Gym Group. Worth between £400m and £500m, they are FTSE All-Share companies, demonstrating that the need for follow-on capital is not limited to the junior Aim market.
Capital increases have enabled these companies to emerge from the pandemic among the best survivors. In May 2021, another company, national bar chain Revolution Bars, raised £21million at 20p per share for a combination of renovations, new site acquisition and balance sheet aid as it sought to take advantage of weakened competition.
There is the question of how beneficial this is for Britain – the markets listed in the UK are much more international than they used to be. We estimate that over 50% of our portfolio companies’ sales are made here in the UK (compared to 25% for the FTSE All-Share). The smaller the company, the higher the national weighting tends to be.
Make the right call
Investing in this sector of the market requires discipline. It’s important to recognize that small businesses can turn to you for more capital. This may mean building a position slowly and saving money for later.
It’s also important to carefully consider a company’s history of raising capital and how it has used the money before. More importantly, it’s crucial to keep an eye on the balance sheet to gauge monthly cash burn – it’s a good guide to when management may return.
You don’t have to participate in capital raises – you may see your participation watered down – but sometimes it’s the right decision. And it’s important to remember that smaller companies aren’t as liquid as FTSE 100 stocks. A quick exit may not be possible, so it’s important to buy carefully.
If that sounds too risky, there’s the funds option. There can be no guarantees, but good active managers have a strong track record of outperforming small business markets over the long term. Beyond our research capacity, fund managers have the resources to diversify, which helps us mitigate the greater risks of swimming in these waters.
By investing in a UK small cap focused fund, you can always feel that you are indirectly supporting UK businesses. If you have a taste for risk investing in companies yourself and can participate in their fundraising efforts, you can contribute more directly. Either way, if you do your research thoroughly and make wise decisions, it can be rewarding in every way.
Laura Foll is co-manager of the Henderson Opportunities Trust