City of London Investment (CLIG) merger with Karpus

Hi,

I was looking to diversify into CLIG because my (very) amateur calculations currently give me a possible upside of 67% on a discounted NPV at a cost of capital of 10% and 23.5 compound rate of return (based on ROE of 46.4% and retention ratio of 28.4%);

However! true to form CLIG then announced a merger with a US operation, ostensibly to get some growth. Of course the share price then rallied.

My understanding of mergers and acquisitions are they increase the risk for the investor.

(I really don’t know much about the merger party, Karpus Management Inc, they don’t appear to be a quoted US company? )

I note BlackRock and Polar Capital has reduced their exposure, but this was before the merger announcement and possibly just a reaction to the drop of AuM at the end of March?

My instinct is to leave this one alone rather than initiate a position until more is known. Any-one have any views on this merger?

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Hi Ben,

Must admit I did think about CLIG when I looked up its monthly FUM update just before the deal was announced.

The shares did look cheap, assuming FUM would stabilise and earnings could cover the 28p dividend. However, over time I have become less enchanted with fund-management businesses as the staff always seem to receive greater compensation regardless of whether shareholders do well or not.

I would be interested to see these calculations. CLIG is not really a business where earnings are driven by reinvested profit. Retained profit is generally added to the cash pile and does nothing, or seeds a new fund. What drives CLIG’s earnings higher is FUM, which fluctuates with the market and occasionally moves due to new/lost mandates. No amount of retained earnings can offset lower profits due to a market crash hitting FUM.

M&A does indeed increase the risk for investors. Companies can buy a dud, overpay, suffer integration problems and/or ‘diworsify’. M&A may also signal the core business has run out of steam and management is bereft of growth ideas.

I have not looked (yet) at CLIG’s statement in detail, but I think the merger broadens CLIG’s FUM from emerging markets which could make future progress a little more stable. Karpus is a private US firm and the forthcoming retirement of the founder/owner appears to have prompted the deal. CLIG’s founder has recently retired from active duty, too, so shareholders have to trust the enlarged business will be appropriately run by the ‘professional’ management.

Something the deal does highlight is the ‘professional’ management is not afraid of somewhat radical action. I have increasingly felt CLIG has been too content to coast along and never really seemed bothered about winning new clients. Maybe the Karpus deal will bring in more dynamic personnel.

Once I have read the statement in full I will report back here with some more thoughts.

Maynard

Hi Maynard

Retained profit is generally added to the cash pile and does nothing, or seeds a new fund.

Yep-I appreciate Retained Profits do not, in of themselves, generate incremental profit but I think this is true of any business.

The point I was trying (and clearly failing miserably to make!) was that in an ideal world these retained profits would be reinvested within the company at it’s ROE to generate incremental profits, maybe through advertising or hiring a new team to then get to increased FUM, or alternatively that share buy backs or special divis may be on the cards. From your comments I think you believe the above would not happen and that any retained profit may effectively be wasted!

For the valuation I tried to replicate K A-L’s valuation calculations from his book. I will try to get these over to you tomorrow. It would be good to have a sense check of them!

Hi Maynard

As promised, I’ve attached my calculation (I’ve changed the PER for the compound earnings valuation from 15x to 10x because I think this is more realistic, however it still gives me 15.7% compound return).
CLIG valuation 170620.pdf (446.6 KB)

Best wishes,
Ben

Hi Ben

Many thanks for posting your sums. 10/10 for effort!

Now allowed xlsx spreadsheets to be uploaded!
CLIG valuation 170620.xlsx (18.3 KB)

Here are some observations that you may or may not wish to consider. I should add that 20 years ago I dabbled with such long-term valuation calculations myself and I thought a lot about how they worked, the theories behind them and whether they actually worked in the real world (I’m not sure).

DCF:

Growth rates

FCF is expected to advance from £8.9m to £15.9m between 2019 and 2029, or c6% a year.

For context, CLIG’s FuM has advanced from $4.38b to $5.4b between 2010 and 2019, so a CAGR of 2.4%.

True, different timescales will give different FuM CAGRs, but ultimately FCF growth cannot outrun FuM growth forever. So you have to consider how FUM is likely to move, too.

The sums indicate FCF bobs around £8-9m between 2020-2022, then starts to advance in a nice smooth manner until 2030. I think you have to ask what has to happen for FCF to advance so smoothly when the forecasts (and past results) suggest FCF tends to fluctuate.

Maybe you could get to FCF of £16.3m for 2030 through a variety of FCF ups and downs (e.g. +20%, -15%, -5%, +15% etc), which may present different values for NPV years 1-10.

Terminal value (TV):

TV is £217m / £16.3m or 13.3x FCF.

Market cap is £100m. 2019 FCF is £8.9m, so the present FCF multiple is 11.2x. So a slight re-rating takes place over the 10 years. Always worth asking whether such re-ratings are justified, or have happened in the past with the share.

TV represents 48% of the £158m estimated value. So a large chunk of the end result is based on this 13.3x multiple. Important that this 13.3x multiple is realistic. Helpful to check whether the shares have traded at 13.3x FCF in the past.

KAL says in his book that “in an ideal situation you want 100% of the present market cap to be represented by the existing business meaning that you are getting the prospect of the forward plan thrown in for free”.

You could therefore skip all the Y1-10 sums and place FCF on a multiple of 10 to get KAL’s ’10% annuity’ valuation. CLIG’s share price was I think close to a FCF multiple of 10x before the merger announcement. KAL’s theory would have said then that all of CLIG’s future growth would be ‘in for free’ — which sounds appealing.

Compound earnings model.

Retention ratio — I would use a longer history than the last three years. In years gone by, CLIG has paid out more than 100% of earnings as a dividend, and that could alter your retention ratio.

Also, I would include special dividends. I see them as cash that has built up and in effect could have been distributed as ordinary dividends during earlier years.

Plus, CLIG has a dividend cover target for 5-year periods of 1.2x, which is a retention ratio of 17%. So that will give a different result from a 28% ratio (I estimate an 11% compound return versus 15%).

ROE of 46% and a retention rate of 17% = c8% annual earnings growth. Again, you have to look back and consider whether that is realistic. As mentioned, FuM is up 2.4% CAGR between 2010-2019 and earnings can’t outrun FuM growth forever.

Similar to the DCF, the compound model gives a smooth trajectory for future earnings that, given CLIG’s past EPS ups and downs, may not be realistic.

Finally, always worth considering other shares in the sector. Most fund managers exhibit high margins, net cash etc, and yet are valued at 10-15x earnings. So perhaps the whole sector is under-appreciated, or perhaps the market recognises that the sector’s earnings can fluctuate with FuM and is not prepared to pay a high multiple. Other drawbacks, such as pressure on fee rates, may be at play too. A favourable industry-wide ‘structural shift’ that bolsters active fund-managers and their multiples seems unlikely, too.

Maynard

Hi Maynard,

Re DCF;

FCF is expected to advance from £8.9m to £15.9m between 2019 and 2029, or c6% a year.

For context, CLIG’s FuM has advanced from $4.38b to $5.4b between 2010 and 2019, so a CAGR of 2.4%.

Yes, you are of course right that I should ‘sense check’ the results- my current opinion of the reason for this divergence is that CLIG is working hard just to stand still, so retained earnings are being employed to replace attrition in the existing business, leading to;

  • the raison d’etre for the merger and

  • operating profit numbers need to be discounted a little more than average

10% annuity valuation - Good idea! I shall use this to see if it is worth-while working up a full valuation in the future.

Compound earnings model;

I don’t really pay attention to volatility of earnings just because on average the end result over 6 years should be there or thereabouts as a long-term investor - so whether volatility is modelled in I see as a personal preference of the investor.

Regarding this sector I do worry about the move to passive investing and the race to the bottom regarding % charge rate.

Thanks for looking at these models - it is really appreciated.

I think I have persuaded myself not to invest in CLIG, but then that is what seems to happen in most of your ShareScope articles so I am in good company!! :smile: Ben

Hi Ben,

I have now looked at the CLIG/Karpus deal and reported some snippets on my blog:

The small-print suggests Karpus’ FuM has grown entirely from market movements during the last 5 years rather than additional client money. My basic sums indicate post-merger EPS and DPS are not notably higher than my pre-merger estimates. A question also remains about whether Karpus’ 60% margin is sustainable – I reckon the new staff may take a greater profit share.

All told, I am not minded to acquire more but will collect the decent yield and hope the merger works out and maybe new client money can be won over time.

I have not bought any of the shares I have written about for SharePad – although I have taken second looks at Renishaw and Victrex. I tend to highlight the negatives to the shares I write about for SharePad as I find that more interesting than covering the positives that most people already know about anyway.

I read ages ago an interview with Lord Hanson, where he said to ‘box off’ the downsides first when looking at an investment. That is, determine what the negatives are, how bad they are, and whether you can cope with them etc. Only then should you consider the positives.

Maynard

Hi Maynard,

I’ve been meaning to add a post to this excellent forum and finally have a decent reason to do so. I joined the CLIG interim presentation online this afternoon presented by Hardman and Co for the first time (watch the recording here). I’m pleased that it was open to retail investors; actually one of the positive things to come out of Covid is the greater / easier access we now have to many companies.

CLIG is one of my larger direct equity holdings having bought in 2014, reinvested the dividends since then and picked up a chunk in the low 300’s in April 2020. To be honest, I’m really pleased with the recent increase in SP which had not managed to break through 500p.

In general I liked the fact that all of the management team had a chance to speak this afternoon, and always prefer that above a dominant CEO who likes to do all the talking. I also had quite a good impression of them; not too showy or rampy towards the audience. Actually, perhaps they could be viewed as not that engaging and this may work against in some eyes??

I thought that they rattled through the presentation quite quickly and I did not really learn a whole lot from what they said in the main presentation.

I would have liked the session to have gone on for another 20 minutes as none of my questions were answered and think it was probably too short at 45 minutes.

Hardman appeared to focus on outlook in the Q&A but it would have been good to hear more about how the integration has progressed. Especially as they indicated integration had been slower due to the impact of Covid 19 (thinking IT, Finance, shared services). I hope they attempt to answer the other questions and send replies!

I came away with a good impression of the reasons behind the merger: to diversify and broaden interest in the business through combining with a company they know well and trust have the same values. I liked the fact that the CEO, Tom Griffith, indicated he felt this was necessary to increase interest in the shareholder base of CLIG. Tom Griffith appears to be much more focussed on growth - one would hope this is a good thing.

They mentioned about the one year and one year soft ‘lock up’ on the shares issued on merger with KIM. I worry about the overhang of shares should George Karpus decide to sell up after the lock up period. I would have thought this is highly likely given his age and US citizen. Perhaps they are going to try to drum up institutional interest to take some of these in due course.

There was quite a big focus put on increasing marketing spend and brand recognition, especially in relation to Karpus. It has not historically had an integrated marketing function, had not been working on their brand profile, so hoping new marketing hire will set them up to do this. Big focus on marketing in the Q&A. I do agree that if they have historically outperformed their benchmarks (as suggested in the presentation) but are not adequately marketing this to potential customers then marketing spend may be effective.

I’m a simple chap and I didn’t understand the issue about “capacity constraints” limiting growth of the business. Is this management speak or something sensible in the Investment Management industry?

Looking at the dividend cover template and cash generation, I would hope that they will be in a position to pay a special dividend in FY 22. Tom indicated this will not happen in FY 21, perhaps as he senses a market downturn and the need to hoard cash to maintain the 1.2 x coverage on profits.

My questions which they did not answer:

Will the KIM employees take a profit share in the same way as the CLIM employees?
Acquisition / integration costs were high in H1, are these now out of the way or more in H2?
What are their thoughts on defending the reduction in management fee - down to 74bps.
Why are the growth forecasts which they predict in their dividend template model so low (around 3%)? They highlight growth pipeline for opportunistic value, international and REITs elsewhere.

What impressions did you come away from the meeting with?

Regards

James

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Hi James

Many thanks for the message.

I watched the presentation, too (watch the recording here). One of five webinars this week for me! I do hope companies will not revert to offline presentations post Covid.

Agree with you there, although one could argue the lack of show might equate to a lack of enthusiasm for their work. Maybe that is why the business has grown as slowly as it has.

Yes, limiting the event to 45 minutes was poor form from Hardman/CLIG. Should have lasted an hour for all the questions (a few of mine were not asked either).

I have found most company presentations don’t really think about the audience. The directors run through a load of slides which most of the audience has already seen, and time is then limited for Q&A – which is by far the most interesting part for most attendees.

I think the merger has diversification and cultural logic, but I am not sure about the deal by itself increasing interest in the shareholder base. That is more likely to be achieved by attracting greater levels of new client FuM and the original CLIM division growing faster than previously.

I would like to think Mr Karpus will sell out over many years. He founded Karpus 30+ years ago and seems to have a long-term business mindset. He might like collecting dividends of £5m+ in retirement, too! But I don’t know. For now Mr Karpus offers outsiders the ‘owner’s eye’ now Barry Olliff is selling down his holding.

CLIG’s marketing (‘business development’) function is just 3 or 4 people. Karpus we learnt never had one and is now hiring somebody. All told I am not expecting marketing miracles anytime soon. The webinar talk was of selling through consultants – they are the ‘gatekeepers’ as such to the end clients. Mentioned more than once was CLIG ‘focusing on performance’ – which I translate to be: if the performance is great, eventually consultants/clients will find us and sign up. Not sure this attitude always works with investing products.

Ha – that was my question! Capacity is an industry term used to describe the level at which a fund’s performance starts to deteriorate because it has too much money to invest. If I had a fund with a mandate of investing in sub-£10m companies, I would have significant capacity issues with £1b.

For CLIG, I got the impression from the webinar the emerging-market funds have a capacity of c$5.5b and they are very close to that now.

On the acquisition costs, I think they are all now done. CLIG cited £4m at the full years stage, with reported exceptionals now at £3m alongside £1m of merger share-issue costs taken direct to the balance sheet.

I submitted the same questions as you on the other three topics. Disappointed they were not asked.

Writing up my thoughts for my blog at present. Should be published next week and I will post a link here (and here is the link to the blog post).

Maynard

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