Dear Unitholders,
This month the NAV of the Hurdle Rate Unit Trust increased in value by 2.75% to a unit price of $1.0487. Including performance fees, the Net return during the month was an increase of 2.07%. An additional $75,000 was also received from 4 new unitholders this month. Thank you for partnering with the Hurdle Rate Unit Trust. The full history of performance data can be found on the full document.
Something important to note is that the Hurdle Rate Unit Trust is NOT a managed investment scheme and rather is classified as a ‘small scale offering’ (SSO), as a result is not required to issue a product disclosure statement to prospective investors. To retain this freedom, our trust is not allowed to have >19 Unitholders with >$2m cumulative investment in any rolling 12-month period. For regulatory purposes, an investor that counts towards the count also includes ‘beneficial owners’ such as beneficiaries of a trust or shareholders of a company. These are counted as several unitholders; such is the case for some of you with family trusts and SMSF’s. Given this threshold, it is appropriate to disclose now and ongoing that we have 12 used (Not including myself as trustee) and 7 free slots for prospective unitholders along with $1,805,000 remaining of the $2,000,000 threshold. It is my intention that once we reach the cap, further unitholders will have to materially out-invest the smallest beneficial owners of the trust to be admitted as a replacement unitholder. Furthermore, I believe that we are not allowed to have >19 Unitholders apply in total, so we will not be able to replace until the first unitholders have been within the unit trust for 12-months. Caps will be reported on the left to ensure ongoing compliance.
Something else I wanted to touch on was the specifics of how the Trust’s performance fees work. As specified previously, the fees are levied when the Trust generates an ROI of 6% on an annual basis. To administer this, it is applied monthly as is the cycle of applications and withdrawals. This means the rate is converted to a daily rate and then applied based on the days in the month.
To illustrate this at the end of June someone who has invested an initial $10,000 as of 31 May 2023 has a threshold of $10,048.01 which is $10,000 compounded at 0.01597% (rounded to 5 Dec) for 30 days. Compounding at this rate for 365 days will get you to $10,600, which is a return of 6%, consistent with the trust’s fee threshold.
The value of a $10,000 investment made on 31 May 2023 excluding the impact of performance fees on June 30, 2023, is $10,207.45. This is $159.44 above the $10,048.01 calculated above. As such 25% of $159.44 is the accrued incentive fee, or $39.86. Lastly, this is then converted to units using the month closing price of $1.0207, which resulted in a transfer of 39.0503 units from the unitholder to the trustee. This is repeated monthly.
I have also simplified the Hurdle Rate Substack. I have ceased the weekly one-page stock pitch and monthly deep dive in favour for a variable schedule of deep dives with an executive summary. Lastly, I have also combined the portfolio update with these letters, so I will be writing more about portfolio positions within these letters as a result. As noted in the previous month, the hurdle rate for the trust is an aspirational return of >25% before fees for each investment made. Furthermore, we want >15% from Dividends and EPS Growth alone, leaving 10% or less from market factors. Given this goal, I wanted a way to report this so I will be dedicating a table for this going forward, shown below the performance table.
You’ll see quite a strong contribution from EPS Growth this month, which is worth touching on. The metric I’m using for this is statutory EPS. In many cases there are factors impacting EPS, which in this month includes predominately DSW Capital’s lack of IPO costs, causing them to jump into statutory profitability. I intend to maintain consistency by using the accounting earnings per share for each business. The average statutory multiple of EPS we have paid to date is ~24x PE, but on an earnings power basis I am estimating more like ~10x PE, which should lead to elevated statutory results as the earnings normalise, but over time it should smooth out any anomalies in year-to-year EPS.
Portfolio Diversity by Area
To demonstrate my commitment to remaining firmly within a circle of competency that involves professional services firms and their respective suppliers, I have compiled the below chart to show each individual service offering of all our companies. There is no doubt some overlap which is predominately contained to licensee services with little overlap elsewhere. This doesn’t necessarily matter too much as you will see below licensees aren’t driving much of our results.
In terms of profit-pools, on a portfolio basis in terms of Net profit after tax (NPAT) margin I estimate a weighted (Using market value to account for differences in valuation multiples) margin of 13.1% portfolio wide with the following ranking in contribution:
1. 27.7% of NPAT = Firms
2. 27.5% of NPAT = Software
3. 13.0% of NPAT = Services
4. 7.4% of NPAT = Separately Managed Accounts
5. 6.1% of NPAT = Licensees
6. 5.6% of NPAT = CPD/Training
7. 5.6% of NPAT = SMSF Outsourcing
8. 2.7% of NPAT = Legal Documents
9. 2.7% of NPAT = Equity Markets
10. 1.0% of NPAT = Financial Media
11. 0.7% of NPAT = Self-Licensing
So clearly, a few key takeaways for me are that the most lucrative areas in terms of quality of earnings are without a doubt software, training, SMAs and services with the least being licensees and equity markets which rely heavily on volume.
Diverger (ASX:DVR)
Diverger started out the month with an announcement detailing a new partial vertical acquisition into a financial advice firm (ASPW) for $2.37m. For this, Diverger is expecting a first year EBITA contribution of $0.33m, an EV/EBITA multiple of 7.2x. ASPW is a firm under the Paragem AFSL, which consists only of unrestricted financial advisers. Founded originally by Steve Atkinson in 1993, this transaction looks to supersede Steve with long-time employee David Saynor, who originally purchased a partial stake in the firm in 2017. David not only can provide financial advice, but also is accredited by the SMSF association of Australia allowing SMSF related advice. Beyond David, there appears to be 2 paraplanners and 2 admin staff in the firm.
More broadly, it was specifically noted that they are making strong progress in their M&A endeavours and have acquired more than $1.3m EBITA in the past 12 months. My own analysis indicates that they paid an average EV/EBITA of ~6x using initially announced EBITA of $1.53m, however it appears that they are using a lower EBITA number in the most recent announcement. Their FY25 target is to acquire $1.5-2.1m of EBITA, meaning they are just short of the lower band 1 year in. They also provided reaffirmation of a highly improved 2H for FY23, consistent with comments made on release of 1H results stating that there would be a 2H earnings skew and flat underlying earnings relative to FY22. This would be an impressive result given that the 2H requires 62% higher EBITA and 93% higher EPS just to get a breakeven result for the full year.
Sequoia Financial Group (ASX:SEQ)
Sequoia announced the acquisition of Castle Corporate and Castle Legal. Castle Corporate, like several other subsidiaries Sequoia owns assists accountants, financial advisers, and lawyers with entity formation. Castle Legal partners with the corporate business to ensure documents are up to date with regulations and provide more nuanced commercial advice with regards to business structuring. The Castle business has been operating for 31 years under the direction of its founder, Jenny Hamley, who will join the professional services division on closure of the deal. Consideration is up to a total of $3.15m, with $1.8m paid in cash upfront along with the issuance of 200,000 SEQ shares. The balance is paid in cash via 2 tranches after 12- and 24-month milestones, contingent on undisclosed performance hurdles. With $0.8m in EBITDA, this values Castle at an appealing upfront multiple of just 2.4x EBITDA upfront with a further 1.6x EBITDA on contingent terms for a total of 4x EBITDA.
Speaking of Diverger and Sequoia, having spoken to Garry previously, In light of the divestment I asked a very relevant question:
Q: If you had unlimited capital- what initiatives would you take on that you are currently not able to?
A: Buy Diverger and Countplus
Given that we own both these Sequoia and Diverger, I had thought about what the outcome could potentially look like. In my view shareholders wouldn’t vote through a deal unless it was at a ‘material’ premium to the offer price. If I was to entertain an offer price of $1.20 per share, paid all in cash, it would equate to a +50% capital gain on our DVR cost basis, but we would benefit from what I potentially believe to be as a greater combined dividend policy, given DVR intention to pay 50% as opposed to SEQ 70%+. Therefore, we would benefit from freeing up ~25% of our account for reinvestment and only a minor impact to our total dividends. For purely illustrative purposes, were I to reinvest the proceeds into Sequoia shares, Our Portfolio Dividends would increase from an estimated $18,119 to $29,233, a change in yield from 5.8% to 9.4% of NAV.
Kelly Partners (ASX:KPG)
For those unaware, I up until recently (December 2022) was an accountant in the Kelly Partners Wollongong office over a time span of 2 years, and furthermore was a shareholder from October 2019 through to December 2022 (Which you will note was longer than my employment). I feel that Kelly Partners is the single business which I feel qualified to say I have an informational edge on because of relationships and experience formed across my employment. Despite its optically expensive valuation. The primary reasoning was hidden in one of the group’s recurring dividend announcements where they quote:
“The company notes that the current dividend policy will be subject to review in the next 6-12 months as the company considers moving to a no dividend policy as part of a process of determining it’s optimal capital allocation”.
This was music to my ears as the primary reasoning for me selling last year was due to its demanding valuation and international intentions. With what is likely to be $110m in revenue and $11m in net profit in FY2024, with an enterprise value of $240m, the group is valued at ~22x 2024E earnings. But cutting the dividend, and the M&A pricing unit economics outlined in this post, should afford the group the ability to grow their earnings at sustained high rates (>25%) for some time to come. Given the lack of dividends returns will be better to most of you net of tax, as such the group hits our hurdles from earnings growth and deserves at least some capital.
AF Legal (ASX:AFL)
AF Legal put up its 2nd month of significant contribution to our results in terms of share price increase. More importantly, the group announced a swathe of senior executive movements which in my view, further improves the quality of the management team. The most important changes are that Chris McFadden has moved into a group CEO role (from CFO/COO), Stace Boardman has been clutched back from a prior notice of resignation to be retained as CFO/COO, and Grant Dearlove is remaining on, but taking an important step back from operations.
DSW Capital (LSE:DSW)
DSW Capital released its full year audited report. As we know from May’s trading update, Network revenue is flat at £18.3m and adjusted pre-tax profit (Company defined) is down 30% to £1.4m. On the bright side, cash conversion was strong with licensee lockup days falling to 27 days from 30 days (appealing Q4 comparative), fee earners grew to 97 (+10%), and they announced the acquisition of license fees from a 10 Fee earner Insolvency firm called ‘Bridgewood’ in a new geography. This is an excellent move as it runs contrary to the economically exposed corporate finance business, counterbalancing revenue.
Primarily, the decline in profits is from a reduction in Revenue/Fee earner down to £193k from £227k (-15%), which given the flat parent revenue and 10% growth in headcount, must have therefore come from licensees with a lower than average % revenue share to boost the average rate of realisation, which is the legacy corporate finance business. As a result of a change in business mix the average share of revenue moved from 16.9% (13.8% License fee + 3.1% Profit share) the year before to 16.6% (14.0% License fee + 2.6% Profit share). What’s important to note here is that the group remained profitable in 2H with ~£450k in net profits in the 2H (After adding back the growth share expense), despite Revenue/FE in the 2H amounting to ~£78k, which at consistent license fees indicates that the group could operate profitably with >30% NPAT margins even at the lowest levels of Revenue/FE they have seen in the past decade of ~£156k per fee earner. In an ordinary year I would expect them to generate ~50% profit margins on the license fee and profit share income, equivalent to ~8-10% of Network Revenue.
Regarding cost growth, DSW has invested heavily in its corporate team, not too dissimilar to the additional investments that Kelly Partners makes in its corporate team, having hired a Talent and Resource Manager, a Strategic Projects Director, marketing executive and office administrator. In the current year a senior IT resource has also joined the central office. Furthermore, it was flagged that a potential £0.144m License fee could be lost in from December 2024 due to PHD acquiring the trademark from DSW Capital for £1. Given this is in relation to a trademark, presumably this drops directly to the bottom line and hence will also highly impact net profits.
The Insolvency firm mentioned earlier is structured as a license fee acquisition, which unlike a merger, does not result in a change in control. Rather what DSW is doing is providing an interest bearing and repayable loan of £880k to 2 existing younger partners to buy out the succeeding founders equity, in addition to which the business has agreed to sign a term of agreement for DSW to provide centralised support services in return for a license fee. Lastly, a minimum return has been guaranteed of £130k per annum for the next 3 years, which given the interest on the loan, tailwinds to insolvency and the 10 fee earners joining the DSW network, appears to be a low amount and should easily be outperformed.
With M&A activity remaining supressed going into the start of the FY2024, the group remains cautious about its expectations for FY24 results, but that does not stop their strong recruitment drive, having signed two new licensed businesses since the year end. The trust’s first dividend was declared with the ex-dividend date being the 14 September 2023 and the amount of 2p per share will convert to A$978 at today’s foreign exchange rate (3.3% of our DSW cost basis). I remain highly confident about DSW Capital’s prospects for the medium to long term.
Later in the month I spoke to James Dow (Founder) which was insightful with some revealing answers such as avoiding network contagion due to the variability of license fees, James’ succession plan, Bridgewood and international expansion.
Conclusion and Final remarks
Our performance has been pleasing to say the least, but what is humorous is that the best performer was the lowest conviction holding and worst performer the highest conviction. Given that AF Legal is our lowest conviction holding, it is entirely possibly, that if it should continue to be forced up by market participants, that it may reach or exceed our estimate of intrinsic value and we will consider selling in favour of alternatives. To be fair, there is still a large gap between the market price and our estimate, so I have no immediate pressure to do anything. Sequoia Financial as our highest conviction holding will be reporting results in August. Given the imminent receipt of the final tranche of the Morrison divestment, I am very much looking forward to what they intend to declare as a dividend, along with and if any intentions for the cash balance they now have.
This brings the July letter to a close, which I apologise if it was too long. I suspect with 6/8 of our portfolio companies reporting next month in ASX reporting season, that there will be a lot to talk about next month as well. Pleasingly, I am having a lot of fun and have passion for the hunt of attractive investment opportunities, it is my hope that this continues to translate into brilliant long-term return for the unitholders of the Hurdle Rate Unit Trust. As a reminder, you can apply for more units at any time.
Yours sincerely,
Tristan Waine
Sole Director of the Trustee of the Hurdle Rate Unit Trust
Phone – +61 426 928 026
Email – Tristan.waine@outlook.com