Best and Less Group Case Study:

How Do Private Equity Managers Make Money?

Vantage Asset Management

03 September, 2021

In the third of our case studies on how Private Equity managers make money and the importance of exits (Part 1, Part 2) we will examine a recent transaction that highlights opportunities that exist to transform assets that do not form part of a larger organisation's core strategy.

Turnaround opportunities often represent the higher risk/return opportunities in the Private Equity universe, however a distressed business can present a great buying opportunity to a Private Equity manager where they have a unique insight into what the problems plaguing a business are and have a clear thesis on how those problems can be rectified.

In a 2016 study by McKinsey "How private-equity owners lean into turnarounds", a comparison of the performance of 659 Private Equity backed and publicly owned businesses recovering from a distressed situation showed that the Private Equity backed firms recovered significantly faster than public counterparts.  Their study showed that Private Equity backed firms on average recovered their EBITDA margin within 18 months of a negative quarter, much faster than public firms.  McKinsey attributed this to Private Equity owners holding management teams accountable for driving a turnaround and the speed at which Private Equity backed firms decide upon and in turn, implement turnaround strategies.

But not all turnaround opportunities come in the form of distressed businesses.  Sometimes opportunity comes in the form of an "unloved" or non-core asset within a larger business that is undertaking a strategic change in direction.

CASE STUDY: BEST AND LESS GROUP

The Best & Less business was founded by Berel Ginges and opened its first store in Parramatta in 1965. Best & Less predominately sold basic products (socks, underpants, tea towels, t-shirts, etc.) and was known for its frugal in-store appearance, with minimal fixtures, and an advertising slogan of "You don't pay for any fancy overheads". Like most successful Australian retailers at that time, Best & Less opened new stores and transitioned into a national retailer.

In 2012 Best & Less' ("BLG") new owner Pepkor put in place a new management team to reposition BLG and improve financial performance. As part of a renewed focus on product, BLG's strategy evolved, with the aim to be "famous for the baby and kids' categories" as well as for underwear. New design, buying and planning capability was added into these functional areas and purchasing directly from manufacturers increased.

Further transformation of the business progressed from 2016 when the current CEO Rodney Orrock joined the business however after the acquisition of Pepkor by Steinhoff International, Best & Less was integrated into Steinhoff International's Australian furniture division which included the Freedom Group. During this period, BLG operated within a group that had a different focus in respect to strategic, operational and financial outcomes as well as capital allocation. Important elements of the BLG transformation program were put on hold, trading and inventory decisions were affected and sales and profits were adversely impacted, especially in FY19.

Steinhoff International, through its Australian subsidiary Greenlit Brands, divested BLG to Allegro Funds in December 2019 after a strategic review of its holdings.  Allegro Funds then put in place an experienced Chair to oversee the delivery of three significant outcomes:

1. Separate Best & Less Group from Greenlit Brands and take control of its own strategy
2. Accelerate the disrupted transformation program
3. Set a more ambitious growth strategy

During the period following Allegro Funds' acquisition, BLG successfully established itself as a standalone business, accelerated its business transformation and traded through COVID-19, during which BLG experienced continued sales growth. This occurred by bringing focus on the following key areas:

• understanding the customer;
• attracting traffic to each channel;
• growing the baby and kids' categories;
• ensuring that online sales were profitable;
• increasing the Friends Club database while concurrently upgrading the customer relationship management (CRM) capability;
• improving productivity;
• optimising the store portfolio; and
• improving the performance of Postie by introducing the key elements of the Best & Less brand to the Postie offer.

Under Allegro's turnaround program BLG has repositioned from a discount retailer to a value apparel specialty retailer with a 245-physical store network in Australia and New Zealand and an online platform across its two brands:

• Best & Less (in Australia); and
• Postie (in New Zealand).

With approximately 50% of product sales being in the baby and kids' categories, BLG aims to be the "Number One" choice for mothers buying baby and kids' value apparel in Australia and New Zealand.  Revenues have increased from $608.7m in FY19 to $663.2m in FY21, which includes a remarkable doubling of online sales in the last two years.  More impressively,  EBITDA was reported at $71.6m for FY21 up from $24.5m in FY19 and an increase of 165.2% for the year.  This validates the effectiveness of the changes that Allegro and the management team put in place.

During July 2021, Allegro completed the successful exit of BLG via an IPO. Best & Less Group (ASX: BST) listed on 26 July 2021 at a share price of $2.16, giving it a market capitalisation of $271m. Pleasingly BST has continued to perform since listing up 63c from its listing price at the end of August off the back of recent results well in excess of prospectus forecasts.  Once fully completed the exit will deliver Allegro fund investors, including VPEG3, with top tier performing returns across a 1.7-year investment period. 

If you would like to share in the growth and ultimate returns derived from similar small to mid-market company investments, Vantage Private Equity Growth Fund 4 ("VPEG4") remains open until 30 September 2021.

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 A very good business

Aitken Investment Management

September 2021

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 7 Easy Ways to Get Hurt

Yarra Capital Management

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Higher inflation can be a friend to real estate investors

Quay Global Investors

August 2021

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Chris Gosselin, CEO of Australian Fund Monitors, speaks with Graeme Carson, Director & Portfolio Manager at Cyan Investment Management.

The Cyan C3G Fund has a track record of 7 years and has outperformed the ASX Small Ordinaries Total Return Index since inception in July 2014, providing investors with a return of 15.58% per annum, compared with the index's return of 9.42% p.a. over the same period. The manager has delivered this outperformance while maintaining a down-capture ratio since inception of 52%, indicating that, on average, it has only fallen half as much as the market during the market's negative months.

Funds operated by manager: Cyan C3G Fund

Is your fund manager skilful or just lucky?

Andrew Mitchell, Ophir Asset Management

August 2021

There is no doubt in the world of sport that the likes of 20-time tennis Grand Slam winner Roger Federer outperforms because of skill, not luck. When investors evaluate the performance of equity funds, however, it's not as obvious which funds are skilled or have just been lucky.

Fund manager league tables were recently released for the last financial year, and the media, as usual, trumpeted funds with hot performance.

But now is a particularly difficult time for investors to assess fund managers. With markets rising, some funds have just been lucky and ridden strong gains. There is now a danger that investors chase these hot, lucky funds and become saddled with poorly performing investments for years.

In this article we outline how investors can try to tell which funds managers have 'skill' - and can be expected to keep outperforming for a long time - and those that are simply 'lucky' and likely to disappoint when markets change.

If investors can spot the difference, they are significantly more likely to choose the right fund for them, a fund that delivers sustained performance, and a fund that ultimately helps them reach their financial and lifestyle goals.

The skilled few

The big problem for investors is that few funds are truly skilled.

In a 2014 report on equity investing, Willis Towers Watson, the global investment consulting firm, argued that only 10 per cent of fund managers could be considered genuinely skilled over the long term, while 70 per cent show mediocre performance and 20 per cent are inferio

The fact that so few managers were deemed truly talented is a product of the multiple forces which influence portfolio performance, such as:

• Being lucky
• Gambling on high-risk stocks during a rising market
• Having exposure to the right investment style at the right time
• Taking on hidden risks like selling put options
• Being skilled

Obviously, managers that perform via the first four should be avoided. But how can we tell who has the right qualities to be considered genuinely talented managers?

4 attributes of the skilled

Although no specific rule book exists on how this should be judged, we believe that skilled investors have four characteristics in common.

1. They perform through time

The number one attribute of skilled investment managers is their performance over time. By studying this, we can observe if performance has aligned with their intended investment style. For example, if they are a "Growth" style manager have they tended to perform well when that style is in favour? If they are an "all -weather" manager, have they been able to perform well through all different kinds of market environments? We can also measure how persistent returns have been across different stages of the market cycle.

2. They have a high number of winning bets

One should also study the number of bets made over time. A manager who makes many bets over time, and wins a reasonable number of them, deserves to be rated far higher than a manager whose success is solely attributable to one or two knockouts. The former manager has been tested more times, and hence we can be more confident in their ability to replicate that success in the future.

3. They are on a quest for "better"

Besides just looking at each manager's track record of returns, those with skill at investing have an attitude to their craft that combines intensity, flexibility, and humility. These managers have a passion for investing and are constantly striving to put in the work to become more skilled investors.

4. They accept the role of chance

At the same time, best-in-class investors are aware of the role of chance in their investment outcomes and don't try to paint their success as pre-ordained. By contrast, fund managers who don't realise how much chance impacts their results can end up being painfully stubborn or arrogant. And when the environmental variables that help outperformance eventually stop, a humble manager is more likely to adapt and evolve their process commensurately.

The harsh reality is that even a skilled investment manager will underperform at times, and an unskilled manager can outperform, potentially even for years. Still, the longer the period over which a given investment manager delivers superior performance, and the larger the investment base involved, the more likely the results reflect skill rather than luck. To put this another way, over time as an investor becomes more skilful, their performance should become more consistent.

Like medical research

So how do professional fund manager selectors statistically test whether a fund manager's performance is truly different from their benchmark, or the market?

They perform tests similar to the type medical researchers use to test whether a drug's treatment of a condition is statistically different from a placebo.

A simplified example of this test is below:

Where:

T = the so-called 'test statistic'

X = is a measure of the outperformance (if positive) or underperformance (if negative) of the fund versus the benchmark. (Note: providing the benchmark is 'risk-equivalent' to the Fund)

N = is a measure of how long the fund has been going for

S = is a measure of the volatility of the outperformance or underperformance of the manager through time

A 'test statistic' greater than about 2 means you have 95%+ confidence that the manager's outperformance or underperformance is different to zero. This level of confidence is the most commonly used to determine if something is truly different from its comparator or baseline.

3 takeaways

What you can quickly see is that both the greater the size of the outperformance and the longer the manager's track record are both positive attributes. Also, the lower the volatility of the outperformance, the more likely that outperformance is 'statistically significant' (different to zero) and due to skill rather than luck.

Some takeaways from this are:

1. You should pay less attention to 12-month returns reported by the press in the newspaper because returns this short have a greater potential to be due to luck, rather than 3, 5 or 10-year returns.
2. The larger the outperformance, the more likely this is to be due to skill, which can sometimes make up for a short track record. A word of warning though on this one: It is a good idea to test whether a manager has simply been 'punting' the fund and has made a big lottery-type payoff on one, or a small number of bets, or whether it is due to a broader series of unrelated investments.
3. Smaller, consistent outperformance may potentially be more likely to be due to skill than large, but volatile outperformance. There is a trade-off here.

Secretly skewing to small caps

More sophisticated statistical tests also exist to help ensure managers aren't simply outperforming by taking more risk than is embedded in the benchmark or market they are trying to outperform. A manager, for example, might claim outperformance during a bull market, but they only outperformed because they used leverage in their fund to increase its risk, and hence returns, in that market environment.

Finally, we need to question whether a fund's investment returns represent exposure that could be obtained at a much lower cost by investing through passive-type products. In such instances, there is no need to pay fees to a skilful investment manager to access these returns.

For example, small-cap equities, which is our space, have tended to outperform large-caps across many different equity markets over long periods of time. Investors should turn their nose up at large-cap managers who skew their funds to small caps, and where their small cap holdings have accounted for a meaningful share of their outperformance over their large-cap benchmarks.

Sorting the skilled from the plain lucky

To summarise, it is clear there is much to think about when trying to determine whether a manager's returns have been due to skill rather than luck.

Hopefully we have dissuaded you though from putting too much weight on a manager's short term annual returns reported in the so-called 'leagues tables' in the press!

At Ophir we judge the performance of our funds, and our analysts who contribute to it, primarily on its size, duration, consistency, and number of unrelated positions that have led to the result. We also seek to control for excessive risks that could jeopardise absolute performance over the long run.

As long-time readers will know, we think there are two other key criteria that help the skill of any manager shine through:

1. Alignment: nothing focuses your mind and skills like having your own money on the line when investing. As Charlie Munger has said: "Show me the incentive and I'll show you the outcome". Having a significant percentage of your own wealth at risk we believe increases the incentive to perform well.
2. Capacity constraints: Size kills performance. Managing a lot of money is hard - it can impact your nimbleness and force you to operate in more efficient markets that are more difficult to outperform in. As Warren Buffett has said: "Anyone who says that size does not hurt investment performance is selling". A skilled manager who has been outperforming for years can quickly turn into an apparently unskilled manager whose performance drops off when they start managing a lot more money.

There are of course many other factors to consider as well when trying to disentangle the skilled from the unskilled, but the above is what we consider to be some of the most important here at Ophir.

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Chris Gosselin, CEO of Australian Fund Monitors, speaks with Rodney Brott, CEO & Executive Director of DS Capital.

The DS Capital Growth Fund has a track record of 8 years and has consistently outperformed the ASX 200 Total Return since inception in January 2013, providing investors with a return of 16.77%, compared with the index's return of 9.94% over the same period. DS Capital has delivered these returns with -2.44% less volatility than the index, contributing to a Sharpe ratio which fallen below 1 once and currently sits at 1.31 since inception.

Funds operated by manager: DS Capital Growth Fund

 High-margin, asset-light businesses

are the best defence against inflation  

Bob Desmond, Claremont Global

August 2021

With the latest US CPI reading over 5%, we have been receiving a number of questions from investors about what this means for the future composition of our portfolio. Well, the simple answer is not that much ― and here's why.

The difficulty with economic forecasts

As regular readers of our articles will know, we believe that accurate and consistent economic forecasts are exceptionally difficult, and it is even more difficult to successfully construct a portfolio to express such a view.

We received a very good example of this in March as the US 10-year Treasury bond yield moved above 1.70 per cent on stronger economic growth and fears of higher inflation. One view accompanying this move was that now was an opportune time to sell "growth" businesses and buy their "value" counterparts.

The narrative was that growth companies will suffer disproportionately as the market attaches a higher discount rate to their future profits - which are longer duration than their more cyclical value counterparts. In addition, more cyclical companies can expect to see a recovery in their profitability due to stronger economic growth.

At a basic level, you can edit the "sell growth, buy value" argument to "sell technology, buy financials". In June we wrote an article where our advice was - and continues to be - don't sell great businesses based on an uncertain economic forecast!

And once again, recent events have turned out to be somewhat different than consensus expectations. Bond yields have since retreated to 1.2% ― which when combined with some exceptional "big tech" earnings over the last two quarters has seen a strong rally in many of their share prices.

Another quarter of big tech earnings growth

To illustrate this, let's take our portfolio's two technology companies - Alphabet and Microsoft - which saw their revenue rise by 62% and 21% respectively, an astonishing result for companies of their size.

Admittedly Alphabet was up against an easy comparison last year, as COVID-19 cut advertising revenue ― however, even on a two-year basis revenue is still up by 26% a year. In contrast, JP Morgan - one of the world's most respected banks - saw their revenue fall by 8% year-over-year.

It just makes no business sense for us to sell some of the world's most competitively advantaged businesses, pay capital gains tax and then reinvest in slower growing, more cyclical businesses based on a macro prediction ― which may or may not be correct. 

Or, even if we look at the events of the last 18 months - an authority no less than the Reserve Bank forecasted that the Australian economy would shrink by 20% as a result of COVID-19, whilst the reality is an economy that is actually larger than pre-pandemic.

But to the point of this article … let's assume that the macro forecasters are correct and inflation rises materially in coming years. What type of businesses would you want to own?

Lessons from Zimbabwe

I do have some experience in this regard, having spent the early part of my career in Zimbabwe under hyperinflationary conditions. While this is an obviously extreme case, it's still worth trying to draw some lessons from that experience.

Intuitively, one's immediate response (and one you often see in the media) is to "buy assets". However, my experience was that the best businesses to own in inflationary periods are asset-light ones, and more obviously those with pricing power and high margins.

As inflation rises, so do the capital demands of the business you own. This includes the capital that needs to be invested in working capital and fixed assets, with the inevitable impact that has on free cash flow.

In Zimbabwe, it was not uncommon to see companies report exceptional profits, as inventory and depreciation was expensed through the income statement at much lower historical prices. In contrast, free cash flow was far lower than profit, as new inventory and fixed assets are replaced at much higher prices.

Warren Buffett described this aptly when writing about inflation in the 1970s:

"Inflation acts as a gigantic corporate tapeworm. That tapeworm pre-emptively consumes its requisite daily diet of investment dollars, regardless of the health of the host organism. Regardless of a company's profits, it must spend more on receivables, inventory, and fixed assets to simply equal the unit volume of the previous year. 

Asset-heavy businesses with meagre returns on equity "have no leftovers" to spend on expanding, paying down debt, issuing dividends, or making acquisitions. Spending cash in those areas could mean sacrificing sales volumes, long-term competitive position, or financial strength. The tapeworm of inflation simply cleans the plate."

In our companies, two key metrics we focus on are gross margin and capital expenditure to sales.

Companies that have a high gross margin are often blessed with a low cost/high-value ratio from a client perspective. This means they are a very small part of a customer's cost but are essential to running that business and have few substitutes.

Microsoft provides immense value relative to the cost

A clear example in our portfolio is Microsoft. What company can afford to turn their subscription off to save on costs and how much cost would they really save anyway? The monthly subscription to Office 365 is only $29 a month for an enterprise customer. There is an immense value provided relative to the cost. The worst business to own is one that has:

• low gross margins, 
• is asset-intensive, 
• is a large part of a customer's expenses, 
• is one where there are plenty of substitute products with low switching costs.

The first thing a CFO is going to do when costs are rising, is look at the list of the largest suppliers and ask them to reduce costs ― just at a time when those suppliers own costs are rising. Good luck trying to ask Microsoft to reduce prices!

The combination of limited pricing power and asset intensity can be particularly pernicious. A business cannot raise prices in line with inflation, whilst simultaneously its own capital needs are accelerating as the "tapeworm" of inflation requires more dollars to be spent just to maintain unit volume and its capital base.

If things get bad enough, free cash flow turns materially negative. And in this scenario, the company takes on debt (at ever-higher interest rates as inflation rises) or is forced to issue equity at depressed prices ― resulting in permanent value destruction.

Allocate your capital as a CEO would

Across our portfolio, the weighted gross margin is 55% and this compares to 35% for the S&P 500, which demonstrates the competitive advantage and the inherent pricing power of our businesses.

Our capital expenditure to sales ratio is 5% versus the market at 7.9%. As such, our businesses have a collective gross margin that is more than 57% higher than the market, with capital expenditure needs that are 37% lower.

It makes no business sense to us to sell some of the best businesses in the world to buy slower growing, lower margin and more cyclical businesses on the basis that inflation is just around the corner. After all, which CEO do you know who would sell the highest margin, most asset-light, cash generative, competitively advantaged divisions to reinvest capital in the lower margin, capital intensive ones on a view that higher inflation is on the way?

To quote Warren Buffett again:

"I am a better investor because I am a businessman; I am a better businessman because I am an investor. Investing is most intelligent when it is most businesslike".

High conviction investing

Claremont Global is a high conviction portfolio of value-creating businesses at reasonable prices. 

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Investment Perspectives: REITs and inflation - where is the sweet spot?

Quay Global Investors

August 2021

We've often stated that real estate (listed and direct) tends to outperform equities during periods of high inflation and have previously cited the following chart as evidence of this dynamic.

Source: NAREIT, Bloomberg, Quay Global Investors

What is not clear is whether listed real estate outperforms during moderate (say between 3-6%) or higher levels of inflation (say +7%).   

While these levels of inflation may seem rare, the fact is that over the last 50 years US inflation has been above 3% more times than below. And during such periods, the nominal returns for listed real estate have been higher than low inflationary environments; and relative to equities, higher in both nominal and real terms.

The rise and rise of CPI

Anecdotally, we believe real estate - and thereby listed real estate - to be a good inflation hedge. Land is tangible, and well-located land has an intrinsic value in that it can be used as a place to build shelter or as a place to do business or access services. Because of supply constraints, well-located land will generally appreciate over time. In addition, the cost of replacing any improvements built on the land will also increase through inflation. This is important, because if there is excess demand for a type of real estate, the market will have to accept rising costs and thereby the rents required to economically justify construction - regardless of the inflation environment.

Last month saw the US Bureau of Labour Statistics (BLS) release CPI for June (see following chart). For the last 4 months it has continued to rise and is now at a 5.4% 12-month increase, which is the largest such increase since the heady days before the GFC in August 2008. And if we exclude volatile food and energy prices from this headline number, while the absolute level is lower it is now the highest CPI print for this adjusted series since November 1991.

Discussion around the impact of rising inflation on investment returns is now firmly on everyone's lips.

Source: US Bureau of Labor Statistics

There are pundits that believe this is cause for concern for the bond market, the stock market and the US dollar. All three could have an impact on our portfolio returns, but a lot will depend on whether this inflation is transitory in nature or not. We have previously published our thoughts on the debate here.

Regardless, it is worth understanding how listed real estate has performed in previous periods where inflation has been elevated. More specifically, at what levels of inflation does real estate perform best? Can there be too much inflation? Not enough inflation? What if the current US bond yields are correct (currently 1.2% per annum) and we are headed for sustained low inflation?

What it means for real estate

To examine the impact that different levels of inflation have had on listed real estate, we have looked at the returns over the last 50 years in absolute and real terms, and relative to general equities. Because global real estate indices don't go back this far, we have instead used US REIT data and compared it to the S&P500. In our opinion, this represents a good proxy for listed global real estate given the large size and diversity of the US REIT market and also that it represents greater than 50% of the global sector.

The methodology was to analyse US REIT and S&P500 real and nominal returns by constructing indices for when headline CPI was both less than and greater than 3% and in increasing increments of 1%. From these indices the average monthly nominal and real returns could be calculated for the purpose of comparison. A summary of this output is highlighted below.

^{Source: US Bureau of Labor Statistics, NAREIT, Bloomberg LLC}

The results show that listed real estate is an excellent hedge for inflation and has historically delivered strong positive nominal and real returns in higher inflationary environments. It also offers a better relative return when compared to general equities. This is especially so when inflation is in the moderate 3-6% range, where listed real estate has historically generated more than double the real return relative to equities. Even with very high inflation (>6% and above), listed real estate continues to outperform equities (albeit at a lower relative level than in a moderate inflation scenario).

It's also interesting to note that over the last 50 years, inflation has been above 3% more often than below. When it has been below 3%, listed real estate nominal and real returns have been quite a bit lower than in a moderate inflation environment. And contrary to common belief, in lower inflation settings listed real estate returns actually tend to lag equities.

Concluding thoughts

What can we conclude from this analysis?

Don't fear inflation. In fact, when investing in real estate, inflation can be your friend. Higher inflation will protect your investment from supply issues (and therefore competition for tenants) and will drive up the replacement cost and residual value of your improvements. We have long argued that for most real estate, the ultimate anchor for value is replacement cost - and rising replacement costs are good for real estate. It is why replacement cost analysis is an important part of our process.

What is equally important is that a low inflation environment (<3%) tends to be relatively more favourable for equities (compared to listed real estate). This data cuts against the common narrative that low interest rates, and therefore low inflation, are better for property.

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