While browsing a bit random on the internet I found this post on Craven House Capital at the Investing Sidekick blog. The author is quite enthusiastic about the company with a 30% portfolio allocation. The company in question is an obscure investment trust focusing on frontier and emerging markets. Part of the attraction is the fact that the company has repeatedly issued equity at 1.25p per share while it is trading at ~0.25p. So far all things that I like, so my interest was piqued enough to dig a bit deeper.

Equity transactions

The biggest and most obvious problem that the company faces is it’s size. Readers of this blog know that I’m often attracted to small and obscure companies, but you need some size to cover fixed costs. At the end of this year the company reported a NAV of just £2.5 million while it’s current market capitalization is just £1.78 million (approximately 2.75 million USD). If the company is indeed able to grow by issuing equity at 1.25p per share it’s not going to be a problem, but in order to believe they will be able to do this you need to believe that the shares are indeed worth this much today. Because why would someone otherwise want to buy their equity at that price?

Looking at transactions in the past months it seems that they have no problem using their equity as a currency at 1.25p/share, but there is one big problem. Most of the transactions are structured as follows:

In January 2013, the Company purchased 17,502 shares in Finishtec – Acabamentos Técnicos em Metais Ltda. – ME (“Finishtec”) representing 50.1% of Finishtec’s issued share capital.  The shares were purchased at a price of approximately $57 per share, amounting to a total consideration of $1,000,000, from the founding partners of Finishtec (the “Shareholders”). Simultaneously, the Shareholders agreed to subscribe for 49,739,760 new ordinary shares of 0.1 pence each in the Company for 1.25p per share, amounting to an aggregate subscription of £621,747 (approximately equivalent to $1,000,000).

So if you sell a big part of your company for one million USD would you accept payment in shares that are worth just $200,000 on the market? I wouldn’t, unless of course the stake isn’t worth one cool million but something more in the direction of the current market value of Craven House Capital shares. And this brings us directly to a related problem: can we trust the reported net asset value? Craven House Capital has multiple investments on the books at the original cost price, and with those non cash transactions I’m not really trusting it as a good approximation of intrinsic value.

Incentives

The second big problem I have with the company are the performance fees that are paid to the investment manager. When you read how they are calculated it seems pretty reasonable: they get 20% of the growth in NAV above a 5% hurdle. There is however one big problem: it’s not on a per share basis. Last year NAV went from minus £200K to +£2.5 million, resulting in a £552,368 performance fee.

That would have been pretty insane for a company with a sub £2 million market cap, but the investment manager ‘very generously’ accepted shares priced at 1.25p/share. This resulted in ~8% dilution for current shareholders which isn’t too bad, but it’s still a lot considering it’s based on a largely irrelevant performance metric. A payment in shares also doesn’t decrease the NAV of the company, making it easier to hit the 5% hurdle next year. The performance fees also provides an incentive for the manager to structure deals that artificially inflate NAV: exactly the thing I’m already worried about with the equity swaps.

You also wonder who would want to buy a significant amount of equity if the manager immediately takes a big cut. Makes it only harder to argue that 1.25p is fair for new shares.

Conclusion

Is everything related to Craven House Capital negative? No. The company did for example manage to raise £721K cash at 1.25p/share in 2011, but why anyone would want to pay that for this company is beyond me. Their NAV/share doesn’t even come close, even if you believe it’s accurate, and with the current size of the company I think you would be crazy to pay a premium. I simply don’t see the value here…

Disclosure

No position in Craven House Capital.