CIP Merchant Capital: Can a 75% discount on the stock portfolio be justified?

This relatively new investment company has only invested half of its cash, yet the share price weakness effectively allows you to pick up the underlying stock portfolio for 25 pence in the pound.

CIP Merchant Capital (LON: CIP) raised £52.4m when it floated on AIM in December 2017. It intends to use the cash to buy influential minority stakes in small undervalued businesses and then take a private equity approach to unlocking the value. The target companies will mostly be listed and the fund will seek board representation where appropriate with exits expected within 12 to 60 months.

Its key investments will normally be listed on a Western European stock exchange and will mainly be in the oil and gas, healthcare, pharmaceutical and real estate sectors. These can include both equity and debt securities. Once fully invested it is expected to hold stakes in approximately ten companies with market caps of less than £200m.

Not be fully invested at least until the end of 2020

Investing the capital has been a lot slower than originally envisaged with the fund manager not wanting to invest ahead of potentially damaging macro-economic news stemming from Brexit or the trade war between Europe and the US. Events like these could have a material impact on the value of the holdings and because of this the fund will probably not be fully invested at least until the end of 2020.

At the end of June, the date of the latest accounts, the manager had invested 47% of the fund’s net assets, although this has since increased to 50%. As you would expect, it is a highly concentrated portfolio with just seven different companies.

The largest positions include: the US healthcare stock Orthofix Medical (NAS: OFIX); Happy Friends, an unlisted Italian veterinary services provider; and Coro Energy (LON: COR), a UK-listed Asian focused upstream oil and gas company. These are all quite recent acquisitions, so it is still too early to see any increase in the fund’s NAV as a result.

It is only really the valuation of CIP that singles it out for attention. The shares have been highly volatile, but at the time of writing were available at a mid-price of 56.5 pence. This represents a discount of 37.5% to the latest NAV of 90.49p on October fourth.

An effective discount of 75%

In itself this wouldn’t be especially remarkable given the lack of track record and illiquid nature of the portfolio holdings, except for the fact that half of the underlying net assets are still in cash. What this means is that in essence, each 56.5 pence share purchase would buy 45.24p of cash and 11.26p of stock worth 45.25p, an effective discount of 75%.

So why the huge discount? The underlying small-cap holdings are fairly illiquid and could suffer in the event of a major market correction caused by the trade war or Brexit. It is also early days, so there is no guarantee that the portfolio will do well and the cash will act as a drag on the overall performance. The high charges are another drawback with annual management fees of one million pounds and other costs of about £400,000.

I suspect that in reality it is just one of those low profile funds that tends to go unnoticed by many private and institutional investors, with the sentiment in this area further undermined by the high degree of macro-economic uncertainty.

If there is no lasting damage to the economy and the underlying holdings start to appreciate in value, then I would expect the shares to be positively re-rated. The directors certainly seem to think there is significant value as two of them recently bought a total of 730,000 shares at 60p taking their combined stake to 7.2% of the fund.