How do we find businesses to invest in?

Charlie Huggins (CFA) - Fund Manager

4 April 2017

Sanne Group is a business Steve and I followed for a while before taking a position in the HL Select UK Shares fund. Now close to 3% of the fund, Sanne reported a strong set of full year results last week, with revenues and underlying profit before tax rising by over a third. From discovery to purchase, we think it’s a good example of the sort of process we follow when deciding whether to invest or not.

How we discovered Sanne

Fund administration is, to put it mildly, staid. But whilst we must obviously understand what a company does to earn its living, it’s the financial characteristics and strength of the business model that concern us most. And it was the finances that first attracted us to Sanne in 2015, shortly after it listed.

High quality, cash generating businesses with strongly recurring revenues, high margins and returns on capital, all earned with little use of debt, don’t come along very often. We’re always alert to new opportunities (mainly this comes from reading lots and lots of company results). Sanne ticked a lot of these boxes. After further investigation we decided to set up a conference call with the chief executive and finance director.

What we learned

Our goal with any new company we are looking at is to deepen our understanding of the business model. We want to get a handle on why the business generates the returns it does (what is it that makes the company ‘special’?), and whether these returns are likely to be sustained.

Sanne services the Alternative Funds sector, which includes Private Equity, Real Estate and Debt, rather than mainstream fund managers; providing general administration, financial reporting, regulatory and treasury services across multiple jurisdictions.

One of the key attractions of Sanne’s business model is that the majority of the group’s revenues are recurring. This reflects the long-term nature of client relationships (typical fund duration is c7-10 years). We also liked the fact that a large proportion of Sanne’s fees have a fixed element, rather than being linked to assets under administration, making for a less volatile income stream.

The fees charged by Sanne are minimal in the context of other fund expenses and the main focus is on service rather than price, given the bespoke nature of the offering and the importance of complying with the regulations. This accounts for Sanne’s high margins. Staff costs are the main expense for Sanne, and barring IT infrastructure and offices, there is very little capital expenditure required, meaning the business has thrown off cash.

Because Sanne is so well integrated into the fund managers’ systems and processes, it can be difficult and risky for its clients to switch to an alternative provider. As I explained in a previous blog, we like companies that benefit from high switching costs because this creates an economic moat around business. This ‘moat’ is reinforced by regulatory standards which are increasing all the time, making it more difficult for new entrants to join the industry.

Growth opportunities

Growth is coming from a number of sources. With bonds and cash offering little in the way of income, demand for the alternative asset classes is growing strongly, leading to plenty of new funds for Sanne to administer.

Demand for out-sourced solutions is also being supported by new regulations, making it more costly and complex for fund managers to do their own administration. This increased regulatory burden is leading to new client wins, and is encouraging Sanne’s existing clients to put more work its way. Typically, about 60% of new business comes from existing customers and 40% from new customers.

Sanne’s markets are highly fragmented. This has enabled it to supplement organic growth with earnings-enhancing acquisitions, with the group completing 5 deals in 2016 alone. Sanne acquires in order to access new product categories and geographies. In 2016 the company added hedge funds to its repertoire, and extended its geographic reach into North America and emerging markets.

Where next?

Sanne’s near term priority will be to integrate recent acquisitions. At this early stage, the integration process seems to be progressing to plan, and we take comfort from Sanne’s strong M&A track record. But there are inevitably risks involved with any acquisition strategy, and we are not underestimating the management resource and investment that will be required.

Sanne seems well positioned in our view. The growth drivers that we saw back in 2015 remain firmly in place, while recent acquisitions should provide plenty of scope for Sanne to support existing clients in new territories, and capture new business.

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Please note, a connected party of the author owns shares in Sanne Group.