Funding company growth: an investment opportunity

Stock markets serve a dual purpose. They provide savers with returns on their investments over time, and they filter capital to the businesses best placed to earn those returns.

Historically, it has been returns that have captured most investor attention. Yet today, increasingly, savers also want to make a difference with their money. Delivering follow-on capital to growing companies is a great way of doing this.

One of the most satisfying aspects of my job as a fund manager is seeing a small firm grow to be a midsized company, knowing the role our investors’ money has played in that transformation. Between us, we can help companies create more jobs, make bigger profits and – hopefully – pay more taxes.

Corporate success is in large part due to prudent management and good products or services. Yet even the best policies, practices and ideas can go to waste in the absence of capital.

Making your money count

The larger FTSE 100 groups rarely come to the market for money. These companies can often borrow relatively cheaply if they are not generating cash from their own operations. It is in the early-stage and small-cap arena where you see more demand for follow-on capital.

Early-stage investing can be particularly risky. The Aim market still holds dangers, but it is a happy hunting ground for shrewd stockpickers and home to many fast-growing companies that need help. Just over half of our portfolio – a UK multi-cap fund – is in Aim stocks.

The smallest Aim-listed company has a market cap of under £1mn; the largest around £3.5bn as at the end of January 2022. Somewhere between these extremes are another 770 companies, many of which will want to raise equity capital to fund their growth.

Last year, more than £9.5bn was raised by companies on the junior stock market. There were 66 IPOs, but most interesting perhaps is that around two-thirds of that £9.5bn was follow-on activity – £6.31bn from 297 equity raises.

Putting the money to best use

K3 Capital is a Bolton-based corporate services firm that spans mergers and acquisitions, restructuring and tax advisory services. We have held its shares since 2019 and supported several equity raises. In July last year it raised £10mn to fund an acquisition of a complementary M&A and tax advisory business.

Since IPO in July 2017, when K3 had a market cap of £40mn, a strategy of raising equity capital for smart acquisitions has helped the company grow into a much more substantial and diversified business. It now employs more than 500 staff and its market cap has grown to about £230mn.

Scottish housebuilder Springfield Properties raised capital by issuing shares in 2017 at 106p and in December 2021 at 140p. It has used the money to buy land and purchased smaller private housebuilders opportunistically. As a result, it is now broadly spread across Scotland and has a substantial land bank.

Smaller companies in the early stages of growth often have very low revenues and need capital to take advantage of orders when they come. An example of this is Surface Transforms, which manufactures next-generation brakes for cars. It originally raised money to prove the effectiveness of its products to auto manufacturers. More recently it has begun winning orders from well-known electric vehicle manufacturers. In February 2021 it raised nearly £18mn to build capacity to help service those orders.

Sometimes investors are called upon for less positive reasons. At one point in the spring of 2020 I was assessing several capital raises a week as Covid wreaked havoc on the UK economy. It was brutal, but often buying more shares felt the right choice.

Companies we supported included Hollywood Bowl, a bowling alley chain, and the Gym Group. Worth between £400mn and £500mn, these are FTSE All-Share companies, demonstrating that the need for follow-on capital is not confined to the junior Aim market.

Equity raises allowed those businesses to come out of the pandemic as among the fittest survivors. In May 2021, another company, national bar chain Revolution Bars, raised £21mn at 20p a share for a combination of refurbishments, acquiring new sites and helping the balance sheet as it sought to take advantage of weakened competition.

There is the question of how beneficial this is for Britain – the UK-listed markets are much more international than they were. We estimate that more than 50 per cent of our portfolio company sales are here in the UK (which compares with 25 per cent for the FTSE All-Share). The smaller the company the greater tends to be the domestic weighting.

Making the right call

Investing in this area of the market requires discipline. It is important to recognise that smaller companies may call upon you for more capital. That may mean building a position slowly, and holding some cash back for later.

It is also important to review carefully a company’s record on capital raising and how well it has used the money previously. More importantly it is crucial to keep a close eye on the balance sheet to assess the monthly cash burn – it’s a good guide to when management may come calling again.

You do not have to participate in equity raises – you may see your holding watered down – but sometimes this is the right decision. And it’s important to remember that smaller companies are not as liquid as FTSE 100 shares. A quick exit may not be possible, so it is important to buy carefully.

If this sounds too risky, there is the fund option. There can be no guarantees, but good active managers have a strong record of outperforming the smaller companies markets over the long term. Beyond our research capacity, fund managers have the resources to diversify, which helps us mitigate the greater risks of swimming in these waters.

By investing in a UK fund with a small-cap focus you can still feel you are indirectly supporting corporate Britain. If you have the risk appetite to invest in companies yourself, and can participate in their follow-on fundraising efforts, you can make a more direct contribution. Either way, if you do your research thoroughly and make decisions wisely it can be rewarding in every respect.