Market Cap - £227m/ $363m
NAV reported at 31st October - $9.09/ £5.73
Price/NAV – 61%
I am a Bear; it’s actually quite a disheartening activity. I’d rather be something else. Every sporadic spurt higher in the market singles you out for slightly mocking, slightly pitying platitudes from colleagues and clients. Let history be my judge.
I have a hearty cash balance of north of 20%, some substantial short positions and macro hedges, but yet still I feel loathe to take risks or to make positions too large. Because of this I currently find myself attracted to special situations, spin-offs and to investments which offer a much greater margin of safety than would appear on first glance (see my write up on Gravity - http://kelpie-capital.com/2011/11/09/gravity-an-irresistible-force/ ).
This is how I arrived at this prima facie very unappealing idea! Private equity? Maybe a decade ago! But, when you look under the bonnet I think JZ Capital Partners (JZCP.L) offers the opportunity for us to buy the proverbial $1.00 for maybe as little as $0.40. JZCP is now a 3% position in my portfolio.
JZCP is a closed-ended investment company advised by JZ Capital Partners, a small & microcap private equity fund invested in a broad range of industries across the US and more recently Europe. Its investment strategy includes buyouts, mezzanine loans, second lien loans alongside equity stakes in smaller businesses that are stock market listed. Up to 20% of the fund can be invested in European situations.
JZ Advisers was founded in 1986 by Jay Jordan and David Zalaznick. They were later joined by Chief Investment Officer Gordon Nelson who has been with them for 20 years. In lieu of a character reference, Mr. Zalaznick is a vice chairman of Cornell University’s board of trustees.
The managers use their extensive and mature rolodexes along with their track record to source their deal flow. They also co-invest with other private equity firms on occasion.
In their 30-year track record in the micro cap space JZ Advisers has had over 70 realizations or exits with an IRR of 40%.
JZCP focus their investments in five narrow “verticals”: industrial service solutions, sensor solutions, specialty foods, water treatment and, finally, testing services. The aim is to target high-margin, low-capital and technology intensity businesses that are scalable.
The managers in the recent report sounding suitably value-oriented.
“Our basic premise is that we can continue to achieve superior returns by maintaining our investment discipline, and investing your (and our) money in a diversified portfolio of good quality niche businesses at reasonable prices.”
Unlike most private equity businesses too they do not pour leverage upon leverage; they may take on moderate debt within the operating businesses to enhance returns but at a portfolio level there is none except some outstanding zero-div preference shares.
Listed Equity -
Safety Insurance Group (SAFT), the largest position in the fund at around 9%, is a $650 million property and casualty insurance company specifically focused on the Massachusetts market. JZCP owns around $50 million of stock in the company. Insiders own another 10% of Safety stock.
TAL International Group is one of the world’s largest lessors of shipping containers.
With 810,000 containers leased out of 216 depots across 39 countries. It is a top-five holding representing around 6% of assets as of August 31. TAL has a market cap of just over $1 billion. JZCP now owns circa 3% of the equity after selling 22% of their TAL stake in April 2011, realizing a gain of $7.7 million on their investment. This demonstrates some good portfolio management, realizing gains at prices almost 30% higher than the current market price. Lord Abbett LLC owns 7% of the equity and the CEO has $11 million invested.
Micro Cap/Private Companies –
Wound Care Solutions provides management services for the operation of wound healing centers. These are specifically designed outpatient departments in hospitals for the treatment of patients wounds. JZCP committed $38 million of funds to Wound Care Solutions and this is currently valued at $41.1 million. As of the most recent report, this holding is around 8% of the portfolio.
Accutest Laboratories provides full-service independent testing labs delivering legally defensive data and analysis on water, soil or air for use by industry, consultants or government clients. JZCP originally invested $48.2 million and this is now valued at $42.1 million sitting at around 8% of the portfolio. I take comfort from the fact that the valuation has marked the company down — this avoids any accusation of “upwards only reviews.”
Continental Cement Company mines, manufactures and processes limestone and clay into cement. This 5% investment is part of the Mezzanine Portfolio, the bulk of which has been repaid. The company report as of October 17 said the company was performing well and continuing to pay interest as per the terms of the loan.
Factor Energia is the largest of JZCP’s European investments. It is an energy/utility distribution and reselling business in Spain focusing on the SME sector. At $27.7 million the investment is around 5% of the JZCP portfolio.
As you can see from these six investments constituting 41% of the portfolio, JZCP runs a concentrated portfolio. The top 10 investments are cumulatively 63% of assets.
Broadly in the portfolio operating performance seems resilient; all but 4 of the 15 businesses posted positive EBITDA growth year over year. The portfolio as a whole has posted 12 consecutive quarters of NAV growth increasing to $9.09 (£5.73) per share as at August 31.
From the shareholder report on the portfolio:
“All of these investments employ low leverage, currently at 1.3x EBITDA of debt senior to JZCP’s position. The average multiple used in valuing these entities (for NAV) continues to be low at 6.9x”
The managers believe (although I suppose they would) that their calculation of NAV is conservative.
October 25, the Wall Street Journal reported that JZCP has exited its holding in Dantom Systems Inc. for $40.5 million to a larger buyout firm. This was previously the fourth biggest holding in the fund as of the August 31 report, and it appears as if it was a complete exit. I imagine these proceeds are currently sitting in cash or short term Gilts/Treasuries.
The Margin of Safety
As at August 31 the total assets in the portfolio were $684 million (£427m) compared to the market cap of £227 million. The balance sheet for JZCP is very clean excluding the $85 million of Zero Div Preference shares in issue costing around $6 million a year in interest.
Treasury Securities are $155 million (£97 million) of the $680 million, UK gilts or cash. Compare £97 million of cash or risk-free securities to a market cap of £227 million and you get 42% of the market cap. If the proceeds from the Dantom Systems sale are actually sitting in cash then you could likely be looking at £122 million of cash or risk-free assets against £227 or 53% of the market cap. But let’s just ignore that for the sake of being conservative. Now we remind ourselves that we are paying only 61 cents for every $1 of total NAV due to the discount.
I think we should net off the cash and near-cash instruments to see what kind of discount we are getting on the actual portfolio. So taking $155 million off the portfolio of JZCP leaves us with “invested assets” of $525 million across the listed and unlisted equity and debt. If we take $155 million off the market cap of $363 million (£227 million x $1.6) and we get $208 million.
So now we get a look through at the “Real Discount to NAV” - $208 million/$525 million = 39.6% or $0.39 paid for every $1.00 of NAV.
This provides a large margin of safety given the manager track record and the large amounts of liquidity on hand to provide further equity or debt financing to portfolio companies if they should need it.
We need to also remember that JZ Advisors have proven over time that they can invest capital and grow NAV without the use of excessive leverage. Their longevity is a testament that they are at the very least decent stewards of capital. At the current discount JZCP is priced for disaster and ruinous future misallocation of capital, in the context of a little research that seems unreasonable.
Capital Market Conditions
As markets have dried up and risk aversion has risen into 2011, private equity companies are finding it particularly hard to plan and execute on their exit routes. This will affect JZCP as much as anyone, although one could maybe argue that their tiny portfolio companies are bite size for larger buyout funds or for growth and M&A hungry larger corporates. But, in essence, I think it’s safe to assume that we won’t be enjoying any boom time exit multiples to a choice of eager buyers.
On the flip side, tough markets mean that smaller companies have no access to credit, a topic that has received much coverage recently, ironically in the same period that McDonald's (MCD) can borrow for 10 years at 2%! Periods where small and medium businesses are struggling to get credit and struggling to grow their businesses are potentially rich pickings for a fund with the capacity and wherewithal to invest or lend. This is especially attractive when some of these niche businesses could be operating independently of the economic cycle.
JZCP has, by the managers' own reckoning, made some of their best investments following a recession when times are hard but opportunities are prevalent. They have $155 million to deploy into any coming economic weakness or alternatively to allow them to traverse it without having to damage long-term shareholder value for short-term survival.
The two lead managers, John Jordan and David Zalaznick, own 13% of shares outstanding or roughly $14 million each.
Rothschild Private Bank owns 10% and this stake has recently been increased.
Zeke Ashton at Centaur Capital Partners, Third Avenue Management and Murray Stahl at Horizon Kinetics are three other shareholders on the register that give me some comfort that this is a quality operation. These investors are all distinguished and JZCP must have passed their due diligence in addition to my own.
In addition to this, Fairholme Capital Management owned around $65 million of stock and have taken this down to only $7 million. Now as a percentage of Bruce Berkowitz’s assets both stakes are tiny and I have no idea as to why he sold, but I might hazard a guess. Because of his very poor performance this year, Fairholme has apparently been subject to brutal redemptions, and they may have just decided to liquidate this “tail” position relatively quickly. This would have a minimal effect on their fund but could be some explanation for the very large relative volume of shares sold in mid July and again in October. To emphasize, in what is an illiquid small cap stock the largest shareholder decided to go from a 20% stake to a 3.5% stake in the matter of a couple of months.
The discount to total NAV got as wide as 65% in the midst of the financial crisis and there is no denying that such a discount is a possibility in a severe market downturn however there are enough positives in this story for me to be willing to bear that temporary “mark to market” risk. I believe that JZCP would be able to deploy capital sensibly into market weakness to build long term value for shareholders.
At current prices shareholders are given a 2.2% yield and have the opportunity for substantial NAV growth under a proven management team with the “leverage” of a potential narrowing of the currently excessive discount to NAV.
I can't think of many ideas right now that cause as much of an instinctual "recoil" as private equity, so I think that this idea will automatically be ignored by many — but if everyone thought it was a great idea it wouldn't be cheap! There are two types of businesses: those that have problems and those that will have problems. Many of JZCP's problems and some they don't even have seem to be in the price.