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26 Jun 2023 - Risk-adjusting small-cap upside

By: PURE Asset Management

Risk-adjusting small-cap upside 

PURE Asset Management

June 2023

Those investing in smaller companies will appreciate the difficulties faced by this market segment since early 2022. Central banks have raised interest rates in unison, with liquidity and confidence evaporating as a result. The unfortunate outcome is that share price appreciation has been a mirage for most emerging businesses. When compared to large cap peers, the chart below illustrates the degree of such underperformance. Since January 2022, small cap equities have experienced their own 'GFC'.   

A key adage we live by at PURE is that share prices are not always reflective of underlying operational performance. Market sentiment and liquidity can savagely impact small cap valuations, and while painful for existing equity holders, create phenomenal opportunities for astute new investors. The risk is that equity prices remain under pressure for longer than an equity investor can stomach, resulting in further losses. Our key takeaway from the above chart, it that strong outperformance has always followed underperformance. When small cap share prices appreciate, they do so quickly. The unknown here is timing. 

While no investors have certainty on timing, hybrid investing is a unique way to 'risk-adjust' this variable. Hybrid investments involve entering a transaction via a credit instrument, yet retaining exposure to equity returns via a conversion mechanism. The outcome being sought is to remove downside equity volatility, yet retain exposure to upside equity volatility. This entails swapping some equity upside for capital structure protection, security, and a consistent interest income stream. Getting 'paid to wait' in the form of interest income ensures a cash yield is received as each investment thesis materialises.    

Today's conditions are extremely attractive to deploy capital via hybrid structures. Many borrowers are unable to access debt markets, with most dissatisfied with their cost of equity. The result is a strong negotiating position for deal originators, as value drivers (interest rates / conversion premiums) are being agreed from a position of power. If capital preservation can be achieved as a secured creditor, upside potential from this cycle low should be self-evident. 

While an attractive way to invest, hybrid deals are are difficult for investors to source as they involve a direct negotiation with the Borrower. PURE's funds were established as a vehicle to provide exposure to this form of investing, a strategy which remains unique to this day.

Have you considered hybrid investments as a way to risk-adjust your exposure to emerging companies? 

Funds operated by this manager:

PURE Income & Growth FundPURE Resources Fund

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