From disappointment to delight: Why Hyperion's holding its Afterpay shares tight

James Marlay

Livewire Markets

When Hyperion duo Mark Arnold and Jason Orthman caught wind of Square’s $39 billion bid for Afterpay they weren’t happy. Afterpay is the largest holding (11.8%) in Hyperion’s Australian Growth Companies Fund and the pair were concerned that one of their highest conviction ideas was about to get taken out.

“We never want to lose our companies to takeover, because we want to enjoy that growth for the next 10 to 20 years.” Orthman says.

However, the initial disappointment faded as the pair digested the details of the offer, learning that the all-script deal would enable them to roll their 11.8% portfolio position in Afterpay into an ASX listing in Square. 

It’s a unique situation given that the NASDAQ listed Square is a top 3 holding (7.8%) in Hyperion’s Global Growth Companies Fund. Orthman says that Hyperion intends to retain their current holdings in the domestic and global portfolios arguing that the tie up will release ‘massive synergies’, paving the way for decades of growth.

In this Fund Manager Q&A, Jason Orthman explains where he sees the longterm growth opportunity in payments and why they are backing companies like Afterpay, Square and Paypal over incumbents like Visa and Mastercard. 

Image: Jason Orthman, Portoflio Manager, Hyperion Asset Management (supplied)

What was your initial reaction to the deal and was it a surprise?

Our initial reaction was quite negative until we'd read the detail because we thought, “Oh no, Afterpay has been taken out. This will be a cash bid and we've lost one of our structural growth companies.” 

We never want to lose our companies to take-over, because we want to enjoy that growth for the next 10 to 20 years. So initially we were concerned and then we quickly read the detail and saw that Square was going to provide a secondary listing or CDI, which meant our Afterpay position can be rolled into Square in the first calendar of next year.

That's a significant positive because it does de-risk the investment in Afterpay, which is a single product company, whereas Square's a lot more established with more products. 

So Afterpay shareholders shouldn't be nervous about rolling into Square. It's a huge win and a big deal for the Australian Stock Market to get a business of the calibre of Square onto the Exchange.

In terms of whether we were surprised, it's quite interesting because when we were talking to clients to explain Afterpay - Afterpay's our largest position in the Australian fund at 12% and Square is a top-three position in global at 8% - we would explain the journey that Square's been on, and Afterpay is a mini-Square in effect. 

Afterpay was trialling Afterpay Money, which is to come out into the Australian market later this calendar year. That product would be like savings and deposits, and broadening it from a single Buy Now, Pay Later company.

Offshore, Square's been really successful in disrupting the traditional financial industry by offering a number of products and not just peer-to-peer, but receiving your pay early, receiving cash transfers, being able to buy Bitcoin, being able to buy equities to do your tax. What's interesting is a business like Afterpay operates outside the traditional financial system, but so does Square.

So we were initially surprised, but when you step back it makes complete logical sense. There's not a better synergy or better combination of companies, particularly in Fintech or payments globally than Square and Afterpay and bringing them together.

You hold Square in your global fund and Afterpay in the Australian fund. Have you changed, either increased or decreased, position sizes since the deal was announced?

No. They are still core positions. Even at these current levels, our forecast internal rate of returns for both stocks is quite high. 

Square's forecast internal rate of return is actually higher than Afterpay's. So by eventually rolling Afterpay into Square, not only are you going to de-risk things, increase the quality, but the return profile's attractive. 

The reason why we haven't reduced our exposures is because we think the synergies between these two businesses is going to be particularly large. 

Square has two ecosystems, it's got a seller ecosystem where it sells your readers or point-of-sale and hardware.

Then there are solutions to merchants where retailers can link up between the Cash App, which has that peer-to-peer device and offering that Square does to 70 million users. Those are two separate businesses in Square, by bringing Afterpay on, you can potentially link them because the sellers that use Square's product have been asking for a buy now, pay later service, and particularly Afterpay.

The executives at Square are excited about it, and maybe that's stating an obvious thing because of the premium that they offered. But Afterpay is unusual in that it's gone viral, but not only viral in Australia, viral globally. And Square's market position has been hard fought over a long time. COVID-19 accelerated the use of that Cash App. And the Cash App is also North American-centric, not globally. 

So, you can't underestimate the significance of Afterpay's viral growth and Square getting in the slipstream of Afterpay as it grows and expands. There are massive synergies both ways between the two businesses.

Why do you favour stocks like Paypal and Square over things like Visa and MasterCard?

That's a good point and part of it is to understand the journey of Hyperion through the global fund.

We held Visa and MasterCard at 6% to 8% weights, if you go back 5, 6, 7 years ago. Currently, they're at 1% or 2% weights, and we also own PayPal. 

To put in context, more importantly, is the industry structure. There's clearly a shift from cash to digital payments and the next generation is behaving differently in terms of how they consume and transact. There's three buckets that we think people should think about:

  • The first is offline, who is winning in facilitating payments in physical retailing? And that is Visa and MasterCard because they've spent decades getting that network going and signing up all those users and all those retailers. So MasterCard and Visa have still got long-duration growth in physical retailing or that part of payments.
  • Then you go online and the dominant player is PayPal. Mega cap names like Apple Pay, have not been able to crack online, whereas PayPal has 370 million users.
  • Thirdly, you've got your final bucket. And this is what we believe a lot of market participants have missed, is that you've got outside the system. We've talked about offline, online, and now outside the system.

Outside the system is really those in their twenties in Gen Z, that don't have a credit rating, don't use a credit card and don't have any relationship with your incumbent financial system. 

They're the next group of users that are being under-serviced and completely forgotten about, that the likes of Afterpay and Square are targeting. Credit ratings is old technology. You can actually assess people through algorithms and other risk assessment, which is what Square and Afterpay do.

There's absolutely a place for MasterCard and Visa, but we believe those other businesses are more compelling. They're earlier in their growth rates and as we look out, they've got longer duration structural growth. 

Visa and MasterCard are still going to be relevant in 10 years time because their rails are so powerful and other fintechs come across over the top of them. 

But when you look out 10 to 20 years, how the next generation behaves is going to be really important. That's when some of these newer businesses become more relevant than the Visas and MasterCards, we believe.

What are the most compelling reasons supporting Square's acquisition of Afterpay?

Square realises that there is structural change happening in consumption behaviour and how people pay. Investing is about looking forward, not looking backwards. Afterpay has an intimate relationship with these next generation of users and they will become more and more important, they will increase their influence, and the number of Afterpay users will continue to grow. Having a product that's relevant and embedded in the next generation of users is really important.

Secondly, the potential to disrupt the traditional banking industry is real as this generation comes through. Afterpay is well-placed to do that because they have a relationship that the major banks simply do not have with these users. I think Square is looking forward and realises they need to be relevant to those 70 million users that they've got, and they need to offer services like Afterpay. 

So really an acquisition like this is really future-proofing yourself against disruption to the standard financial system, and getting on the wave with that younger generation.

What is the value of the Afterpay founders to a business like Square?

They're really important, stating the obvious! The two things that are unusual about Afterpay (and Square appreciates this) is, firstly, how difficult it is for something to go viral. 

In 20 years of investing, I haven't seen a business go viral like Afterpay.

So that's the first point and they understand that and they want to accelerate and amplify what they are doing globally.

The second point is around founder-led, driven executives and the execution has been amazing. 

We haven't seen anything like that, how they've done some of the deals that they've done, how they've been able to scale like they've done is unparalleled. And to be frank, they probably haven't got the credit they deserve in the broader market.

It's not a very well owned stock. And from time to time, there is negative sentiment in the mainstream media on them, but it surprises us because you only have to spend some time with them to understand how relentless they are, how paranoid they are and how hard they're running to execute.

When we look at them, they look tired a lot of the time, they run the business hard. We're evidence-based and the execution has been absolutely incredible up until here. 

Really, over the next 10 years, being a single product company, they'd have to continue to execute really well, too, because all the value's ahead of them, all the future earnings and cash flows is ahead of them. Coming into a bigger group like Square, it does really de-risk things and makes that business less fragile and gives them more support. We're surprised how people haven't backed a couple of individuals like that.

Alibaba owns Alipay, which is one of the dominant payment platforms in China, and the stock's under pressure as we speak. Is this an opportunity?

We have always been really cautious on China and the risk profile in operating in a framework where you do have one ruling party setting the agenda. 

So we've been cautious and believe it's difficult to make money in an environment like that. That being said, within that framework, there's a lot of really good businesses - Alibaba, Tencent, Alipay, are all exceptional businesses. They're just operating in that framework, which is relatively unusual by our standards.

Until the onset of COVID, we had no exposure to Chinese names and we added Alibaba and Tencent. Alibaba, right in the midst of COVID and Tencent later on during the year, because our forecast internal rate of returns looked quite compelling. 

Obviously, the returns on an absolute and relative sense have actually been better elsewhere because there's been all those regulatory concerns and the actions of the ruling party. So our exposure to those two names, for example, is around 2-3%.

So even with all the noise that's been going on in China of late, we've remained cautious and we haven't turned into buyers. We are retaining those small positions at the moment because the risk profile does go up when you go in into that framework.

But that being said, the valuations look compelling now. So you've got to believe the storm will pass. 


This interview was edited for clarity and length

Managed Fund
Hyperion Global Growth Companies Fund (Managed Fund)
Global Shares
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