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Cash shells are becoming an increasingly common feature on AIM. In association with our sister publication Business XL, we chart their rise to prominence and highlight their benefits and pitfalls. Elliott Davis reports

For most investors, cash shells are a curious anomaly. They have a stock market quotation, cash in the bank and – in many cases – are presided over by well known City figures. What they lack, however, is any form of trading business and that can make it next-to-impossible to assess their prospects objectively.

Nonetheless shell companies are becoming increasingly difficult to overlook. Two years ago, when our sister publication Business XL last investigated this area, there were 25 such vehicles on AIM. Today there are 69. To put this in context, only the financial, media, natural resources, support services and software sectors are now more populous.

Risk/reward

From an investment point of view, cash shells brim with high-risk opportunity. The current crop has a combined £77 million in the bank and the past success stories in this sector are compelling.

Take the first of Richard Wollenberg's three General Industries shells, for example. GI-1 raised £1 million when it launched in late 1997. 12 months later it allowed social housing business HACAS to reverse into it through a £6 million transaction. By mid-2003 HACAS had been sold on to a fully listed rival for £45 million, netting a handsome profit for all concerned.

Serial entrepreneur Mike Edelson is another that has struck gold, growing one shell – Bramhall – into a significant venture that eventually became Magic Moments Internet. It was eventually sold to Pipex for £31 million.

The attraction is that cash shells can provide investors with a relatively inexpensive route into a soon-to-be sizeable corporate entity. But it is also important to remember that for every GI-1 and Bramhall there is a venture like Azure. This lacklustre operation is currently seeking a second reversal in 18 months after its original attempt at reinvention resulted in liquidation.

What's in the price?

Perhaps the most interesting facet of the market is that most shells trade at a significant premium to their net asset value. In fact, as Table 1 illustrates, just over a quarter of the current crop are valued at a 185 per cent mark-up to assets, if not more.

So what are you paying this premium for? To Liam Murray, of broker City Financial, the answer is simple. 'Most shells trade at a premium of at least 40-50 per cent on account of the anticipation that they are about to complete a good deal.' That is not to say, however, the higher the premium the greater the prospects – a fact testified by the presence of bombed-out former investment company Greenchip Investments at the head of Table 1.

For Adam Hart, of broker KBC Peel Hunt, investors contemplating shells valued in excess of their assets need to be extremely discerning. 'Ask yourself, if I am paying £2 for £1 of cash, what am I getting for this premium' urges Hart.

A strong, well-reasoned acquisition strategy, impressive management track record and details of solid commitment among these managers to stick with the acquired business for the medium-term are all reasons to pay a premium. Many of those at the very top of Table 1 match these criteria.

Fitzwilliam Capital, for instance, is headed by Pierce Casey, the former head of venture capital group Apax Partner's Ireland office. It is looking to acquire one or more established businesses. Having said that, it is currently valued at more than ten times net assets, which seems very excessive.

The likes of Conival (which is looking to enter the ready-meal market) and telecoms-focused Belgravia Telecom, meanwhile, are all highly focused and respectively valued at premiums of 525 per cent and 433 per cent. Once again, this is too much for us.

Firms such as these, Tim Cofman of broker WH Ireland explains, set out to exploit 'a genuine opportunity to consolidate a sector', hence the lofty valuations.

But while the likes of airfreight technology developer Aerobox and highly-regarded confectionery business Glisten – which both began as (admittedly private) shells – have built themselves into significant ventures this way, investors should be aware that others have failed to find success. Innobox, for one, was established to build a group operating in the packaging and distribution sectors. It struggled to make much headway and now runs a portfolio of country hotels.

Of course, you can reduce the risks to some extent by backing management and shells valued at a reasonable, but not excessive, premium to assets. The likes of language school hopeful Quintessentially English (headed by Michael Gurner, who helped turn around Prontoprint in the 1990s), John Gunn's Vert-Eco and Urban Dining, valued at a 63 per cent premium to assets and lead by former Pizza Express director John Metcalf, look among the best current opportunities.

In the bargain basement

At the other end of the spectrum, as Table 2 shows, there are also several shells rather curiously valued at a discount to net assets.

In the case of Abraxus Investments and Mark Kingsley this would seem to reflect the fact that both have been seeking a deal for sometime now but have yet to identify suitable transactions and are being largely ignored. By contrast, Prime People only recently turned itself into a shell (and dropped from Full List to AIM), boosting its cash reserves, but not its market value, to £2.9 million en route.

Given the discounts available, each of these shells is worth a punt at present levels but investors should be prepared to be patient.

Following the founders

Perhaps one of the best methods of assessing a shell's potential is to analyse those at the helm and, as Table 3 shows, certain entrepreneurs are specialists.

The likes of Leo Knifton and Peter Redmond specialise in cleaning out the liabilities from bombed-out businesses, identifying reverse takeover candidates and then handing the reigns on to new management. They have enjoyed some success to date. Knifton, for instance, recently completed mobile internet failure OverNet Data's evolution into £50 million-rated plant genetics business FuturaGene.

Over in the clean shell camp, meanwhile, Ardent and TMT chairman Chris Akers can claim a fair record, having first brought Sports Internet to market with a valuation of under £2 million and then sold it to BskyB for £300 million. Akers also enjoyed some success with VirtualInternet, which was sold for a ten-times return, although he has endured his share of failures too (just ask anyone who backed Sports Resource Group at the height of its hype).

Each with £1 million in the bank, trading at a 114 per cent premium to assets and clearly focused on the media, technology and telecoms sectors (in which Akers has enjoyed past successes), Ardent and TMT look very enticing.

Buy the full report:

This document is part of a larger, more extensive, report entitled 'Cash Shells' compiled by sister publication Business XL. The report is available in PDF format priced £195 + VAT. To order a copy, call 020-7430 9777 or email info@businessxl.co.uk.