A shift away from listed stocks towards privately-held companies reflects the advantages of private equity. No portfolio should be without exposure to this form of investment, says Max King.
Stockmarkets are shrinking and ageing. Since peaking in 1996, the number of publicly listed companies in the US has halved while the number owned privately has multiplied nearly fivefold, according to a study by private equity managers Pantheon Ventures. It reveals similar findings in other countries. "The remaining companies are older, larger and slower growing" while "the median age at which companies went public has increased from seven years in 1980-1996, when 285 companies were listing a year, to 11 in 1996-2016, when 136 were listing".
Amazon, for instance, listed in 1997 when it was three years old, Google in 2004 when it was six and Facebook in 2012 at the age of eight. Since flotation, their share prices have multiplied 674 times, 24 times and four times respectively. This has convinced some investors, notably Baillie Gifford, that they need to get in before flotation in order to benefit fully from the uplift in valuation of successful companies. As a result, having added private equity investment to their mainstream investment trusts, Baillie Gifford is now raising up to $600m from institutional investors, mostly in the US, for Schiehallion, a new investment trust investing solely in private equity.
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The shift from public to private investment
So what exactly will this involve? Private equity investment is directed at any company not listed on a stockmarket. This may as in Baillie Gifford's case mean taking a minority stake, but it usually entails taking control so as to influence management, business operations and strategy.
Some investors, such as 3i, are large enough to execute deals by themselves. But most private equity firms raise fixed-term funds financed by institutional investors such as pension funds to acquire businesses, sometimes sharing ownership with other funds. Businesses acquired may be early-stage companies needing capital and expertise to expand, or established firms that the owners are looking to sell?
The Pantheon study found that the number of companies eligible to list in the US had continued to grow by 7.5% a year but the propensity of companies to list had diminished. Listing used to bring exclusive advantages such as access to capital to finance growth, along with the ability to use shares for acquisitions, but private equity can now also fulfil those needs.
The ability of listed companies to reward employees with tradable shares, the provision of an exit for early investors, and the publicity triggered by flotations and subsequent scrutiny remain benefits. However, public companies these days also face significant costs in listing, greater regulation, share-price volatility and the need to report quarterly. What's more, the stronger link between business owners and management that comes with private equity ownership is an important advantage. A publicly listed firm will tend to have a wide variety of investors with very different agendas: some will demand higher dividends, for instance, while others will keep banging on about debt levels or the volatility of profits. What's more, under private ownership detailed information on performance and plans need not be made public, so it can be kept away from competitors.
Outstripping listed companies
Private ownership, then, brings with it tighter control over strategy, management and debt than in a typical listed entity: there is a better alignment of interests between management and investors. Another plus point is a focus on long-term value creation as there is no need to constantly prepare quarterly earnings reports to bedazzle stockmarket investors. Investors can also time their exit through an outright sale of the business.
Throw in the greater scope for detailed due diligence at the time of purchase, and private equity investment can generate higher risk-adjusted returns than public investment, says Merrick McKay, head of European private equity at Standard Life. Given all this, it's no surprise that companies are leaving the stockmarket and going private. Public to private deals, almost unknown until the late 1990s, have become common in both the US and Europe, the most recent example being the $3.4bn bid for London-listed satellite telecommunications company, Inmarsat.
Private equity's advantages have enabled it to outperform public equity "for 30 years in every stage of the economic cycle", according to Helen Steers, a partner at Pantheon. Research by Numis Securities shows that private-equity funds listed in the UK have persistently outperformed global equities for ten years, partly due to a narrowing in the discounts to net asset value (NAV) at which the shares trade, but also by the NAV outperforming equity markets. With discounts to NAV still averaging 14%, excluding 3i, there is plenty of scope for them to narrow further while the strong representation in technology, healthcare and other growth areas should enable underlying growth to continue.
Ample scope for growth
Despite the growing importance of private equity, Steers points out that the value of the entire private equity sector in the US is only equivalent to 1.7% of GDP while the market value of the S&P 500 is equivalent to 127%. Private equity accounts for just 3.4% of assets for the median institutional investor compared to 7% for property and 45% for public equities. In the UK, the allocation to private equity of public pension schemes is generally around 4%.
Yet there are grounds for caution. The amount of "dry powder" money raised by private-equity funds but un-invested continues to grow and is now estimated at $12trn which, at current rates, will take nearly three years to invest. As a result, private- equity valuations have risen steadily. "Private equity is not cheap," says Paul Daggett, managing director of Neuberger Berman private equity, "so you have to believe in the potential for value creation." Yet "public equity valuations have increased more than private so private equity remains relatively under-valued".
The Oregon Public Retirement Fund has been investing in private equity for 30 years, targeting returns 3% above global equities. In the past decade, however, it has persistently fallen short of this target. It blames the deterioration in returns on the growing size and competitiveness of the sector, the consequence being higher prices. Low prices used to mean that deals could be funded mostly with debt but higher prices require more equity, even though the cost of debt has fallen. Falling returns have been exacerbated by the cyclicality of fund flows with little capital employed when returns were most attractive, for example in 2009-2010, but masses when valuations were expensive, such as in 2006-2008. Rising deployments in recent years point to falling returns.
This should worry investors in Schiehallion. Baillie Gifford aims to treble investors' money over ten years, which means a compound annual return of 11.6%, a far cry from the performance of the tech and tech-enabled companies Baillie Gifford targets. For example, payment processing group Worldpay has jumped 15-fold in a decade. One industry veteran struggles to see how Baillie Gifford can achieve its target with a strategy of investing passively in small stakes.
While investors in Schiehallion are paying above asset value for a mountain of cash, the rest of the sector offers established portfolios, conservatively valued and trading at significant discounts to asset value. These funds have cash to invest but can afford to wait for a shake-out to produce cheaper prices. No portfolio should be without exposure.
Six of the best listed funds
3i (LSE: III)
With £8.4bn of assets, 3i is the giant of the sector. It trades on a 20% premium to estimated NAV. This is steep but the five-year return exceeds 200% and the value of the fund management business accounts for some of the premium. Action, the fast-growing European discount retail chain, accounts for a third of net assets. The dividend yield is 3.2%.
HGCapital Trust (LSE: HGT)
HGT invests mostly in technology and service companies in the UK and north Europe. Its shares trade at a discount of just 3% to NAV but it consistently beats expectations whenever it reports and sells assets, suggesting that valuations are conservative. HGT has £800m of assets and has returned more than 100% in five years. Yield is 2.2%.
Pantheon International (LSE: PIN)
Pantheon is a fund-of-funds, investing primarily in "secondaries" (participations in externally managed funds bought second-hand) but increasingly in "co-investments", too (investing directly alongside the funds in the portfolio). Pantheon boasts £1.4bn of assets and a five-year return of 90% but the shares still trade on a discount of nearly 18%. No dividends.
HarbourVest Global Private Equity (LSE: HVPE)
Another high-quality fund-of-funds with £1.4bn of assets. The five-year investment return is nearly 110% yet the shares trade on a 20% discount. No dividends.
Apax Global Alpha (LSE: APAX)
Floated in 2015, AGA has £835m of net assets, two thirds in private equity and one third in "derived instruments" comprising debt and equity. Performance of the latter was poor in 2018 but the overall three-year investment return has still been nearly 50%. Apax trades on a 15% discount and pays out 5% of net asset value in dividends each year.
Standard Life Private Equity Trust (LSE: SLPE)
SLPE is a fund-of-funds manager focused on European mid-cap funds; just 15% of net assets are invested outside Europe. The fund has £620m of assets with a five-year investment return of 84%. Shares trade on a 12% discount and yield 3.6%.
Mastering the journey of creating value in deals has never been so important. Find out how dealmakers can use private equity to realise revenue benefits and lock in real value creation in this whitepaper from PWC.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+.
Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts; two directorships are still active.
After 39 years in financial services – including 30 as a professional fund manager – Max took semi-retirement in 2017.
Max has been a MoneyWeek columnist since 2016 writing about investment funds in magazine and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications.
See here for details of current investments held by Max.
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