Buy these two funds to profit from private companies

Don’t be put off by Neil Woodford’s disaster. These two funds have done well with unlisted firms.

Tesla Model 3 plug-in electric car © iStockphotos

The Woodford affair and the plunging share price of the Patient Capital Trust have been stark reminders that private companies can be highly risky and very illiquid.

But recent results from Scottish Mortgage Investment Trust (LSE: SMT), the global equities investment trust run by Baillie Gifford, reminds us that investing in private companies can be lucrative if done in the right vehicle and with a sensible long-term strategy.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Over the six months to 30 September, SMT suffered from underwhelming returns, with the net asset value (NAV) rising by just 3.2% compared with an increase of just under 10% for the FTSE All World index. But since 30 September, the fund's NAV is up 2.8% versus 0.5% for the benchmark.

Finding the right private companies

According to Numis, between the fund's first unquoted investment on 2 June 2010 and 30 September 2019, the return of all stocks initially owned in unquoted form (whether now listed or not) has been 445.3% versus 341.4% for Scottish Mortgage overall, and 183.8% for the FTSE All-World.

Advertisement - Article continues below

Crucially, the fund invests in private companies that are established, often highly cash-generative companies, typically with valuations well over $1bn.

There is an important trend at work here that helps explain SMT's approach. Many of the best businesses globally are choosing to stay private longer.

Equity analysts at Morgan Stanley (MS) also point out that private equity can use incredibly cheap debt to fund growth. The weighted-average cost of capital is near all-time lows; the cost of equity in Europe is around 6% to 7%, while the European credit yield is under 2%.

Stockmarkets out of fashion

Private equity, by contrast, the report suggests, "is able to take a long-term view". It is willing to finance large capital expenditures, even if these crimp profits at first, and do deals where there is significant short-term political risk.

The real-world effects of this changing culture are clear. Overall mergers and acquisitions activity across Europe is plunging but the share of private equity transactions has rocketed.

Flotations are down substantially as more and more of these private businesses stay private. Eighty-four companies have listed in Europe this year, the fewest in a decade. And among the dwindling band of firms that do list, market-cap size is declining.

Advertisement - Article continues below

So growth businesses are choosing to stay private longer and avoid initial public offerings (IPOs). Many are also choosing to take extra growth capital from both private equity investors and outfits such as Baillie Gifford.

Add it all up and you can see why private equity funds such as HgCapital (LSE: HGT)are prospering. The fund's NAV is up 2.2% since 31 August, while NAV gains since 30 June have totalled 3.9%, driven by strong sales and earnings before interest, taxes, depreciation and amortisation (Ebitda) growth from the businesses in their portfolio. HGT's share price is up 39% so far this year. The Woodford Patient Capital affair is a wake-up call but private businesses are worth investing in the trick is to work out how to build exposure to the right kind of private businesses, using the right kind of fund.




Why investment trusts are the best vehicle for your money

Max King explains the advantages of investment trusts – sometimes called closed-ended funds – over their open-ended counterparts (or Oeics).
11 Feb 2020
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
17 Jan 2020

Investment trusts: the Cinderella of investment arrives at the ball

Investors should look beyond the market noise of a single year and examine the bigger picture. Max King explains what we can learn from 25 years of in…
8 Jan 2020
Share tips

Share tips: eight stocks that should deliver robust returns

Ryan Ermey of US publication Kiplinger’s Personal Finance chooses his favourite stocks for the next decade, which should be able to grow for years.
28 Dec 2019

Most Popular

UK Economy

How the BBC can survive the end of the TV licence

Th TV licence that funds the BBC is looking way past its sell-by date, says Matthew Lynn. Here's how it could survive without it
16 Feb 2020
UK Economy

Britain has a new chancellor – get ready for a major spending splurge

The departure of Sajid Javid as chancellor and the appointment of Rishi Sunak marks a change in the style of our politics. John Stepek explains what's…
14 Feb 2020

Living on a houseboat: the pros and cons of a floating home

Living on a houseboat sounds romantic and peaceful. But it’s not as straightforward as it looks, says Nicole Garcia Merida
14 Feb 2020

The rare earth metal that won't be a secret for long

SPONSORED CONTENT – You can’t keep a good thing hidden forever; now is the time to consider Pensana Rare Earths and the rare earth metals NdPr.
31 Jan 2020