Buy these two funds to profit from private companies

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.

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.

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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.

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.

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.