Most wealth managers and direct investors regard private equity as an optional add-on to a portfolio of listed shares. But Steffen Meister, chairman of Partners Group, argues persuasively that it has become much more than that. Baillie Gifford and other leading fund managers have been allocating funds to private equity for some time now. They note that private companies are floating on the stockmarket later, if at all. So if investors want to capture more of the value created by these firms, they must invest while they are still private.
Distrust of private-equity valuations, and the consequent slump in the share prices of private-equity trusts as discounts to net asset values (NAV) widened dramatically, led to disillusionment with the sector. But confidence is slowly returning. Asset values have held up or increased, the credibility of those valuations has risen, and holdings have been sold at significant premiums to carrying (book) values.
For instance, 3i, up by 42% in 2023, now trades at a significant premium to NAV. Elsewhere, discounts may be slow to fall, but asset values, which have been held back by rising bond yields, should continue to rise. Within portfolios, there will be problems, maybe even disasters, but there should also be startling successes.
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“There has been a role reversal between private and public equity,” says Meister. “In 1980, the corporate initial public offering (IPO) was the sign of a mature business coming to market, offering investment in a growing and profitable enterprise with a long-term strategy. By contrast, private markets were the venue for opportunistic transactions, such as leveraged buy-outs, and for speculation.”
“Today’s high-profile IPOs are often young and unprofitable businesses... Meanwhile, private-equity investors are shedding the perception that they are asset strippers, having increasingly turned their attention to profitable, established businesses. Leverage is no longer the dominant force in transactions and private markets’ investment horizons have lengthened.”
Sinking flotations
The number of flotations has risen and fallen with market cycles, but there has been a clear downtrend since the 1990s. Only 21% of flotations are of profitable businesses, compared with 85% in 1990. According to Morgan Stanley, the number of listed companies in the US halved in the 25 years to 2020 – a result of mergers, public-to-private transactions and a lack of listings.
In 2020-2021, traditional firms in sectors such as healthcare or industrial assets accounted for just 26% of US IPOs, notes Meister. “Meanwhile, private markets have become long-term orientated and for many private... firms, investment activities are centred on operational value creation. This requires building large teams of operators with deep industry knowledge and the relevant experience to steer their portfolio companies strategically.”
This means fostering organic growth, financing add-on acquisitions and providing advice and guidance. Investors worry about valuations, but these have become more consistent and professional, typically reviewed quarterly and audited at least yearly. In the ten years to the end of 2021, Meister calculates, only 41% of the returns from the S&P 500 came from active cash-flow generation; 59% were due to multiple expansion. In Partners Group’s funds, just 25% came from multiple expansion, 68% from growth in cash flow and 7% from business transformation. Other private-equity managers tell a similar story.
In 2010, global listed equity issuance was $600bn, nearly three times the capital raised on private markets. But in 2016, private-market capital raising eclipsed equity issuance and in 2022 it reached $1trn, more than double the listed equity capital raised.
Meister doesn’t cover the growing regulatory burden on listed firms, the costs of flotation and maintaining a listing, and the disruptive effect of share-price volatility. It is also much easier to set up tax-efficient incentives in a private firm than in a public one. In 2000, private markets were valued at $1trn; now they are worth $10trn. “Predictions of decline have been wrong before and we believe they are wrong now.” Investment in private equity should be a core component of any portfolio. There is a broad array of UK-listed private-equity trusts, nearly all on attractive discounts to NAVs.
What to buy
In 2009, Pantheon International (LSE: PIN), along with 3i and most private-equity trusts, had commitments to invest that exceeded its available cash and debt facilities. To meet these commitments, it would have either to sell investments at distressed prices, or raise capital at a steep discount to NAV.
Anticipating this, PIN’s share price fell to a huge discount to NAV. 3i issued cut-price shares, but PIN, led by chairman Tom Bartlam and CEO Andrew Lebus, insisted that it didn’t need to raise capital as the commitments were very unlikely to be called. They were proved right and, in the next 12 years, the stock soared twentyfold. Now, the share price again trades at a 42% discount to NAV. But the market has been wrong about PIN before and appears to be wrong again.
PIN, with assets of £2.5bn, was launched 35 years ago and its NAV has since produced a compound annual growth rate of 12%. Its manager, Pantheon Ventures, employs 138 investment professionals in 11 locations around the world overseeing $93bn, so it is clearly not short of expertise or satisfied customers.
PIN used to be a “fund of funds”, which meant that it invested in the unlisted funds of other managers. This brought great diversification and gave it access to all the top managers, but also increased costs. Now, PIN’s assets are divided evenly between “primary” investments (money allocated to funds at their inception), “secondary” investments (participations in funds acquired later) and “co-investments” (direct investments in firms alongside funds). About 54% of the portfolio is said to be directly invested in companies.
The portfolio is global, with more than half of assets in the US; 70% is invested in buyouts, mostly of small- and mid-cap companies, 21% in growth capital and 10% in venture capital or special situations. The sectoral focus is on IT (34%) and healthcare (19%), but financials and industrial companies each make up 10% of the total.
The best confirmation of PIN’s valuations is that the average uplift on exit realisations since 2012 has been 31%, while, on average, 23% of the portfolio has been realised each year. Helen Steers, a Pantheon partner, points out that “the best private-equity managers have historically outperformed the public markets” and that “Pantheon backs managers investing in resilient sectors benefiting from long-term secular trends”.
A bigger bet on tech
At least as compelling is HarbourVest Global Private Equity (LSE: HVPE), a £3bn fund with similar scale and global reach trading at a 46% discount to NAV. Its 14.6% compound return over ten years in dollars is better than PIN’s 13.5% in sterling. Its performance over one, three and five years is significantly better (138% compared with 87% over five years).
HarbourVest’s exposure to “venture and growth”, a weak area in 2022, is, at 34% of the portfolio, somewhat higher than Pantheon’s, as is its exposure to the technology sector at 51%. It has also been shifting its focus from primary investments to secondary and co-investments. As HarbourVest partner Richard Hickman says, “ discounts in private markets for secondaries are narrowing and [are now] around 10%... the market has priced in an expectation that somehow private equity is due a fall. This has been disproved”.
Also attractive are ICG Enterprise Trust (LSE: ICGT) on a 40% discount; Apax Global Alpha (LSE: APAX, 28%); Oakley Capital Investments (LSE: OCI, 32%) Hg Capital Trust (LSE: HGT, 16%); NB Private Equity (LSE: NBPE, 31%) and Aberdeen Private Equity (LSE: APEO, 40%). Even those on premiums, such as 3i (LSE: III) and Literacy Capital (LSE: BOOK) may be appealing. It is at times of market stress when access to capital is low that the best managers find the greatest opportunities. The same is true for investors.
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