You normally get what you pay for when buying investment trusts. Well-managed funds with a good record generally trade at a premium to net asset value (NAV), while a large discount usually reflects a poor record and doubtful quality. However, there are exceptions. These include several trusts in the private-equity sector, where discounts of around 20% are not unusual and can represent a compelling investment.
Private equity in general is “an incredibly attractive asset class, with $6trn of assets globally that consistently outperform public markets”, says Oliver Gardey, manager of the ICG Enterprise Trust (LSE: ICGT) – itself currently on an 18% discount to NAV. However, the dispersion of performance between managers is high so “accessing the best private-equity managers is critical”. Unfortunately, “top-tier managers are very popular, so you need to be part of the club (which means being well-connected) and able to make a minimum commitment of £5m for each investment,” he says. “It takes £50m-£100m for a well-diversified portfolio and a long-term commitment, as funds take four to five years to invest, and then four to five years to harvest.”
This would put private-equity investment well outside the reach of nearly all individual investors – which is where the listed trusts come in. These democratise private-equity investment, since they are accessible to investors of any size and have the added benefit of not having to lock capital away for many years. The stockmarket listing means that investors can buy or sell at any time, without regard to the liquidity of the underlying portfolio that the trust holds.
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The trade-off for this liquidity – as with all investment trusts – is that the shares can trade at a premium or discount to NAV, and that the size of this can grow or shrink over time. Analysing discounts requires more work with private equity than with other trusts that invest in liquid assets, because the NAV will not reflect the current value of the portfolio. Instead, it will be based on past valuations and so will be understated when assets are performing well. They should also be using conservative assumptions, with the result that disposals of investments by private-equity trusts are usually done at a significant premium to book value.
A focus on growth businesses
Much of the case for private equity is that companies are taking longer to float on the stockmarket – partly because they have less need for capital than the asset-intensive companies of old, partly because the supply of private capital has increased and can deliver whatever they require, and partly because of the reporting and regulatory constraints of listing.
The number of “unicorns” – private companies such as Airbnb and Bytedance (owners of TikTok) that are valued at over $1bn – has multiplied more than tenfold in less than ten years. Waiting until these businesses go public before investing could mean missing out on huge profits, so a growing number of investment trusts now invest in private, as well as listed, equities. RIT Capital Partners and Caledonia Investments have done so for decades: Caledonia shareholders have had to be patient for results in recent years, but the NAV of RIT has recently been boosted by 8.4% through the flotation of Coupang, an e-commerce business in South Korea.
Trusts managed by Baillie Gifford – most notably Scottish Mortgage Trust – adopted the strategy more recently. Two years ago, the firm went further and launched a new trust, Schiehallion (LSE: MNTN), dedicated to private equity, following in the footsteps of Chrysalis (LSE: CHRY) a few months earlier. Both trusts, which seek to be passive investors in growth companies prior to their listing, have been hugely successful. CHRY’s shares have doubled since listing and MNTN’s returned 80%. Both have raised additional equity and are seeking to raise more, and both trade on significant premiums to NAV.
This makes returns in the rest of the private-equity sector seem rather pedestrian. These trusts pursue a more traditional model of investment based on buying control of companies. Historic out-performance, according to Gardey, is driven by “long-term ownership, turning good companies into better companies through active engagement and ensuring greater financial and investment discipline. Long-term value creation is put ahead of short-term profits and the interests of company management are aligned with those of the private-equity managers, who are only rewarded on disposal.”
Some trusts struggled in the 2008 crisis but lessons were learned, trusts are conservatively financed and the last ten years have been good for investors. The investment focus now tends to be on attractive growth businesses in sectors such as technology, media, healthcare and business services. With Better Capital, Jon Moulton tried the opposite strategy of buying cheaply companies that were on the rocks and trying to turn them around, but this was not a success.
Top performers and big discounts
A few listed trusts give investors direct access to investments managed by a single private-equity manager, such as those run by 3i (LSE: III) or HgCapital (LSE: HGT). However, most private-equity managers do not have their own listed funds. Access to these is via trusts which are “funds of funds”, meaning the trust invests in a portfolio of private-equity funds. Examples include ICGT and Pantheon International (LSE: PIN). This imposes an additional layer of costs on shareholders, although the managers can often reduce costs through obtaining discounts on fees, direct investing and co-investment in businesses alongside the funds they invest in.
At the top of the performance table is HgCapital, focusing on technology-related businesses, whose share price has trebled in the last five years. Its shares trade at a 4% premium to NAV but its consistent record of positive surprises on valuations (reflecting strong underlying performance) and disposals mean that the NAV is almost certainly understated. 3i, the £10bn sector giant, trades on a larger premium of 22% despite the share price rising “only” 70% in five years. However, it yields over 3%, twice as much as HGT, and the NAV attaches no value to 3i’s business managing funds for other investors.
The sector’s most improved performer is Apax Global Alpha (LSE: APAX), listed six years ago, which has Apax’s current and former partners as major shareholders. It sought to combine private equity with yield by investing half its assets in Apax-managed funds and half in “derived investments”. The latter are shorter-term investments in equity and debt derived from knowledge gained and ideas generated from the private-equity funds. These provide income, hence Apax offers a yield of 5.3%, but their performance has been disappointing compared to the private-equity portfolio.
The difference in relative performance means that the private-equity portfolio now accounts for nearly two-thirds of the total and the “derived” portfolio for barely a quarter, so overall performance is improving. The investment return in the last year was 19%, but the return to shareholders was 34% since the discount shrank. Last week’s sudden widening in the discount to 11% provides an excellent buying opportunity, given that the NAV is likely to be understated.
Fund-of-funds PIN trades on a near 15% discount despite having cleaned up an unwieldy share structure a couple of years ago and exited a long tail of small holdings in the portfolio. Investment performance over all periods, including back to inception in 1987, is a remarkably consistent 12% per year. Given that most of the portfolio was last valued at the end of September, there is sure to be more to come. Despite the absence of a dividend, the shares are cheap.
Intermediate Capital took over management of ICGT five years ago, giving the fund access to a broader range of private-equity contacts and expertise and enabling nearly half the portfolio to be internally managed. This part of the portfolio has returned 19% per year over five years while the third party funds have returned 14%, promising continued improvement as the internally managed portfolio grows. This progress should bring down the discount from a heady 18%, as it did for Apax.
NB Private Equity (LSE: NBPE) managed a 12-month return of 21% but still trades on a discount of 25% to estimated NAV, reckons analyst Chris Brown at JPM Cazenove, making it “excellent value”. He estimates the discount for Harbourvest (LSE: HVPE) to be 19%, which looks anomalous given its excellent record (a return of 100% over five years) and high exposure to the tech sector (29%). The record of Princess Private Equity (LSE: PEY) is even better, 106% over five years, but Brown rates it as only a “hold” as its discount of 16% is “fair relative to peers”. In absolute terms, it still looks attractive.
Perhaps the biggest bargain is Oakley Capital (LSE: OCI), which is trading on a 26% discount after an 18% return in 2020 and 114% over five years. Performance is held back by the 31% of the portfolio in cash, but this is matched more than twice over by commitments to invest in Oakley funds. The portfolio looks modestly valued given its focus on the popular technology and education sectors. The third leg of its investment strategy, consumer brands, provides recovery prospects once the coronavirus crisis passes – notably via Time Out, the well-known publisher of entertainment and nightlife guides, which has been expanding into food centres and events in cities around the world.
“I am very positive about the outlook for private equity and believe that it will continue to out-perform public equities,” says Gardey. “Long-term ownership has provided superior governance and there have been fewer disasters in the last ten years.” This confidence is reflected across the sector, which makes the cheapness of most of the listed trusts an anomaly. Perhaps, as one cynic says, “the brokers are too busy earning fees from issuing equity in anything renewable to pay any attention to listed private equity”.
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 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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