Investment trusts are fascinating vehicles. While there are different versions of these investment companies in other countries, London’s collection of investment trusts is the largest and most diverse in the world.
They are so-called closed-ended vehicles, meaning the number of shares in issue is fixed.
This gives rise to an interesting quirk of investment trusts: they trade at a discount or premium to net asset value (NAV), the value of the underlying portfolio. An investment trust’s NAV is calculated by adding together all of the assets owned by the investment company and deducting any liabilities. The figure is then divided by the number of shares in issue to give a NAV-per-share number.
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If there are more sellers than buyers for an investment trust, it’s common for the share price to dip below the NAV per share. That’s just what’s been happening in the UK over the past year.
According to analysts at Stifel, a wealth management and investment banking group, the average discount to NAV across all investment trusts listed in London widened to 16% in the first quarter, a level not seen since the 2008 global financial crisis (GFC).
A longer-term view
The closed-ended nature of investment trusts gives them another advantage. Trust managers with a fixed pool of capital don’t have to worry about daily inflows and outflows, meaning they can take a longer-term view when buying and selling assets.
Thanks to this benefit, investment trusts have sprung up offering investors access to a wide array of assets – from farmland to cargo ships and tankers, aeroplane leases, mortgage debt and hedge funds.
There is also a range of private equity-focused investment trusts listed on the London market, offering everyday investors access to a market generally only accessible to institutional investors, large pension funds and family investment offices.
Deep investment trust discount
According to asset manager Investec, the valuation gap between the reported NAV per share and the current share price of London-listed private-equity trusts ranges between 18% and 54%.
It calculates that the 14 largest private-equity investment trusts (excluding 3i, the largest by far) had a combined NAV of £17.3bn as of 23 May, compared with a market capitalisation of £11.1bn. The average discount across private-equity investment trusts was 34%, more than double the figure for the wider investment trust sector.
This discount appears to stem from the belief among investors that the trusts’ reported NAVs do not accurately reflect the values of their underlying portfolios.
Unlike venture capital, which tries to pick smaller companies and often has a high loss rate, private equity invests in firms with robust fundamentals, often mature businesses with room for improvement. The managers acquire these operations, improve them and then try to sell them at a higher price. Typical holding periods can range from three years to five years, although that will vary from manager to manager.
HarbourVest Global Private Equity is the one exception here. The trust has far more exposure to earlier-stage ventures than its peers, “and while unfashionable at the moment, these, in aggregate, have performed very well for us historically”, says Richard Hickman, the trust’s managing director.
Most of the time, private equity will use borrowing to improve returns, only putting in a tiny slice of its own cash and using debt to fund the rest of the acquisition – the idea being that a profitable company will be able to pay off the debt once it is acquired; it can also sell assets to raise cash.
With the cost of debt rising, the outlook for the sector is uncertain. There is therefore mounting concern over valuations and whether managers can sell the private businesses they own at the prices they want to achieve. If we assume the market is efficient, and all available information is reflected in security prices, the 34% discount on private-equity investment trusts suggests the market believes businesses in the portfolio are worth 34% less in the new higher interest-rate environment than trust NAVs suggest.
But is that true, or is this one of the most exciting value trades available to investors?
Primary and secondary investments
Private-equity trusts use a variety of different strategies. “Primary” investments are stakes taken in private-equity funds at their inception. Stakes in these funds can be traded at a later stage, and these are called “secondary” investments.
Then there are “co-investments”, also known as “direct” investments. These are direct holdings in private businesses, either with a partner or directly by the private-equity investor.
Whichever approach a private-equity investor chooses, returns are always going to depend on the performance of the underlying assets – the private businesses themselves. And establishing the value of these assets today is the hard part.
“The reality is, wellrun listed private-equity investment companies employ a strict, consistent valuation methodology and audit process throughout their structures, which should give shareholders comfort in the validity of the asset values,” says Hickman.
He also notes that trust managers were careful not to write up the values of assets in line “with the peaks seen in public markets in 2021”. As a result, portfolio values are unlikely to suffer the same kind of drawdowns in 2023.
Helen Steers, the lead fund manager of Pantheon International (PIP), another private-equity trust, agrees with this view, noting that “private-equity managers are inherently conservative when valuing their portfolio companies”.
The fund manager’s preferred measure of this is the recorded uplift of value at exit. On this measure, which tracks the value of stakes sold compared with their carrying (book) value over the previous 12 months, the “weighted average uplift from PIP’s portfolio has been 31% on average”.
Steers says “it’s important to note that private-equity managers are not paid their performance fee until their funds are fully realised and certain hurdles have been [overcome]; therefore there is little incentive for them to overinflate their valuations.”
On a similar note, ICG Enterprise, which is around half the size of Pantheon, recorded a 24% uplift to carrying value on the assets it sold in 2023. “We think that’s a really strong validation of portfolio growth and portfolio valuations,” explains Colm Walsh, the trust’s managing director.”
Valuations are under pressure
According to managers in the sector, so-called secondary deals (the trading of stakes in private-equity funds) comprise one of the most attractive markets today. Pantheon and ICG have both been increasing their exposure to these markets.
It is here that private-equity trusts have the edge. Oliver Gardey head of private-equity fund investments at ICG says private-equity managers – those managers raising money for private-equity funds – love working with trusts because they’re a fixed pool of capital. They know they’re not going to demand the money back and they can invest with a long-term horizon.
The fixed pool of capital also allows these trusts to invest counter-cyclically. Walsh explains that some “vintages coming out of the GFC ended up being some of the best vintages”, referring to private-equity fund stakes and secondary investments. “In times of economic disruption private equity is very well positioned,” agrees Steers: deals often have “very attractive pricing and downside protection.”
Private-equity managers ultimately want to make money, so they focus on the companies that are likely to be good investments. And if they need to help the underlying businesses along they will.
Thanks to this focus on top-quality firms, holdings in both trusts’ portfolios have outperformed the MSCI World index’s average earnings growth over the past 15 years. The earnings growth of companies in the underlying portfolio has consistently been higher and more stable than the wider market.
The discount dilemma
At the smaller end of the private-equity trust spectrum lies Literacy Capital - one of the only private trusts trading at a premium to NAV, which stands as a testament to the company’s model. Since listing in June 2021, its share price has returned 202%, making it one of the best performing trusts on the London market.
The other private-equity trust trading at a premium is 3i, the sector’s biggest trust with a market value of nearly £20bn.
In both cases, the market does not seem to be too worried that the managers of Literacy and 3i are overstating the value of their assets. This suggests the issues with other private-equity trusts are more localised. Here we have one of the great paradoxes of markets: just because something looks cheap doesn’t mean it will ever trade up to fair value.
What to buy now
Considering the uncertain outlook for private-equity valuations, it might be best to stay away from any investment companies in the sector trading at a premium. A discount to NAV may offer a cushion against further valuation declines.
It may also be sensible to stick with the sector’s largest players, which are generally the most liquid names. The more liquid a trust, the easier it is for managers to repurchase shares and close NAV discounts, and for larger investors to buy significant stakes (which will also reduce the discount).
The largest players in the sector, with market values of around £1.5bn, are HgCapital Trust (LSE: HGT), HarbourVest Global Private Equity (LSE: HVPE), and Pantheon International (LSE: PIN). HarbourVest Global Private Equity and Pantheon International are trading at the biggest discounts: 45% and 41% respectively.
A longer version of this article appeared in MoneyWeek issue number 1161.
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