Scottish Mortgage proposes change to private companies investment policy

Scottish Mortgage (LON:SMT), the £15.2 billion investment trust that focuses on high-growth innovation companies, is proposing a shake-up to how it invests in private companies.

Consistently one of the most popular investment trusts among DIY investors, Scottish Mortgage invests in companies it sees as long-term winners thanks to their innovative technology and ability to grow in value over the course of years or even decades.

Some of the most promising investments on that front are private companies; those that haven’t yet listed publicly and whose shares therefore can’t be bought and sold on a stock exchange. The investment trust’s largest holding as of 28 February, Elon Musk’s space exploration firm SpaceX, falls into this category.

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Shareholders in Scottish Mortgage will vote on a change to the trust’s rules at an upcoming extraordinary general meeting (EGM) that, if passed, would allow its managers greater flexibility when buying private companies.

“Our role is to be patient, long-term partners to exceptional private companies as they continue to scale,” said Tom Slater, manager of Scottish Mortgage. “From time to time, market movements can restrict our ability to make further investments in private companies.”

What changes is Scottish Mortgage proposing to its investment process?

At present, Scottish Mortgage’s rules permit it to invest up to 30% of its assets in private companies.

But private companies can be difficult to value – for reasons which we’ll explain in greater detail below. The upshot, though, is that a 30% cap could restrict Scottish Mortgage’s ability to pursue promising opportunities in private companies or support ones it has already invested in when they raise more capital.

This is exacerbated by the fact that SpaceX currently accounts for 15.4% of Scottish Mortgage’s portfolio - more than half the current private allowance by itself. Its third-largest holding, TikTok owner ByteDance, accounts for another 4.1%, meaning that between them these two companies account for nearly two thirds of Scottish Mortgage’s entire permitted private company allocation.

Scottish Mortgage’s board will recommend that shareholders vote through a proposal giving the trust’s managers the discretion to allocate up to £250 million in additional private investment capacity. This would enable them to make new or follow-on investments in private companies when they see an opportunity, even if that means bringing its private company exposure above 30%.

“This proposal gives the board additional flexibility to act in shareholders’ long-term interests by permitting us to support our private holdings when it matters most, while remaining selective about new opportunities,” said Slater.

From the firm’s 2027 annual general meeting onwards, Scottish Mortgage shareholders will vote annually on whether or not this additional flexibility is continued.

Why are private companies hard to value?

Shares in private companies don’t trade on stock exchanges, and therefore don’t change in value day by day like those of a public company (like Nvidia, or indeed Scottish Mortgage).

Instead, their valuation changes at much less frequent intervals – usually whenever they raise fresh capital or, occasionally, in a secondary share sale event (where existing shareholders, such as company employees, have a specified window in which they can sell some of their shares).

Because a lot of time passes between these events, and a lot can happen during that time, the valuation of the company can change a lot in between them.

SpaceX, for example, was valued at around $800 billion during a secondary share sale in December, but it is widely believed to be targeting a valuation of nearly double that at a potential IPO later this year.

Investment trusts and other investors can only value private companies on their books at their most recent valuation.

Large uplifts in valuations between these events can lift the allocation in a trust like Scottish Mortgage beyond their maximum allocation even without buying any new shares. This is good news in some respects as it means these early investments are paying off, but it can also put fund managers in a position where they can’t buy new private companies (or, in the case of follow-on purchases, more shares in private companies they’ve already invested in) without being forced to sell off some of their portfolio holdings.

Scottish Mortgage’s board hopes its proposals will enable it to navigate this and be able to continue to both support its existing private investments, and take advantage of new opportunities as and when they appear.