Private equity’s discount dilemma

Do the exceptionally wide discounts to net asset value (NAV) of private equity trusts represent a bargain or are they a warning of trouble ahead?

Keynes reminded us that “markets can remain irrational longer than you can remain solvent”, but markets can also be prescient. Investors often smell trouble before companies acknowledge it but does that apply to private equity trusts?

Pantheon (LSE: PIN) trades at a 50% discount to its end of February NAV, but after adjusting for listed holdings and cash of about 57p a share, the discount is 56%.

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Due to lags in the posting of valuations by the underlying funds, just 30% of the unlisted portfolio was valued at the end of December, with the remainder at the end of September.

The NAV return over the past year is 12% and the scope for write-downs has diminished rapidly.

Other funds of funds – HarbourVest Global Private Equity (LSE: HVPE), Abrdn Private Equity Opportunities (LSE: APEO), CT Private Equity (LSE: CTPE) and ICG Enterprise (LSE: ICGT) – also trade on discounts to NAV of more than 40%, despite doubledigit returns over the last year.

Apax Global Alpha (LSE: APAX), which invests in Apax funds, trades at a smaller 35% discount and yields 7.4%. It’s one-year performance is 5%. However, 14% of the portfolio is in listed equities.

Conservative valuations

Among trusts that invest directly in companies, the shares of Schiehallion (LSE: MNTC), managed by Baillie Gifford, trade at a discount of 42% to the end of January NAV.

Its 74 holdings were revalued 451 times during the year so are likely to be right up to date. HG Capital (LSE: HGT) trades at a 27% discount to NAV to the end of 2022 after a total return of 5.4% for the year.

With an annualised performance of 16.5% over 20 years, it is a top performer. HGT’s portfolio was valued at 27.2 times cash flow, but valuations were supported by £404m of realisations at an average uplift to book value of 28% on the exits.

Oakley Capital (LSE: OCI) trades at a 32% discount and also has an outstanding record. It returned 24% in 2022, in line with its five-year record. About two-thirds of the increase was driven by earnings growth and the rest by multiple expansion.

Exits and re-financings on 26% of the portfolio generated £244m, representing an average uplift to carrying value of 70%.

This is a strong indicator of conservative valuations. Literacy Capital (LSE: BOOK) trades at a discount of only 5%, but its shares have returned 147% since listing in 2021.

A recent disposal was at a 110% uplift to carrying value. It surely deserves a premium. Likewise, 3i (LSE: III) trades on a 2% discount, but its average premium – which reflects the value of its fundmanagement activity – is 14%.

3i’s largest holding is the European discount retailer Action, which accounts for 63% of NAV, and it reported a 23% rise in sales in 2022 and 46% growth in operational cash flow.

Action expects to open 1,300-1,400 new stores in the next four years, compared with 938 in the last four, supporting further growth.

Out of favour

Some argue that the reason why private equity trusts are so cheap is that their valuations are too high and don’t reflect economic and market reality.

However, this would require a sector-wide conspiracy by boards, valuers, auditors and managers. This is absurd.

More pertinently, the whole investment-trust sector trades on a 17% discount to NAV. UK listed companies trade at large discounts to comparators overseas.

Some have listed or migrated their listings overseas, and others, such as Shell, BAT, Prudential and HSBC are under pressure to follow. So the problem for private equity trusts may be that a London listing is toxic to valuations across the board. It is hard to see what will change that.