According to the Association of Investment Companies (AIC), private equity trusts delivered an average return of 409% over the 10 years to 31 May 2023, which compares very favourably to 156% for all investment companies.

Yet despite this spectacular long-run performance, 14 out of 17 trusts in the AIC’s Private Equity sector trade on double-digit discounts to NAV (net asset value) at the time of writing.

This derating of the sector, one flush with long-established funds offering diversified access to an asset class normally off-limits to retail investors, could offer a compelling buying opportunities despite the testing economic backdrop of high inflation and rising interest rates.

Felix Haldner of Partners Group, which manages Princess Private Equity (PEY), explains that 2022 was marked by concerns around inflation, higher interest rates, and energy and supply chain constraints leading to disruption across markets.

But peering ahead, ‘a more positive market environment bodes well for private markets as price expectations between sellers and buyers converge and credit becomes more available’.

Haldner points out that when private market investment activity picks up after an economic downturn or a severe market correction, there is typically ‘an interesting period where private market investors can acquire attractive assets at lower valuations’.

Seasoned industry player Helen Steers is lead manager of Pantheon International (PIP), which invests in a diversified portfolio of private equity funds and occasionally directly in private companies.

While there will be winners and losers in the current environment, Steers argues the best private equity firms will ‘rise to the occasion and take advantage of this period of change to uncover interesting investment opportunities’ and expects there will be some ‘excellent returns’ made during this period.

 DELAYED RECKONING ON THE WAY?

As discussed, there is real concern the industry is entering an era of structurally lower returns due to the impact on valuations of rising interest rates, which will also constrain debt availability in the years ahead.

They also see a delayed reckoning ahead for private equity as managers mark down their portfolios. This concern also weighs on Global sector trusts with exposure to illiquid unquoted stocks such as Scottish Mortgage (SMT) and
F&C Investment Trust (FCIT) and Flexible Investment sector constituents Caledonia Investments (CLDN) and RIT Capital Partners (RCP).

The counter argument is that private valuations follow clear industry standards and are audited annually and, even in today’s difficult markets, portfolio companies are being sold at premiums to carrying values. Private equity trust managers also point out that buyout valuations have been conservative over the last decade, which is why the industry has continued to see valuation uplifts when private companies are sold.

‘Private equity managers are generally pretty conservative when it comes to valuing their businesses,’ stresses Steers, ‘because there is nothing in it for them to show large uplifts in unrealised valuation. They are paid a management fee but the carried interest that they get really all resides on how much they can actually sell businesses for in cash.’

Richard Hickman, managing director at HarbourVest, the manager of HarbourVest Global Private Equity, points out private market valuations ‘have historically been less volatile than public markets both on the upside and downside.

‘Private valuations were not, in most cases, written up in line with the peaks seen in public markets in 2021, and therefore should not be expected to suffer to the same degree on the downside. Any remaining valuation scepticism might be allayed by noting that maturing portfolio investments are still being realised at a premium to carrying value.’

Also weighing in is ICG Enterprise’s manager Colm Walsh, who emphasises the conservatism of private equity managers, who ‘don’t get paid on unrealised valuations unlike some asset classes.

‘And when managers sell things, they don’t want to be reporting a sale at a reduction to the previous carrying value, and that is one of the reasons why you see this consistent pattern of uplifts. If we spot something that looks particularly egregious, which is rare, we will provide against it.’

WHY INVEST IN PRIVATE EQUITY?

Private equity trusts provide diversified access to an asset class that some see as complicated and controversial and is normally inaccessible to retail investors; their shares are traded on the stock market, making it easy to make small investments. Private equity’s ability to grow businesses through methods including sales optimisation, focusing on company management, investing in new markets and tech enablement such as digitalisation and automation, has led to private equity consistently outperforming public markets.

Fans of the asset class argue growth in this industry has become structural, because companies are able to stay private for longer as private equity is able to provide them with more capital. In turn, investors need an allocation to private equity to access the high-growth niche market leaders and disruptive businesses of the future, operating in everything from AI and digitalisation to the green transition or medical technology.

Steers also stresses that in recessionary periods and bear markets, ‘top quartile managers have outperformed public markets by even more than in bull markets’.

SO WHY THE CHUNKY DISCOUNTS?

But industry sceptics doubt private equity can replicate the returns seen over the last 10 years in the new era of stubborn inflation and higher interest rates, which has created a less conducive exit environment and caused IPO (initial public offering) activity to slow down dramatically.

The biggest worry right now centres on the risk of write-downs in the private equity sector (see Delayed reckoning on the way overleaf) because of falls in listed market comparable companies, a possible recession and higher debt costs for a sector which continues to face questions about fees.

This cocktail of concerns has left some listed private equity trusts selling on discounts of more than 40%, versus more typical levels of 10-20%. The last time discounts were this extreme was during the March 2020 Covid sell-off and, before that, the aftermath of the Great Financial Crisis in 2008.

Among the sector’s largest and most liquid trusts, HarbourVest Global Private Equity (HVPE) trades at a 46.3% NAV discount, while ICG Enterprise Trust (ICGT) and Pantheon International both sell at similarly wide discounts of a smidge above 42%.

Reflecting its position at the top of the sector’s best 10-year share price total return performers, HgCapital Trust (HGT), an investor in unquoted software and services businesses with resilient business models, is on a smaller 20.9% discount while NB Private Equity Partners (NBPE) sits on a 30.9% discount.

The two outliers are the UK’s largest listed private equity firm 3i (III), which trades on a 13% premium, and Literacy Capital (BOOK), which invests directly in private UK-based businesses and sells on an 8.6% premium; Literacy stands out for its strong performance since IPO in June 2021 and a unique charitable objective to donate 0.9% of annual NAV to charities focused on improving child literacy.

On the thorny issue of fees, Alan Gauld, manager of abrdn Private Equity Opportunities (APEO), concedes private equity is a relatively expensive asset class but the NAV returns, which are net of fees, continue to be strong. He also points out that private equity involves ‘active value creation, which requires serious resource and expertise’.

To make differentiated returns in private equity, it is about ‘accessing and partnering with the best private equity firms that generate the best net returns. 

‘These are typically oversubscribed and hence have negotiating power when it comes to fees.’

OUR FAVOURITE PRIVATE EQUITY TRUSTS

HarbourVest Global Private Equity (HVPE) £20.70

Discount to NAV: 46.3%

This trust’s wide NAV discount shows a ‘clear disconnect between the resilient portfolio returns versus risk perception’ according to broker Peel Hunt, which sees scope for a recovery in the rating. HarbourVest, which invests in private companies and portfolios of private companies through funds managed by HarbourVest Partners, has a track record of materially outperforming public markets through the cycle and has generated 10 year annualised total returns of 13%. Ultra-diversified with over 1,000 underlying company holdings, the fund’s spread of exposure reduces risk and should continue to help support its NAV in these testing times. HarbourVest buys back shares but it doesn’t pay a dividend, electing instead to reinvest realisation proceeds into new investments. At last count, cash and cash equivalents of $310 million and available credit $600 million totalled $910 million, giving it plenty of firepower for deals, although the large investment pipeline (unfunded commitments) as of 31 May totalled $2.7 billion. In the unlikely scenario the trust has a period of negative cash flow with exits continuing at low levels, it could have to sell assets on the secondary market, which is a risk to consider.

NB Private Equity Partners (NBPE) £15.60

Discount to NAV: 30.9%

Well diversified by industry, company and vintage year, NB Private Equity has delivered 10-year total annualised returns of 14.7% by investing in a portfolio of direct investments in private companies hand selected by Neuberger Berman’s team of experts. A 30.9% NAV discount is already prices in a valuation ‘haircut’ at the FTSE 250 trust, which invests alongside top tier private equity managers with a bias towards North America, the largest private equity market. NBPE’s focus is on the technology, healthcare and consumer/e-commerce sectors and on companies expected to benefit from structural growth trends and with low cyclicality. Boasting a strong long-term performance and dividend growth record, NBPE has a strong balance sheet following a strong period of realisations which has helped NAV growth and reduced leverage. Stifel sees NBPE as ‘relatively well positioned’ for this environment due to this low leverage, modest outstanding commitments and relatively low company-specific risk, with the largest 10 investments representing 35% of NAV. The largest investment is European discount retailer Action, while other investments include Constellation Automotive and insurance brokerage USI. The fund also benefits from a favourable fee structure, due to its focus on co-investments which results in the bulk of the portfolio having no management fee.

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