Are private equity trusts a bargain?

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Supported by
Vanguard
Are private equity trusts a bargain?

The period from the end of the financial crisis to the start of 2022 created many market conditions that were ideal for private equity investment trusts.

Asset prices generally rose, while interest rates remained low, enabling such funds to boost returns, while many investors looked to such products as a way to achieve diversification away from listed equity and bond markets, which were rising stoutly.

This enabled trusts to borrow very cheaply, and deploy the capital into already rising markets, all the while charging active management fees. 

But as this year has worn on, many of those trends have reversed, the cost of debt is higher, and many investors are prioritising liquidity at a time of market downturn, which means the outlook for the asset class has changed.

And that is reflected in the chart below, which shows the average discount to net assets at which private equity investment trusts trade has roughly doubled in the past year. 

In more normal circumstances, the price of an investment effectively halving in a year may prompt investors to buy more. 

But an issue unique to private equity trusts is they invest in companies not listed on any stock market, so the price of the investments they make is not calculated on a daily basis, as it is with investments made by other funds in listed bonds or equities. 

Anthony Leatham, investment analyst at Peel Hunt, says: “This sector sees a 3-4 month reporting lag from the underlying managers and at volatile times like these that can cause uncertainty around the 'true' value of the portfolio, which can impact sentiment and cause discounts to net asset value (NAV) to widen.” 

On your marks

Alan Brierley, director of investment trust research at Investec, says this can mean the valuations of the investments listed on a trust’s factsheet considerably lags the reality of what price those assets could actually be sold for if they were on the market today. These prices are known in the industry as 'marks'.

The discount or premium at which an investment trust trades is the difference between the total value of the shares in an investment trust and the total net value of the investments made by the manager of the trust on behalf of the shareholders. 

We are seeing more resilience across the private equity portfolios than the market is giving them credit for.Anthony Leatham, Peel Hunt

A trust trading at a discount to its net assets implies that investors do not believe the present value of the investments will be maintained in future, either as a result of lack of confidence in the fund manager, or in the asset class. 

Brierley says: “The key to understanding where private equity trusts are right now is that several of them have not written down the value of their investments to reflect where the market is now. Many of them do that only on a quarterly basis, and some even less frequently. The end of the year is the next point where many will revalue.”

The context of this is that further downward revaluations could mean the present share prices could fall much further, and cause the discounts to widen even more.

Brierley says it is difficult to generalise across the sector in terms of whether the present share prices of the trusts reflect any coming write-downs in the value of the investments. He notes for some trusts “the impacts of the write-downs is still to come”.

Iain Scouller, managing director for investment funds at Stifel, says that even if widespread write-downs are to come, the bad news may be reflected.

At current valuations, we take a positive view on the sector and see significant scope for a re-rating.Iain Scouller, Stifel

He says: “While we continue to expect some 'haircuts' to valuations at the important December 31 2022 valuation point, we think current discount levels are implying NAV write-downs of 20 per cent to 30 per cent.

"We think this is excessive given earnings at many underlying companies continue to be relatively robust and many balance sheets remain strong. Catalysts for a re-rating of the listed private equity sector could include a significant positive re-rating of smaller and mid-cap listed companies, possibly once markets can see beyond rising interest rates.

"Another factor that would re-rate the sector is the emergence of corporate activity. At current valuations, we take a positive view on the sector and see significant scope for a re-rating.”

Leatham notes: “When we look at the NAV data reported so far this year, we are seeing more resilience across the private equity portfolios than the market is giving them credit for. 

"Based on our analysis of share price performance versus lagged NAV’s (to take account of the delayed reporting), there have been six clear instances of discount 'overshoot' for private equity fund of funds over the past 15 years and this is one of them.

"Our pick in the sector is HarbourVest Global Private Equity, which has delivered 23 per cent annualised NAV total return over the past five years and is trading on 45 per cent discount to end September 2022 NAV."

The private equity fund managers knew the party wouldn’t last forever.Richard Hickman, HarbourVest Private Equity trust

Leatham adds: “If we look at valuations going into 2022, the aggregate underlying portfolio valuations (using EV/EBITDA multiples) across the private equity fund of funds were undemanding, particularly in comparison to the S&P 500. 

"In our experience, funds are typically conservative with their valuation adjustments on the way up, which is why we have seen such attractive uplifts to carrying values on realisations. This also suggests that the valuation correction might not be as bad as listed equity markets might imply.”

This point around the difference in valuations between public and private markets, and the ability of private equity to act as a diversifier is something also highlighted by Brierley, who says some trusts have a correlation of only around 50 per cent to listed equity markets, and therefore can act as a diversifier.   

Interested parties

Richard Hickman, who runs the HarbourVest Private Equity trust, which invests in other private equity funds, says one feature of the sector in recent years is they have not overloaded with debt, despite interest rates being low, as he says "the private equity fund managers knew the party wouldn’t last forever". 

Brierley agrees that debt levels are much lower this time, and says this contrasts favourably with the debt levels that were reached, but he says a bigger issue may be the fees charged – he notes that even in normal times “the high fees were leading to discounts staying quite large at around 20 per cent”. 

Leatham notes the disadvantages outweigh the problems right now, saying: “The longer-term track record of some of the leading private equity managers has been strong with material outperformance of listed equity indices and lower volatility.”

David Thorpe is special projects editor of FTAdviser