For more than a decade, investors who operate private equity trusts enjoyed a very fair wind.
An outcome of the quantitative easing policies that emerged after the global financial crisis was that both listed equity and bond prices rose sharply, prompting a cohort of investors to seek diversification in unquoted, or private, equity.
This made raising money from investors relatively easy, while low interest rates made the cost of debt cheap, potentially boosting the returns from investments as private equity trusts both raise equity from clients and borrow.
The extent of that performance is illustrated by the returns achieved, with those private equity investment funds that have a 10-year track record delivering an average of 301 per cent over the period, compared with a return of 187 per cent for the MSCI World index and 87 per cent for the FTSE 100, according to data supplied by Investec.
But an examination of the share price performance of the private equity trusts available to UK advisers and their clients indicates a sharp drop in sentiment towards the sector.
Investment trust discounts
This share price decline means many of the largest funds trade at steep discounts to their net asset value.
Part of the more cyclical factor reflects the economic and market conditions described above — 2022 saw bond markets sell off, thus enabling the traditional inverse correlation between bonds and listed equities to be restored, reducing the appeal for some investors of owning private equity trusts for diversification.
Additionally, given the extent to which interest rates have risen, private equity trusts are faced with higher debt-servicing costs at a time when the companies they bought — and which are supposed to generate the cash to service the debt — may be struggling to grow profits given the wider economic climate.
The potential for these trusts to suffer as they refinance the cheap debt built up during the pandemic has been described as a “cliff edge” by some market participants, but Stifel managing director for investment funds research Iain Scouller says there is “no sign” of the higher debt costs eroding returns yet.
He thinks that fears around the impact of higher rates are misplaced because many of the trusts took the opportunity to lock in low borrowing costs in the years when rates were very low.
For Peter Walls, who runs a fund designed to invest in investment trusts, the Unicorn Mastertrust, much of the bear case cited above is overblown.
He says it is a “good time” to invest in private equity trusts, because many of the negatives such as the potential impact of higher interest rates are dissipating, with it being likely that we are near the peak of the interest rate cycle.
On your marks?
Walls adds that there is “little evidence” that the net asset values of the listed investment trusts in the UK are “too optimistic” at present, and that there is no real incentive for the fund managers to do this because their bonuses are linked to the prices the investments are sold at, rather than the price they are valued at in the accounts.
Real life examples of the true value of the investments held by private equity trusts can be found in the recent results of both the Pantheon International and the RIT investment trusts.
Pantheon reported that, on average, when it has exited an investment over the past two years, it has achieved an average sale price more than 20 per cent higher than the value of the investments in their accounts.
As part of its results announcement, Pantheon says it is taking action to close the discount at which the shares trade, by buying back £200mn of the equity.
Alan Brierley, who heads the investment trust research team at Investec, says the strong net asset value performance of investment trusts “hasn’t been much use” to clients, because they do not get paid the net asset value on the sale, but rather the share price, which is lower. He says Pantheon’s actions may spur other trusts to follow suit, and be a “game changer” in terms of sentiment towards the sector.
Given the extent to which interest rates have risen, private equity trusts are faced with higher debt-servicing costs at a time when the companies they bought may be struggling to grow profits given the wider economic climate
The RIT investment trust is not a dedicated private equity fund, but it does have extensive unquoted holdings, and on recent asset sales the prices achieved were higher than the value of those assets in the accounts.
Scouller says he remains confident in the valuations of unquoted companies, at least in the context of businesses that were last revalued at the end of 2022.
He says there are two reasons for this view: the first is that the profits of listed companies have not been declining, just growing at a slower pace, so similar can be expected, in aggregate, for unquoted companies.
Scouller adds that the multiples — that is the valuations of listed companies relative to their current profits — have remained steady, implying that the same multiples should apply now to private companies as they did at the end of 2022.
Brierley believes the issues around valuations apply more to earlier-stage companies, which he says could suffer “brutal” writedowns, than to private equity investments, which are later-stage.
Timing is everything
Mick Gilligan, who runs the model portfolio service at Killik and Co, believes there is a very specific time in a market cycle to invest in private equity investment trusts, namely when public equity markets are beginning to recover following a sell-off.
He says: “I think current conditions are more indicative of late-cycle [in listed equity markets] rather than early cycle. So I would prefer to focus on quoted equity, with lower fees and greater transparency.”
Brierley says a structural problem can be added to all those cyclical issues, as the fees levied on such trusts are high, and share buybacks — the instruments by which discounts can be reduced and which boost shareholder returns — did not really happen.
He describes this as “not fixing the roof when the sun was shining”.
But he adds that there are also structural positives for the sector, particularly because a phenomenon of recent years has been for companies to remain unlisted for longer, meaning there are a greater range of unlisted companies to invest in than has been the case in the past, changing the long-term reasons for owning private equity funds.
Gilligan, however, is sceptical whatever the long-term positives, because he believes some of the long-term negatives associated with the asset class remain.
He says the fees charged by private equity trusts tend to be far greater than those charged on conventional investment trusts, the latter tend to have charges of below 1 per cent whereas the average fee for a trust in the private equity sector is 2.8 per cent. For this reason, he says he prefers venture capital investment trusts instead.
Brierley is less concerned about fees, because he says the returns achieved by the sector, even after the deduction of fees, are attractive compared with those available from listed equities.
But he believes the cost disclosure regime has been a “dragging anchor” on sentiment for many years and this has contributed to wide discounts and elevated volatility.
However Brierley said the ongoing review of this regime, including the recent decision to scrap the packaged retail investment product rules in the UK, may level the playing field for the closed-end sector, which would be a “significant boost”.
Market conditions change, but clients’ demand for diversification is continuous. The years ahead are likely to determine how prominent a role private equity trusts play in those portfolios, following a period of exceptional returns in extraordinary market conditions.
David Thorpe is investment editor at FTAdviser
