Are Scottish Mortgage’s private holdings overvalued?

Scottish Mortgage’s 25% in unquoted companies are sheltered from stock market volatility. Sam Benstead asks if they are due a big downgrade. 

Hidden under the relative calm of stock market indices, growth stocks have crashed. Pandemic winners Ocado (LSE:OCDO), Zoom (NASDAQ:ZM) and Moderna (NASDAQ:MRNA) have all fallen more than 60% from their highs.

All three are held by Baillie Gifford’s flagship investment trust, Scottish Mortgage, whose shares have plummeted 33% from their peak in November last year.

Other high-risk Baillie Gifford trusts have also suffered, including US Growth, down 36% from highs, and Edinburgh Worldwide, off 47%.

But because Baillie Gifford trusts also own private companies – valued every three months – there could be more pain to come as public market valuation falls feed through to unquoted shares. 

As of February 2022, the £14 billion Scottish Mortgage owned 49 private companies, which accounted for 25% of total assets. Top investments include roughly 2% positions in payments group Stripe, rocket company SpaceX and battery firm Northvolt.

Smaller companies specialist Edinburgh Worldwide has 13% invested in private companies, while Baillie Gifford US Growth has 26%. 

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In 2021, 13 of Scottish Mortgage’s portfolio companies went public, some of which had been delayed from the previous year. Shares have fallen dramatically as investors turned against companies that promise lots of growth but are short on profits – all because rising interest rates mean that future profits are less valuable.

This included biotech firm Ginkgo Bioworks, which has since fallen 72% from its highs, flying car company Lilium, which has dropped 73%, and cloud computing firm Snowflake (NYSE:SNOW), down 42% from highs.

Are Baillie Gifford’s private holdings being downgraded?

The private company valuation process is carried out by a “valuations committee” at Baillie Gifford which takes advice from an independent third party, IHS Markit. It values a third of the private component of the portfolio each month, so each three-month period provides a full portfolio valuation.

Baillie Gifford’s private companies are beginning to be marked down. Jefferies, the stockbroker, calculated that half of Scottish Mortgage’s holdings had been downgraded in January, with an average drop of 10%.

This included a 17% drop for online payments firm Stripe, and a 14% downgrade for ByteDance, the Chinese tech firm behind TikTok.

Tom Furlong, equity analyst at Jefferies, said: “The reduction is broadly in line with listed indices, as the Nasdaq 100 was down 8.5% during January. But there could be additional write-downs to come when the remaining portion of unquoted portfolio is reviewed during February and March.”

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He noted that a further 10% of Scottish Mortgage’s total assets could be due to be revalued. According to Furlong, applying the 10% discount points to a 1% drop in the trust’s NAV.

He adds: “Markets declined further during February, so additional write-downs across the board may be required. We also note press reports that some venture capital investors are reducing their valuations of upcoming funding rounds,” he added.

For example, American delivery app Instacart cut its valuation last week by 40%, from $39 billion (£30 billion) to $25 billion.

Does the private portfolio reflect market conditions?

James Carthew, head of investment company research at Quoted Data, said there was a lag effect between public and private market valuations. However, he said that because Baillie Gifford was one of the most proactive fund managers at assessing the value of its private portfolio, investors would not be in for an unwelcome surprise this year.

He said: “Public market sentiment is fickle. Private investors are more long term and therefore unlikely to get huge write-downs compared to public markets. There won’t be lots of flotations this year so there won’t be the huge drops like we saw last year.

“Private equity firms also have a lot of cash, over $1 trillion, so there is enough money waiting on the sidelines to keep valuations high.”

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One measure investors can draw on to assess whether the private book of an investment trust is overvalued is to look if there is a big discount between the share price and the stated net asset value.  A discount could show that investors are more pessimistic than valuers and are marking down private company valuations themselves.

For example, Chrysalis (LSE:CHRY) investment trust is on a 27% discount due to expectation that its portfolio of UK fintech companies are overvalued. However, Scottish Mortgage is trading close to par, suggesting that investors think its private portfolio is not overpriced.

However, Carthew adds that Schiehallion, Baillie Gifford’s private-only portfolio, which trades at 24% premium to its net asset value, is too expensive given the tough market for technology stocks at the moment.

Should investors be worried?

Ewan Lovett-Turner, head of investment company research at stockbroker Numis, said private markets did not behave in the same way as public markets so investors should not expect Scottish Mortgage’s private stocks to mimic the moves of its public stocks.

He points out that the nature of the private companies means that there may not be listed peers, meaning valuations can be less sensitive to stock market sentiment.

Stewart Heggie, investment specialist for Scottish Mortgage at Baillie Gifford, echoes this, saying: “Many of the private names held are disruptive businesses at the cutting edge of huge new markets that could develop into multi-decade opportunities. As a result, they have no obvious comparators in public markets and the valuation adjustments applied to them will not always be in-step with the overall direction of public markets.”

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Lovett-Turner adds that private companies are hugely beneficial for a portfolio and are worth holding even if prices fall.

He said: “Baillie Gifford was early to spot that companies were staying private for longer and have been able to capitalise through their flexible style, which is agnostic to listing status. These are therefore generally relatively large, well-established companies, rather than start-ups.”

Moments of stress in markets often prompt shareholders to ask how we value private companies, according to James Budden, director at Baillie Gifford.

However, he argued that the valuation process at Baillie Gifford was robust. He said: “Shareholders can be confident that the current net asset values are a fair reflection of the assets. Indeed, it is worth remembering that often public equity can be valued on the basis of short-term market sentiment which can bear little relation to the underlying fundamentals of a company.”

Baillie Gifford has been upping its permitted allocation to private companies. Scottish Mortgage recently increased its limit from 25% to 30%, and Baillie Gifford European Growth doubled its allowance from 10% to 20% this year.

Meanwhile, Baillie Gifford US Growth can have up to 50% of the portfolio invested in unlisted company and Edinburgh Worldwide can have up to 25%.