A glaring opportunity to snap up these cheap investment trusts

Private equity investment trusts look like a glaring opportunity. They are trading at or near all-time record discounts after a long period where the sector has been out of favour. Holdings in the trusts have generally continued to perform well, with valuations stable. Yet these trusts continue to be unloved by investors, who mistrust valuations and fret about the risks. Can sentiment turn?

The long-term arguments for private equity are sound. Many companies are staying private for longer, giving private equity investors a broader opportunity set. There are fast-growing companies in private markets that have no equivalent in the public markets. At the same time, private equity has delivered higher returns to investors over the long term. Even after its recent rout, the Association of Investment Companies (AIC) private equity sector is up 43% over three years, the third best-performing sector over the period.

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However, the short-term experience for investors in private equity has been painful. Investors have headed for the door, spooked by a combination of rising interest rates, fears over valuations and a general “risk off” mood in markets. Private equity has also suffered from poor public relations - the high leverage, aggressive tactics, eye-watering fees and chunky remuneration packages for chief executives seen among the largest private equity players has done the broader sector a disservice. This is not where most most private equity investment trusts ply their trade, but they have suffered by association.  

Colm Walsh, managing director, investment team at ICG Enterprise Trust Ord (LSE:ICGT), is clear that not all private equity is created equal.

He explains: “The sector covers a range of sectors, countries, investment styles. Making an investment in a venture capital start-up is a very different proposition – with very different risks – to acquiring a controlling stake in profitable, cash-generative companies that have been around for years.”

However, investors have not been making this distinction. Rising interest rates have impacted the sector in a number of ways. Most private equity trusts do not dabble in the leveraged buyout market, which has benefited so richly from low interest rates and now looks particularly vulnerable to higher borrowing costs. This is the part of the market that gathers many of the headlines. However, higher rates have still had an impact elsewhere.

Valuation worries

Specifically, it has hit the way companies are valued. When interest rates are high, the long-term cash flows of a business becomes less valuable because investors can get a higher return on low-risk assets. This has forced a period of adjustment and created some uncertainty – and mistrust - on the underlying valuations for the assets in private equity trusts.

There have been other problems on valuation. While almost all trusts have their assets valued independently, usually every quarter, this process has become more difficult. Many valuers rely on comparable valuations in the public markets or IPOs to guide their analysis. Weakness in the public markets until November of last year has been a problem.

Richard Hickman, manager director on the HarbourVest Global Private Equity Ord (LSE:HVPE) trust, adds: “Interest rates have impacted the cost of capital. This has had an effect on exits and the number of companies being sold.”

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In addition, the IPO market has been sluggish, with high-profile IPOs such as those of buy-now-pay-later group Klarna and clothing group Shein postponed. This has been felt all the way down the market and helps explain the chunky discounts.

Operational strength

However, amid all this noise, many private equity fund managers report that the companies in their portfolios have been ticking along nicely. Jim Strang, chair of HgCapital Trust Ord (LSE:HGT), says the group’s portfolio continues to perform well with the fund’s top 20 holdings growing sales and earnings at a healthy 25% and 30% respectively over the past 12 months. The trust focuses on software and tech-enabled services, which have proved largely immune to economic volatility.

In many cases, the underlying portfolios are well-diversified, and focused on profitable, cash-generative private companies, rather than higher risk, or higher leverage companies. HarbourVest, for example, is a fund of funds, its assets spread across a vast range of businesses and seeking to partner with the best private equity managers. In addition, Pantheon International Ord (LSE:PIN) invests in a diversified portfolio of private equity assets managed by third-party managers across the world. Neither fits the popular stereotypes of private equity.

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James Carthew, head of investment company research at QuotedData, says the discounts look increasingly irrational: “The discounts are, for the most part, entirely undeserved.” He points out that (as at mid-April 2024), while some top-performing funds have low discounts - Hg Capital has a -5% discount and its NAV returns over one year are 20.1% and Literacy Capital PLC (LSE:BOOK) is on a -4.5% discount and its returns are 47.0%. – this is not universally true.

“Looking at the peer group on this basis, the -33% discount on Oakley Capital Investments Ord (LSE:OCI), which has outperformed Hg Capital seems odd. Not far behind Hg is HarbourVest Private Equity, up 19.5% per year. Yet it trades on one of the widest discounts (-42%) of the lot.”

Most private equity managers are confident that there is no looming bad news on valuations. Strang says: “The Hg Capital Trust portfolio is robustly valued and validated by external auditors. Furthermore, the trust’s exit activity over 2023, saw an average uplift of 25% above carrying values. Evidence from other listed PE peers also supports the valuations that these managers ascribe to their assets.”

Walsh agrees that the best proof-point is at exit. The ICG Enterprise trust also has a solid track record of exiting businesses at higher valuations than they were held at on its balance sheet.

Will investors catch up?

The question is whether the gap between perception and reality will be recognised by investors. Hickman is encouraged by an improvement in secondary sales for companies. “This should improve liquidity,” he says. He says the recent revival in public markets will also be important in reassuring investors that valuations are sound. Equally, a stabilisation in interest rates should improve sentiment.

Boards are also taking action to improve share price performance. Carthew points out that private equity trust boards are buying back shares to boost the share price and draw in discounts. The ICG trust has also implemented a progressive dividend policy to help support the market for its shares.

Buybacks are a double-edged sword. Nick Greenwood, manager of MIGO Opportunities Trust Ord (LSE:MIGO), says that they should help address the over-supply problem in the sector, but it does mean that some trusts are selling assets to fund buybacks and that could impact performance.

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There is an elephant in the room, however. An obscure regulatory ruling on how costs are attributed has made it difficult for wealth managers to buy the trusts, removing an important source of demand. Carthew says: “The main problem is that professional investors are not buying these funds, and some are actively selling them, because of misleading cost disclosure rules that make the professional investors’ services look quite expensive to their underlying clients if they incorporate funds, and especially funds of funds, within their portfolios. Various politicians are working to fix this problem, but progress has been frustratingly slow.”

Greenwood agrees that this is a key problem: “There are lots of investors who love investment trusts stuck on the sidelines.” If the problem is resolved, it could spark a wave of buying, but it difficult to predict when that might happen.

Knowledge gap

Private equity trusts recognise that improving the understanding of private equity trusts would help. Hickman says. “There tends to be a view that private equity is a black box. We are working to try and break down barriers, putting more information in our annual results and being seen to defend the sector.”

In particular, the investment trusts can seem homogeneous, but do quite different things. For example, HGT is focused on technology, HVPE is more generalist, and Oakley Capital specialises in technology, consumer and education. There are also generalised growth trusts that have a share in private equity – such as Scottish Mortgage Ord (LSE:SMT) - although this tends to be at the larger cap end.  

Private equity has a place in an investor’s portfolio, for both diversification and long-term growth. The worst is probably over for share prices, valuations are sound, and the underlying investments in private equity trusts are, in many cases, growing robustly. In this respect, there is a glaring opportunity in private equity. However, sentiment is fickle, and there remains a regulatory cloud over the sector. This may delay a revival in share prices in the short term.