The investment trust discounts that risk becoming ‘embedded’

An analyst has called on investment trusts in the sector to become more proactive to tackle their wide discounts.  

Private equity investment trusts risk languishing on wide discounts until there’s a collective re-think on share buybacks, according to analysis by Investec.

In a note on the sector, Investec pointed out that there’s some impressive long-term performance, with HgCapital Trust (LSE:HGT) and HarbourVest Global Private Equity (LSE:HVPE) standing out with net asset value (NAV) total returns of 391% and 379%. This comfortably outpaces the MSCI World index return of 187%.

However, the analyst points out that wide discounts “dilutes returns”, and have now “become embedded” due to investor concerns over valuations on unlisted companies, which are made behind closed doors.

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Discounts have widened across the private equity sector in response to higher interest rates, which has caused a re-pricing of risk assets. Some investors are sceptical that the valuations for unlisted companies have not fallen enough.  

The predicament that investors face is that the value of the underlying investments, the NAVs, are reported quarterly by private equity trusts. This results in a timing lag on when the valuations are reported. Therefore, those NAVs potentially do not reflect the reality of what those assets could be sold for today.  

Investec points out that while the NAVs of the traditional private equity companies have proved resilient since the beginning of last year, the average discount has widened from 13% to 37%.

The analyst was critical that the boards of private equity trusts have failed to tackle the wide discounts with share buybacks. It points out that share buybacks have been just c.0.7% of shares in issue for the sector.

Investec's investment director Alan Brierley noted: “To be candid, for many years, we have been underwhelmed by discount management in the Listed Private Equity sector. The typical modus operandi for too many companies appears to be to state that the discount materially undervalues the portfolio, express frustration about stubborn discounts, and proclaim that buybacks ‘don’t work’.”

According toBrierley a collective re-think is required. He adds: “Rather than simply dismiss share buybacks out of hand, we strongly believe that they should form an integral part of an effective capital allocation strategy.”

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Share buybacks reduce the number of shares in circulation. This creates less of an imbalance between supply and demand. In theory, this will reduce the trust’s discount, benefiting its shareholders as the share price will be given a boost as it narrows towards the value of the trust’s underlying investments.

However, some boards are reluctant to do share buybacks because the overall size of the investment trust is reduced. 

Moreover, it is not a panacea. Buybacks won’t prevent discounts widening if there is just no demand for the shares.

In the case of private equity trusts Brierley points out that buybacks would “give some comfort over valuations at a time when there are clearly concerns.”

He also points out: “In addition, buybacks provide liquidity and can help to calm discount volatility.”

If discounts are not addressed, Brierley is concerned private equity trusts could face a wave of takeovers from hostile investors attempting to benefit from the big gaps between net asset values and the share price.

Brierley points out that for the traditional private equity focused investment companies “the quality of the underlying portfolios and a conservative valuation process represent solid foundations for superior long-term NAV growth.”

He adds: "In the event of a risk-off environment (and we note that stagflation expectations are near historical highs in the latest survey of global fund managers), we would expect these key features to underpin relatively defensive and resilient characteristics."

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Private equity versus growth capital 

Private equity invest at the higher end of private equity market through taking majority control in cash-generative, profitable and more mature businesses.

At the other end of the scale are growth capital focused mandates. These investment trusts back earlier stage companies, which carry both greater risk and greater potential rewards. All of the seven trusts in this sector have posted notable share price losses over the past year, with Seraphim Space Investment Trust (LSE:SSIT), Schiehallion Fund Ord (LSE:MNTN) and Chrysalis Investments Limited (LSE:CHRY), all down just over 50%.

In contrast, private equity trusts have held up better. With the aforementioned HgCapital Trust and HarbourVest Global down -1.6% and up 0.7%. 

In conclusion, Brierly notes “our central thesis remains that this sector is now enduring a valuation reset” following on from “an exceptional period when a tsunami of easy money drove late-stage venture capital valuations to nose-bleed levels, which we believed were, and still are, unsustainable.”

He adds: “Either underlying companies must now grow into these valuations, or these valuations must move towards fair value.”