The investment trusts dangerously close to their private stocks limit

Allocations to private stocks are rising as public markets fall. Sam Benstead finds out what this means for your investments.  

Some of the UK’s best known investment trusts are close to crossing their self-imposed limit on ownership of private companies due to plummeting public stock markets but stable unquoted stock valuations.

Scottish Mortgage, the second-largest investment trust in the UK, has 28.7% invested in private companies as of May. Its limit is set at 30%.

Edinburgh Worldwide, another trust run by Edinburgh-based growth investor Baillie Gifford, has 20.2% invested in private companies and has a cap of 25%. Baillie Gifford US Growth has 36.8% versus its 50% limit, while Fidelity China Special Situations has 14.6% in unquoted stocks but is limited to 15%.

Limits are at the time of purchase and breaching them due to stock market moves does not require the fund manager to sell shares. However, it does limit their ability to add new private investments or top up existing positions. The limits are set by a trust's board and any changes must be approved by the board. 

Private company valuations are set behind closed doors, rather than decided constantly by a large pool of investors, as in public stock markets. Baillie Gifford carries this process out every three months using a “valuations committee”, which takes advice from an independent third party, IHS Markit.

Even with regular portfolio valuations, there is a lag between public market and private market share prices.

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William Heathcoat Amory, head of investment trust research at analyst Kepler Trust Intelligence, says: “Private valuations are performed less regularly than public ones, which are effectively every milli-second. Typically, it is quarterly or half-yearly for private investments. Scottish Mortgage reviews all valuations quarterly, with one-third of the portfolio reviewed each month.

“When public markets fall, there will be a lag for private valuations, so as a proportion they will rise initially. Over time, when valuations catch up, there is a chance they become back towards the original balance.”

Anthony Leatham and Markuz Jaffe, investment trust researchers at stockbroker Peel Hunt, note that in normal market conditions, the balance between public and private equity in a portfolio remains steady.

However, they say that when public equity markets experience heightened volatility and sharp drawdowns, the reaction time across the portfolio varies greatly. 

They said: “While the public equity side is marked to market daily, the private equity portion can remain static, causing a shift in the percentage allocations between the two.

“An independent board of directors, tasked with overseeing the investment trust and protecting shareholders’ interests, is expected to be on high alert at times like these. 

“Close scrutiny of the manager’s performance and monitoring of investment limits forms part of their role. Under normal circumstances, should a portfolio reach or exceed its limit in private equity holdings, the manager is prevented from making any new investments on this side of the portfolio.”

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Leatham and Jaffe note that during volatile times such as these, they expect more frequent, independent appraisals of private equity holdings and, importantly, timely adjustments to the valuation of these holdings based on several input factors.

“These factors can include the operating performance of a company, the outlook for a particular sector or industry, the valuation implied by a recent funding round and/or a read-across to public market multiples,” they said.

Heathcoat Amory says coming close to these limits is not ideal, noting that some companies may be relying on existing investors to continue funding them, and so investments might get diluted if the trust can’t fund future investment rounds.

“It is good that there are checks and balances on the manager’s enthusiasm for illiquid investments,” he said.

But Jaffe and Leatham say that it is still worth owning private companies, even when they come up against self-set limits during volatile markets.

They said: “Many investors will have heard of the merits of investing in unlisted companies. Whether it is the view that the world’s most-successful companies could stay private for longer (or might never come to the public markets at all), or that the most exciting phase of growth can happen before a company decides to IPO.

“These investment theses do not suddenly evaporate in the face of volatile markets. However, the expectation is that the valuations of these private equity holdings will be adjusted downwards, [and] the question is by how much,” they said.

One signal that investment trusts are overvaluing their private portfolios is when shares swing to a discount to net asset value.

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Scottish Mortgage trades at a 17% discount, suggesting that investors think that its private portfolio is worth less than Baillie Gifford calculates. Edinburgh Worldwide is at a 16% discount and Baillie Gifford US Growth Trust is at an 18% discount. Fidelity China Special Situations trades at a 2% discount, on the other hand.

Heathcoat Amory says that sometimes private valuations are conservative and sometimes they are frothy.

He said: “Valuers try to avoid froth evident in public markets but if players become too enthusiastic in funding, then valuations will rise.”

Fidelity International said the recent market fall has impacted the net asset value of its China trust as the listed securities have fallen but the static nature of the unlisted investments' valuations had resulted in a greater weighting in the trust.

It commented: “The board is mindful of the risks of investing in unlisted companies, in particular in a single emerging market, but remains confident in the parameters it has set in respect of unquoted stocks.”

Baillie Gifford says that it is not necessarily correct to say that private company valuations are more stable than public company valuations.

James Budden, a director at the firm, said: “Valuations of private company holdings are continually reviewed in tandem with movements in public equity. So, it may not be accurate to say that private valuations are more stable than public – just less immediate.”