Unlisted stocks: risks, rewards and trust routes to profit

Investment trusts are the best option for investors seeking exposure to unlisted companies, explains Cherry Reynard.

At the height of the technology boom, fast-growing companies scrambled to get their hands on a stock-market listing. It brought capital and it brought respectability, giving companies the firepower to grow.

Today, however, initial public offerings (IPOs) have lost their lustre - too much regulation and scrutiny has seen many early stage businesses turn to private capital to fund their expansion. Increasingly, investment trust managers are having to look to this part of the market to capture growth opportunities.

Since the late 1990s, there has been a notable fall in the number of publicly listed companies. Today, there are around 3,000 public companies, around half the level of 25 years ago. In 1996, IPOs ran at a rate of around 700 per year; last year it was just 100. Perhaps more importantly, many of the most exciting, high-growth companies have chosen to stay private for longer – Uber (NYSE:UBER) or Airbnb in the US, Revolut or Transferwise in the UK.

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Why are companies taking this approach? First, there is more money floating around in private equity today. Money has flowed into the sector as investors, particularly institutional investors, have sought out high-growth assets in a lower-growth world. According to the most recent McKinsey annual review of private investing, private market assets under management grew by 10% in 2019, and $4 trillion in the past decade, an increase of 170%. This compares to an increase in global public market assets under management of approximately 100%. This has meant that the capital is there for companies to grow far bigger while remaining private.

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Equally, there are sound reasons why companies may want to stay private. A stock-market listing increasingly comes with a long list of reporting and regulatory obligations. In particular, the obligation to report financial data quarterly can bring unwelcome short-term scrutiny for companies trying to grow for the long term. 

Stewart Heggie, investment specialist on the Scottish Mortgage (LSE:SMT) investment trust, gives the example of a healthcare company. Many early stage healthcare companies burn through capital in the early stages while they are getting drugs to market and public markets are not necessarily forgiving. He says: “Companies may be looking to find a test to detect cancer early, for example, through blood tests and machine learning. It is easier to do that outside the glare of public markets, which demand quarterly earnings numbers.” It is notable that last year technology and biotech firms raised $50.3 billion through public markets, but $130.9 billion through private investors.

Early stage technology shows a similar picture. It takes time and capital to build a technology solution and revenues – and certainly profits – may not appear for some time. A company’s share price can remain depressed and volatile in the interim. Private ownership gives companies more space to focus on the business, rather than meeting short-term shareholder expectations.

Changing the opportunity set

This is changing the opportunity set for investment managers. Within the investment trust sector, fund managers looking for growth companies are increasingly looking at both public and private markets. Heggie explains: “We want to identify the big drivers of change and seek out companies that can become significantly larger. It is nothing to do with whether a company is private or public. It is about the opportunity set that’s presented to us.”

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This phenomenon has seen Scottish Mortgage expand its weighting in private equity from under 5% in 2015, to more than 20% today. Shareholders recently voted in favour of increasing the maximum percentage of privately owned businesses in the portfolio from 25% to 30%.

Scottish Mortgage has tended to stick with large, well-capitalised businesses, in many cases larger than their public equivalents. Ant Financial, for example, has a current valuation of $150 billion. This would make it a FTSE 100 company were it to be listed in the UK. It has had a long-standing holding in Alibaba (NYSE:BABA), which is now a $767 billion public company (the group has held since it was private). Its other holdings include Spotify (NYSE:SPOT) and Meituan Dianping (SEHK:3690), a Chinese food delivery giant. In general, they have enhanced performance, says Heggie: “All had tripled in value by the time they IPO-ed.”

Other trusts operate further down the market cap scale. Nick Greenwood, manager of the Miton Worldwide Opportunities fund, likes the Merian Chrysalis (LSE:MERI) and Oakley Capital Investments(LSE:OCI) trusts. On Merian, he says: “The trust specialises in ‘crossover’ investments – they buy when a company is private and run with it once it has gone public. They have had some early successes with Hut Group and Transferwise.”

Merian Chrysalis holds fewer than 10 investments at any given time. It is run by the group’s small and mid-cap team (now part of Jupiter). “What they found when running a significant book of UK equities was that the real excitement was coming from the unlisted sector rather than the listed sector. They found they had capital to invest but couldn’t access the most interesting part of the economy,” says Greenwood. Oakley Capital Investments has slightly more holdings, with a specialism in online education.

Performance has been good for these two trusts. Merian’s Transferwise sale has helped boost the net asset value of the trust by 23.5% over the past year. Oakley Capital Investments is up 5% over one year and 53% over three years. The potential returns available from private companies are compelling.

The elephant in the room

The elephant in the room, however, is Neil Woodford’s ill-fated Patient Capital trust, now being re-made as the Schroder UK Public Private Trust (LSE:SUPP). Under Woodford, this included a number of holdings in earlier-stage private companies and performance was horrible. Performance under Schroders’ management has been far better, but the trust is still down 73.2% over five years (at time of writing in early September).

While this is more to do with the unique circumstances surrounding the failure of Woodford Investment Management, the experience of Patient Capital exposes the risks in this part of the market – early stage companies are illiquid; there may not be a ready buyer waiting in the wings. They are often smaller, which may leave them more vulnerable in difficult economic conditions. Equally, price discovery is not as clear-cut, and returns will be lumpy because exits can be unpredictable. 

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This is why this type of investment can only really happen in an investment trust structure - this is a long-term game. Nick Greenwood says: “They are completely illiquid and so only suit a closed-ended vehicle, which doesn’t have to manage redemptions.”

Private equity does require a different portfolio management approach. It helps if the team has financial clout. Baillie Gifford has built a lengthy reputation as a long-term and supportive shareholder. It is always likely to get the call when companies are looking for capital. Similarly, says Greenwood, Merian’s experience in the small and mid-cap space gives it considerable muscle and brings it access to the better deals.

There is one final consideration looking forward. To date, private equity has been associated with high-growth companies, but it may fulfil another role if an increased focus on ESG forces “grubbier” companies out of public markets. With greater scrutiny of the way companies are governed and how they run their operations, there are fewer and fewer buyers for companies in toxic industries such as tobacco or armaments.

It may be that these companies ultimately become so cheap on public markets that they are better off in private hands. Tom Beckett, chief investment officer at Psigma, says: “If companies continue to trade at a significant discount, they will start to attract private equity buyers. Public money can’t invest, so companies take private.” This is not currently where many investment trust managers are operating, but it may start to change the nature of private equity investments further down the line. 

The make-up of markets changes over time and fund managers need to change with them. Forward-thinking investment trust managers have recognised that they need to be investing in private equity or miss out on new growth opportunities. This brings risks, but in the right hands, there can be good returns on offer.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.