Has Woodford changed DFM attitudes to unlisted companies?

Scrutiny of unquoted holdings in open-ended funds comes as companies stay private for longer

Woodford

Companies opting to remain private for longer are creating opportunities for fund managers operating in the unquoted space. But the implosion of the Woodford Equity Income Fund due to liquidity problems has shone a negative light on the asset class, particularly when it is held in open-ended funds.

Data detailing the extent of unquoted exposure in UK-domiciled open-ended funds is limited.

In an FE Analytics search of funds in the Investment Association universe containing unquoted companies, it is only Merian that provides data, although it shows weightings from before the shift of unquoteds from its open-ended to closed-ended Chrysalis trust. Merian UK Mid Cap currently has the largest weighting at 6%, according to the Merian website.

Woodford Equity Income, now known as LF Equity Income after ACD Link gave Neil Woodford the boot, does not divulge unquoted holdings to the data provider. Neither does Mark Barnett, Woodford’s protégé at Invesco, who holds many sizeable stakes in the companies preferred by his former mentor.

In Morningstar Direct, there is no standard data point to show the percentage of unquoted stocks in a fund.

Willis Owen head of personal investing Adrian Lowcock does not believe the Woodford Equity Income Fund wind-down has changed people’s appetite for unquoted companies. Instead, discounts on private equity investment trusts, the most accessible route for retail investors to access the asset class, have tightened since the fund first suspended in June, says Lowcock.

IT Private Equity versus Growth Capital sectors

The Investment Trust Private Equity sector discount has narrowed from -26% at the end of December 2018 to -18% at the end of August 2019, according to Association of Investment Companies data.

The Investment Trust Growth Capital sector was also introduced as part of a sector review by the AIC in May. The £1.5bn sector contains four investment companies: Woodford Patient Capital, which generally takes non-controlling stakes in early-to-maturing unquoted companies; Merian Chrysalis; Adamas Finance Asia; and Baillie Gifford’s Schiehallion, which trades at the largest premium in the sector of 16.2%. In contrast, Woodford Patient Capital was trading at 48% towards the end of October.

The sector is likely to be viewed as more mainstream than private equity, says Lowcock, given the latter is often seen as a separate asset class in its own right and part of investors’ alternatives exposure. He feels Merian Chrysalis is a better fit for the sector than Woodford Patient Capital, because the former is “really an extension of the small and mid-cap funds, and most of the investments are in the pre-IPO phase so are proven businesses”.

In contrast, Woodford was invested in companies at a much earlier stage, he says. “Investors should be confident that funds full of unlisted investments feature in the private equity space and nowhere else.”

But even investment trusts in regular equity sectors are increasing their allocations to unquoted companies. Scottish Mortgage received shareholder approval in 2016 to hold up to 25% in unlisted companies. Also the Baillie Gifford US Growth Trust, launched last year, can hold half of its portfolio in unquoteds. Fidelity recently increased the amount its China Special Situations and Japan investment trusts could hold to 10%.

Baillie Gifford US Growth co-manager Helen Xiong says the investment trust wasn’t necessarily launched to invest in earlier stage companies but to be able to allocate to companies that are staying private for longer. The median age of companies was seven years in the ’80s and it’s now 12 years, Xiong says. The growth of the venture capital and private equity industries have facilitated that shift, she adds.

Her portfolio includes 11 unlisted investments, which in aggregate accounted for 11% of total assets and the 50% cap is not a target, she says. Intermediaries tend to have a preference for holding unquoted exposure via private equity investment trusts.

DFMs favour trusts for unlisted companies

James Burns, who co-heads Smith & Williamson’s managed portfolio service, says they hold NB Private Equity Partners, Pantheon International and Harbourvest Global Private Equity, as well as a sizeable chunk in Scottish Mortgage.

Scottish Mortgage is in the IT Global sector but declares a 22% allocation to unquoteds in its latest annual results, including Airbnb and spectacles business Warby Parker.

At Quilter Investors, Cirilium portfolios have a range of exposure to unquoted companies through listed private equity, varying from 1.69% in the Balanced portfolio to 7.79% in the Dynamic portfolio. Alongside private equity investment trusts, such as Harbourvest, ICG Enterprise and Pantheon, it also holds some trusts invested in a mixture of unquoted and quoted companies, such as Riverstone Energy.

The range also has a small holding in the suspended Woodford Equity Income Fund. Quilter Investors portfolio manager Paul Craig says he is “naturally disappointed” with the situation. “As we get the vast majority of our unquoted exposure through listed private equity investment companies, we will not rush into any decision regarding the Woodford holdings. We will continue to employ a fund selection strategy that has provided successful client outcomes over the long-term,” Craig says.

Miton Global Opportunities manager Nick Greenwood has recently brought Oakley Capital Investments and Merian Chrysalis. Greenwood takes a special situations approach to investing in investment trusts and had looked at Woodford Patient Capital “in detail” before the manadate was handed to Schroders. But uncertainty over the net asset value meant he wasn’t enticed by the significant discount.

The early stage of a lot of Woodford Patient Capital holdings is why he views valuation of the trust as more “speculative” than his other holdings that have unquoted and private equity exposure. He points to the trust’s holding Benevolent AI as an example. In September, a minority stake taken by Singapore sovereign wealth fund Temasek saw the valuation of the tech business halve hitting Woodford Patient Capital’s net asset value. “Woodford in the current scenario couldn’t fund the next round and therefore somebody else had to do it. Obviously, that came in much lower,” he says.

Follow-on funding hiccups

Follow-on funding has caused Woodford grief when it comes to liquidity, too. When Rutherford Health, formerly Proton Partners, listed on the Nex stock exchange in February, Woodford made a contractual £80m commitment to provide follow-on funding over the next 18 months. That meant Woodford was stumping up tens of millions of pounds for the cancer treatment company after his Equity Income Fund suspended and was under pressure to improve its liquidity.

Lowcock says the situation highlights the shortcomings in Woodford’s risk management and planning. “There wasn’t a sufficient plan in place for what happens if the portfolio falls 20% or 30%.

“These things are well disguised in a fund that’s rapidly growing in size. In a £10bn fund, a £20m commitment is insignificant. But at £3.5bn when you’re trying to sell everything it becomes very significant.”

Merian would not comment on its investment pipeline, including follow-on funding, due to Chrysalis being a listed company, but said it had no contractual obligations in place as Woodford did. A spokesperson said when fully invested, the investment trust can hold “an appropriate value” of its gross assets in cash or cash equivalents for follow-on investments.

Are stockpicking skills transferable with private equity?

Fund selectors are mixed on whether stock picking and buying unquoted companies are transferable skills.

EQ Investors chief investment strategist Kasim Zafar says alarm bells go off and he steps up monitoring when public equity managers reach into the private space. EQ Investors prefers private equity specialists with a diversified approach, although is weary of the layer of fees in fund of funds. Due diligence of private investment specialists is significantly more complex than public market investors, Zafar says. “The obvious reason is the relative opacity of the private investment industry, meaning we are more reliant on the information presented by the fund manager with limited ability to cross reference things.”

For its impact portfolios, EQ Investors is interested in opportunities in the circular economy and likes that investors can work closely with companies to improve environmental and social reporting and outcomes.

Greenwood says Woodford’s ability will never be known as the portfolio is being sold before it had time to mature, although he believes Merian highlights how crossing over into unquoted markets can be done.

Lowcock suggests that Woodford’s large-cap style wasn’t suited to the fundamental approach needed for picking early-stage companies. “His calls on tobacco, avoiding the banks and the pharma sector have largely been right but he wasn’t a stock picker. For unlisted companies, being a stockpicker probably matters more than the macro.”

A former rival to Woodford, Adrian Gosden, who now manages the Gam UK Equity Income Fund, says he would never invest in unquoteds. “Unlisted is a very different sport. You’ve got to get on the board, you have literally got to be there for the monthly sales figures. Because no one’s telling you and no one’s looking at it and saying ‘Oh, that’s doing OK, that’s doing badly’. That’s what private equity managers do and it’s a different skill.”

Growth fund managers could have a better shot tapping into unquoteds, says Lowcock.

“They are looking for companies that have IPO’d or are about to IPO and therefore they’ve got the network and the contacts. Whereas an equity income manager is up the cap scale and won’t find many private companies that will suit their agenda.”

At Albion Capital, which offers venture capital trusts for retail investors, the investment team is made up of people from management consultancy, investment banking and industry backgrounds, not fund management. Investment banking experience is helpful for preparing companies to be sold to large corporates, which is the exit strategy for most of Albion’s holdings, says managing partner Will Fraser-Allen.

When it comes to consultants, Fraser-Allen points to the healthcare specialists in his team as an example of what they bring to the investment process. “Within their consulting experience, they will have advised healthcare companies on product strategy, marketing strategy as well as all the logistics so they know what a larger business looks like.”

Xiong observes time horizons and access are the main differences between investing in the quoted versus unquoted markets. The average US mutual fund holds a stock for less than 12 months while a venture capital fund typically holds a company for eight years. The average long-term turnover on most Baillie Gifford funds is 10% to 15%, which translates to between seven and 10 years. “Rather than a financial transaction, it’s more of a long-term relationship.”

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