The Bank of England’s change of direction on interest rates has rippled through investment markets. Perhaps one of its most surprising impacts has been felt in the growth capital and private equity sectors, where trusts have seen a considerable bounce over the last three months. After a torrid time for both sectors – and with trusts still on historically high discounts to net asset value – could they finally reverse its weakness?
Private equity trusts have suffered from a reputation problem since 2008. During the global financial crisis some private equity funds ran into problems – it became harder to sell assets but many trusts had made legally binding promises to fund new investments. That meant they were running out of money quickly and were forced to max out their borrowing facilities. It was a difficult and precarious moment for the sector.
Investors have assumed that the same thing will happen again today. James Carthew, head of research at QuotedData, says: “Burnt by this experience, investors seem to sell private equity funds whenever they are worried about markets. However, we should stress that these problems affected only some funds, many of those disappeared and other funds learned a lesson – we do not think there is an overcommitment problem today.”
There has been some revaluation of assets in the sector, reflecting both weaker corporate activity and lower stockmarket valuations. However, over one year, 10 trusts have delivered a positive NAV return, while five have dropped less than 5%. Only Symphony, JZ Capital Partners and JPEL Private Equity have seen double digit falls.
Sheridan Admans, head of fund selection at Tillit, says this is not unusual for private equity trusts: “They have historically demonstrated more resilience than public markets in the face of economic downturns as asset owners have the flexibility to deploy capital more effectively and can insulate investors from panic selling.”
However, discounts have remained stubbornly wide – mostly between 30% and 50%. It has been a similar picture in the growth capital sector, with net asset values relatively stable, but discounts extremely volatile. Investors have continued to anticipate a looming crisis for the sector. In particular, they have looked at the amount of capital going into the sector in recent years, fuelled by lower interest rates, and assumed the bubble must burst at some point.
Investors have also looked nervously at high profile revaluations, such as that of Klarna. It was valued at $46bn in 2021, but a new funding round in 2022 put its valuation at just $6.7bn, an 85% fall. This was a significant part of the fall in the value for the Chrysalis investment trust (it made up over 6% of its portfolio) and investors started to worry that other trusts had holdings that might be similarly compromised.
Equally, there have been fears over the debt levels in the sector. However, Carthew says this misunderstands most private equity trusts.
He adds: “There is a perception too that private equity investment is all about loading companies with debt. That is far from the truth, most of the listed private equity funds set out to build businesses, working in partnership with management. For example, one of the best performing of all funds over the past five years has been Oakley Capital Investments. Oakley helps to build businesses, providing capital and expertise, and introducing people and potential acquisitions. Most of its returns have been driven by the growing revenue and profitability of the businesses that it invests in.”
Nevertheless, there remains some lingering mistrust around valuations. The FCA reflected this concern, with the Financial Times reporting that it would examine the way private assets are valued. It said it would look at the “disciplines and governance” over valuations. While most private equity trusts have their holdings revalued every three months, there are concerns that valuers are slow to reflect market trends, particularly if there are relatively few market transactions.
For Paul Flood, head of mixed asset investment at Newton Investment Management, this is still a deterrent: “Net asset values can seem quite stable, but the companies need a willing buyer and willing seller. There have been considerable changes over the past 12 months as interest rates have gone up a long way and it has impacted the future value of discounted cash flows. Some private equity can have quite a lot of leverage. As a result, we’re more cautious.”
For many investment trust analysts, the solution is to focus on the quality trusts. In general, these are trading at similar discounts to trusts investing in earlier-stage or more volatile assets.
In a recent report, Numis said: “We continue to believe that listed private equity offers an attractive investment case and that the focus of portfolios on high quality, non-cyclical business with consistent earnings streams should leave them well placed to continue to deliver in a range of macroeconomic conditions. We believe HarbourVest is a high quality manager that should be well placed to navigate the current environment.” It added that its current discount of 42% offers “outstanding value”.
Admans picks Pantheon International, which is currently on a discount of 36%. It is diversified across regions, industries, and stages with more than 500 underlying companies. This, he believes, gives it some protection against the revaluation of any individual company. The team is experienced, and has been managing the trust since 1987, meaning it has seen a number of cycles.
The change in interest rate expectations has given the private equity sector some breathing space and may be the trigger for investors to revisit it. There are still concerns on sector valuations, but – by and large – these are reflected in the huge discounts to net asset value. The higher quality trusts appear to have been marked down along with the rest, so they may be the first port of call for investors.