It is the same for all the less liquid asset classes such as this, as we seek to take advantage of the wide discounts available. While these discounts have narrowed significantly, particularly since the last quarter of 2012, there are still some historically attractive opportunities available, particularly among the fund-of-funds. What we also hope to see is net asset values continuing to appreciate as realisations from the portfolios are made at above book value and valuations reflect the growth in listed comparables.
It is worth dropping back a few years to understand why these discounts exist, but also where they have come from. Most of the fund-of-fund vehicles operate on a policy of over commitment, i.e. they pledge to invest more cash into funds in the future than they currently have available on the assumptions that this will be drawn down over an extended period of time and that their existing portfolio will be churning off cash from realisations. This worked fine until late 2008 when the credit crunch hit.
Narrow escape
Having enjoyed several years of strong IPO markets and plentiful deal flow the over-commitment issue was unquestioned but as liquidity in the system dried up so did the IPO and trade sale market. This left many of these trusts stranded with no apparent ability to meet these commitments when called. As a result discounts blew out massively as investors fled for the exit. Discounts of 60% became not uncommon.
A couple of things happened that led to Armageddon being avoided.
First, commitments were reduced by selling them off in the secondary market. Secondly some trusts were able to raise money to plug any immediate shortfall. Those in strong positions also raised cash to take advantage of distressed selling in the market. Most importantly was that there was virtually no money called for investment in this time as deal flow completely dried up at both ends of the chain.
Prices in the sector did continue to drift lower for a while longer as there was a raft of write-downs on deals done at the peak of the market and a few investors threw in the towel right at the bottom. However, with disaster avoided the brave were able to pick up some ludicrously cheap stock at these levels. As an example, in the second quarter of 2009 you could have bought F&C Private Equity at 49p. Today it trades at 218p.
What has happened since is that asset values have stabilised and have been rising steadily over the past few years. Balance sheets are in far better shape and are generally churning off more cash than they are investing.
As an example, in 2011 F&C Private Equity received distributions of £36.1m and had capital calls of £30.1m. In 2012 these figures were £60.6m and £31.7m. Its NAV also hit an all-time high at the end of 2011 and has improved steadily since.
Compare this to the broader equity markets where the US is just breaking through historic levels, while the UK and Europe are still some way off.
It finally appears that the market has woken up to these facts and we have seen discounts narrow significantly as investor appetite for risk assets has improved. While there is definitely not the same value available today that there was, the sector still trades on a historically attractive discount.
There were, however, a couple of casualties, the most significant being SVG Capital and 3i Group where significant change has occurred.
SVG was far too overcommitted to Permira funds and also had some disastrous, highly leveraged investments when the music stopped. A painful rights issue helped the company emerge wounded but not dead and asset value growth in the recovery has been impressive. 3i Group, long considered the bellwether for the sector, struggled too but this time only down to its structure and poor deal-making throughout the past decade. It too has recovered strongly since Simon Borrows was brought in as CIO mid way through 2012. He has taken an aggressive axe to costs in the business and has been selling assets at an impressive pace to reduce the company’s debt.
Ones to watch
Trusts we particularly like are F&C Private Equity, Standard Life European Private Equity, NB Private Equity, Pantheon International Participations and HarbourVest Global Private Equity. Pantheon has a global mandate; F&C and Standard Life are much more UK and Europe focused; and NB and Harbourvest are predominantly US exposed.
There are others in the peer group we would be more than happy to hold but just don’t have enough space for.
Of the more conventional vehicles that make investments directly – Electra – has for a long time been one of our preferred plays. Their conservative style and long-term view enabled them to ride out the global financial crisis in very good shape. Indeed, over the past 18 months their portfolio has had some significant realisations and uplifts to book value. In December 2010 they launched a seven year, 5% convertible unsecured loan stock, to take advantage of the wave of distressed sellers of assets in the market place.
At the time the ordinary shares traded at just under £17, a 17% discount to asset value. The CULS (convertible unsecured loan stock) would become convertible at a price of 2050p on the ordinary share price. We took part in this issue across all three of our multi-manager funds. Our view was that we could see Electra making ground over seven years in terms of asset value and that over that time, the discount was likely to narrow. If we were wrong and the world economy had another setback or the management team at Electra lost its sparkle, we were being paid a very nice 5% coupon with huge amounts of downside coverage as the convertible was a relatively small part of the overall capital structure.
If we now fast-forward a couple of years the situation looks very interesting. The discount on the ordinary shares has narrowed slightly to 15% but the NAV has risen to over £27. The convertibles have moved ahead from 1000p to 1220p reflecting the likelihood of conversion. Despite this they still yield over 4%. Electra has a lot of cash available for investment and our most recent update with the management revealed they are seeing a lot of opportunities as banks are still forced sellers of assets. With just under another five years to run it seems highly improbable that the convertibles will not convert and that the asset value of the ordinary shares will not be substantially ahead of where it is today.
In conclusion, a lot of the low-hanging fruit in the listed private equity space has already been picked but discounts are still pretty attractive on a historical basis. Asset values looks set to continue and balance sheets are in far better shape than they were before the credit crisis, thus they should hold up far better in any market shock than they did before.
