A change in fortunes for private equity trusts?
David Prosser explores whether the tide might finally be turning for private equity trusts and their investors.
Is the penny finally dropping for investors in private equity-focused investment companies? Shares in these funds have consistently traded at significant discounts to the value of their underlying assets over the past year to 18 months, with investors concerned about nasty surprises to come in their portfolios of unlisted businesses. But sentiment appears to be shifting.
The average private equity fund began the year trading on a discount of just over 25%, data from the Association of Investment Companies reveals. Today, that figure has fallen to a little over 4%. In other words, investors in the average private equity fund would have seen a return of more than 20% even if the underlying asset value had not moved at all (in fact, much of the sector has seen modest asset value gains this year too).
Now, there is one big caveat here. One very significant driver of the tumbling average discount has been the dramatic change at 3i Group, which is by some distance the largest private equity investment company of them all. 3i has moved from a discount of 17.5% at the beginning of 2022 to a premium today of just above 10%. That swing of close to 30 percentage points at such a large fund has had a disproportionate effect on the average figures for the sector.
It's also the case that 3i is an unusual fund, in that a very significant chunk of its assets is concentrated in a single holding, the highly successful Dutch discount retailer Action. There is therefore less uncertainty for investors to worry about, and with Action performing very strongly this year, 3i has reaped the rewards.
Nevertheless, other investment companies in the private equity sector have also seen their discounts narrow, albeit less markedly than 3i’s. By the end of the first half of the year, 11 of the 18 investment companies in the sector stood on a more expensive valuation. Funds such as Princess Private Equity and Dunedin Enterprise saw double-digit improvements.
"The average private equity fund began the year trading on a discount of just over 25%, data from the Association of Investment Companies reveals. Today, that figure has fallen to a little over 4%. In other words, investors in the average private equity fund would have seen a return of more than 20% even if the underlying asset value had not moved at all (in fact, much of the sector has seen modest asset value gains this year too)."
David Prosser
All of which means the dial may be shifting at last. There was a time when it was easy to see why private equity fund discounts were so wide. As the economic storm clouds gathered, it seemed inevitable that many funds would have to announce problems at their portfolio businesses – and that they would need to adjust their valuations accordingly.
However, that hasn’t happened in any meaningful way. Indeed, a number of funds have even been able to dispose of assets at prices significantly ahead of their valuations. We may still be set for a wave of downgrades, of course, but with the economic outlook finally beginning to improve – the Bank of England now expects the UK to narrowly avoid recession, for example – there is reason to hope that crisis has been averted.
In which case, many private equity funds have been trading at much lower valuations than they have deserved. And the good news is that the discount narrowing we have seen so far, other than at 3i, could be just the beginning. As financial markets begin to shed their risk-averse stance, there is the potential for a much more substantial rerating.
We’re not out of the woods yet. It’s still possible that some funds in the sector will publish disappointing updates – and that the macro backdrop may yet take a turn for the worse. Still, private equity funds could just be closing in on their return to the sun.
