Making the private public

Is it time for investors to take a closer look at the Private Equity sector, via investment companies that provide an accessible route into this asset class? The sector has been in the doldrums for the past 18 months, as investors have retreated from assets seen as more risky. As a result, shares in many funds in the sector are now trading on very wide discounts to the value of the underlying assets – 20%, 30% or even more in some cases.

Those discounts might suggest private equity now offers good value. The counter argument is they reflect market expectations that the current value funds put on their assets will be reduced. Private equity funds hold unquoted companies, which are valued periodically. This is very different from holding listed companies, where the share price provides a constant read out of current value. With private equity, it can take time for bad news to filter through into valuations.

Still, having this debate is getting ahead of ourselves. The first question investors should be asking is whether they want private equity in their portfolios at all. In fact, there are good reasons to think so.

For one thing, companies usually only list on a stock market when they reach a certain size and can demonstrate a performance track record; this means investors who stick to listed companies often miss out on the most explosive stages of growth from early-stage businesses.

But also, private equity isn’t only about investing in young and immature businesses; there are also plenty of large and established privately owned companies. In fact, the number of such companies is growing, because many companies baulk at the regulatory and listing demands that quoted status brings. Data from fund manager Pantheon shows that over the past decade, the number of US and European listed companies is down 23%; the number of private companies has risen 74%.

Private equity, then, provides an opportunity to diversify your portfolio. You’re still investing in the equity of a business – as opposed to a different asset class, such as fixed income – but you’re getting exposure to companies with a different dynamic. And over the long term, private equity as an asset class has been a very strong performer.

That brings us back to the question of timing. We may agree that private equity exposure makes sense in theory, but is now the time to buy?

The short answer is that timing the market – listed or unlisted – is rarely a good idea; calling the top or the bottom is often as much a matter of luck as judgement. Instead, you should be focused on the long term – your potential returns over five years, say, or even longer.

Still, those investment company discounts are certainly eye-catching, particularly since it looks increasingly difficult to justify them, other than in terms of market sentiment. If discounts reflect the expectation of bad news on the portfolio to come, we should be beginning to see more evidence of such upheaval. In fact, most portfolio revaluations in recent months have been relatively benign.

In which case, it may well be that private equity funds are undervalued simply because investors are in “risk off” mode – they just don’t feel comfortable with exposure to more risky areas of financial markets, irrespective of their merits. A change in sentiment would therefore provide additional upside.

One final point here. It’s worth noting that private equity has traditionally been an asset class that is off limits to all but the wealthiest investors. Most private equity firms have very large minimum investments and require investors to lock up their cash for years at a time. Investment companies, however, provide a way into this exclusive sector.

Some funds operate in the same way as traditional private equity firms, buying stakes in unquoted companies themselves. Others are “funds of funds”, which take stakes in private equity firms’ unlisted vehicles. Either way, investment companies, by offering dealing on the stock exchange, have opened up private equity to a far wider audience.