Private equity discounts: Too good to be true?

Are bargain basement valuations for investment companies offering exposure to private equity just too good to be true? Shares in these funds have been trading at discounts of more than 30% to the value of their assets for several months. That has prompted a series of briefings from investment company analysts suggesting advisers and their clients might like to go bargain hunting. So far, however, investors aren’t taking the bait in large enough numbers for discounts to start narrowing.

That suggests investors aren’t sure if these discounts really are so generous. The thing about private equity funds is that their assets – largely investments in privately-owned companies – are only valued periodically. Most of these investment companies last updated valuations back in September; if the value of their assets has fallen since then, today’s chunky discounts may actually be no such thing.

Hence the “too good to be true” fear. After all, the economic outlook – in the UK and globally – has deteriorated since September. Inflation is out of control, interest rates worldwide are climbing fast, and growth forecasts are being downgraded. That feels like a world in which the valuations that investment companies gave their assets more than three months ago could well be adjusted when new data is published.

One analyst that appears unworried is Numis. Its investment companies team has just published research on the listed private equity sector that makes a series of different arguments for why investors should put their doubts aside. The research concludes with no fewer than seven investment companies in the private sector that Numis now regards as buys.

The analyst’s case is partly that scepticism about September’s valuations is unfounded – and therefore that today’s discounts are genuine. Private equity valuations never soared to the heights seen on listed public markets so have less far to fall, it points out; in any case, by the end of September, when most valuations date back to, those public market falls were largely over.

Another strand in the story is that private equity funds have continued to surprise on the upside when exiting their investments (the only valuation points that really count, you might well argue). So far, these uplifts have compensated for writedowns in other parts of the fund, which is why private equity funds outperformed, in net asset value terms at least, for much of last year. That, after all, is the whole point of giving investors exposure to diversified portfolios of assets.

Numis is also dismissive of concerns that the rising cost of finance – as interest rates move up to counter inflation – will undermine future returns. It’s true that private equity investors do use borrowing as part of their approach to investment, but the data suggests most of the gains on their portfolios in recent times have come from operational performance rather than leverage. Debt levels at portfolio companies, by and large, do not look unduly concerning.

All of which suggests today’s valuations of these investment companies – with share prices that should be 30% higher to accurately reflect the value of the assets to which they offer exposure – are an anomaly. Numis believes that sooner or later, the penny will drop for enough investors in the market for the discounts to start narrowing.

Naturally, it's difficult to know when that might happen, though as investment companies update their valuations, the true picture should become clearer. Market sentiment is undeniably cautious right now; it may take time for investors to become optimistic enough to take these arguments on board. Still, if Numis is right, investors in these funds will get a boost at some stage.

Clearly, these investment companies are not suitable for all advised clients; private equity is an asset class for investors that already have a good spread of more conventional holdings and a reasonable appetite for risk. Still, this is one area of the investment companies industry where pricing does currently look anomalous. One day soon, investors are going to decide that if it looks like a discount and sounds like a discount, then it probably is a discount.