David Prosser discusses private equity investment companies and a potential ‘surprise on the upside’.
Stock markets tell you how much a company is worth, second by second, day by day, as its share price moves up and down. But when it comes to privately-owned companies, valuations are a bit lumpier: with no public market in their shares, it takes time to assess how the performance of the business and the broader economic landscape may have had an impact on what it is worth.
This is why there is currently some excitement about private equity investment companies, which take stakes in these privately-owned companies. Many of these funds are about to give their latest assessments of what their portfolio companies are worth, with analysts hoping for better news than had been expected until very recently. The investment company team at Stifel, for example, has just published a note predicting that “net asset values may well surprise on the upside”.
There are two main reasons to be optimistic. The first is that while the pandemic has proved disastrous for many businesses, there are a good number of companies that have been able to trade through the storm – and with the vaccine programme now offering a way out of the crisis, the prospects for these companies are now improving. The strong performance of the stock market over the past six weeks or so reflects of this more positive mood.
Second, as Stifel points out, a number of private equity investment companies hold a significant number of healthcare and technology companies in their portfolios. These businesses have proved resilient during the pandemic and are now in a strong position to capitalise on recovery.
As of today, the value of private equity investment companies largely reflects the assessment of what their portfolio companies were worth at the end of September last year. Their latest assessments, which will reflect end-of-year valuations, may well be much more upbeat. In which case, investors in private equity investment companies are holding funds of greater value than is currently apparent.
There may even be a double whammy to come. Shares in the average private equity investment company are currently trading at an 18% discount to the value of the underlying assets. In other words, you can buy exposure to the businesses in the portfolio at a price that is nearly a fifth below their value. But if these businesses are actually worth significantly more than those September assessments, the real discount is even higher; Stifel thinks it could be between 23% and 28% on average. As that becomes apparent, discounts could narrow, boosting returns.
None of which is to say that investors and their advisers should jump into the private equity sector. Trying to time the market in this way is a risky business and is no way to save and invest for the long term. In any case, private equity isn’t right for all investors; you’re buying exposure to smaller businesses, which tend to be riskier, and you’re accepting the risk of greater volatility, given the relative lack of transparency compared to investments in listed equities.
Still, private equity can play a valuable role in a diversified investment portfolio; it is an asset class with a strong long-term performance track record. And, of course, for most retail investors, investment companies offer the only route into private equity, which typically requires very large upfront commitments and an acceptance your money will be locked in for an extended period. The accessibility and liquidity of private equity investment companies, by contrast, opens up this asset class to a much broader audience.