Private problems

Listed private equity funds are struggling to find favour with investors. They have moved from trading at an average discount of around zero at the beginning of the year to roughly 21% today. The largest company in the sector, 3i, has gone from a 17% premium to a 9% discount.

How to explain this collapse in confidence? Well, the markets expect private equity funds to have to mark down the value of their holdings in companies when they next update investors. For many funds, these updates are due at the end of the year – until then, we don’t know to what extent the more difficult economic backdrop has already hit their portfolio companies.

It's not unreasonable, in the current environment, to expect bad news from private equity funds. The companies in which they invest are not immune to slowing global economic growth, high inflation and the other pressures facing businesses in the UK and overseas. And since these companies aren’t publicly listed – where their share price would give a daily read-out of their fortunes – we only get a proper view of them when private equity funds publish periodic updates.

However, markets have a bad habit of fearing the worst. As several investment trust analysts explained in a recent article in FT Adviser, there are a number of good reasons to think listed private equity funds are now standing on ratings that over-estimate the problems in their portfolios.

One is that this is what has happened repeatedly in the past. Analysis from Peel Hunt reveals there have been at least six occasions in the past 15 years when the sector has suffered from “discount overshoot”. In other words, markets have a consistent track record of worrying too much about bad news to come and then being surprised on the upside.

In fact, there is already good reason to think history may be repeating itself. As Peel Hunt points out, when private equity funds have updated the market this year, they’ve revealed a greater level of resilience from their holdings than the market was expecting. So far, at least, their investments appear to be retaining their value to a greater extent than expected.

Also, even if you assume the market gloom is justified, there is a reason to be hopeful. The sort of valuations that private equity fund discounts now imply – investee companies that are worth 20% to 30% less than previously stated – would almost certainly attract interest from bidders. If these holdings really are as bombed out as the markets seem to think, there is every chance of a boost from a round of competitive M&A.

The other point to make here is that most analysts believe private equity fund managers have behaved relatively conservatively in recent times. In particular, they’ve been cautious about valuations during more prosperous periods; that should ensure any correction is not overdone.

It also helps that most funds have been careful not to take on too much debt, despite the low interest rates of recent years, which might have tempted managers into increasing their borrowing. Leverage in the sector remains modest by historical comparisons. Again, this provides reason to be hopeful that funds can weather the storm without excessive damage.

For all these reasons, the lowly valuations of private equity funds right now may prove to be temporary, suggesting that now could be a good time to buy on a long-term view.

No-one is suggesting these funds – and their investee companies – do not face difficulties. It’s also essential to remember that discounts can be somewhat deceptive, as they are based on the current share price and the most recently reported NAV, which is usually months out of date.

But analyst sentiment has turned extraordinarily positive on the sector. The AIC recently asked analysts from Berenberg, Numis, Peel Hunt and Stifel for their views on which ‘alternative asset’ sectors offered value. These analysts will make their own estimates of the likely valuation of companies in private equity funds’ portfolios, rather than relying on stale NAV updates. All four of them highlighted private equity.

Remember, too, that private equity can provide diversification benefits for investors with significant holdings in other asset classes. And for most investors, investment companies represent their only feasible option for getting into the private equity sector.