Hannah Smith explains why private equity could surprise in 2021.
In a recent research note, Stifel’s analysts suggested 2020 results could be “remarkably good” considering the backdrop of economic recession and business shutdowns. “With the reporting season imminent, we think private equity sector NAVs may well surprise on the upside. When combined with the relatively large discounts many of the funds are trading on, this makes the sector look attractive.”
One reason for this is that many private equity funds have significant exposure to healthcare and technology sectors which have been strong performers, especially in the fourth quarter of 2020. Seven funds have more than 30% of their NAV in these sectors, Stifel notes.
HgCapital, for example, was one of the best-performing trusts in the first half of last year, which Stifel says reflects its tech specialism.
Meanwhile, discounts have been consistently wide among these trusts – Stifel estimates that the average real discount is 23-28%. Why is this? Part of the reason is that investors are put off by the higher costs of some of these trusts which are structured as fund of funds and so come with layers of charges.
“Discounts have proved very stubborn over the last 10 to 12 years,” notes Investec’s director of investment companies research Alan Brierley. He adds that private equity trusts don’t tend to use share buybacks as a discount control mechanism, in contrast to other types of investment company.
The legacy of the global financial crisis
These trusts also suffered more than most in 2008/09, and have not entirely bounced back, Brierley adds. "They didn’t have a great experience during the global financial crisis as a lot of companies were over-leveraged with too many commitments, many struggled and the sector hasn’t really recovered since then.”
Investec has strong conviction in private equity trusts, however, and is currently three times overweight listed private equity compared to the wider market. Pantheon International and HarbourVest Global Private Equity have featured in its model portfolios for a number of years.
Brierley explains that these trusts allow investors to access the ‘de-equitisation’ trend, in which high-growth companies (many coming from the west coast of the US) don’t feel the need to seek capital from stock markets. “They can stay off the equity markets for a lot longer in their evolution,” he points out.
Outside the unquoted companies space are a lot of highly leveraged and growth-challenged businesses, he adds, so investors are looking for ways to reach those more appealing, less indebted companies that may be better placed to grow rapidly. "It is a real challenge for investors in general: how do you get exposure to that interesting part of the market?”
Most UK-listed private equity trusts have delivered market-beating NAV returns over the last decade, at least compared to UK indices, notes Milosz Papst, director, investment companies at Edison Group, and such a solid track record makes them look attractive long term.
Private equity trusts had been increasing their exposure to resilient sectors even before the Covid crisis took hold, in anticipation of an economic downturn following a prolonged bull run. “This should help sustain good earnings growth across their portfolio, but current NAVs are based on quite demanding public market multiples used to value most of these businesses,” says Papst.
As Papst suggests, while their exposure to tech has been a tailwind so far, private equity trusts could suffer if the sector loses momentum. Even bullish Stifel points to the risk of a “significant stock market correction, especially in the tech sector”.
For investors wanting to tap into interesting and entrepreneurial unquoted businesses, private equity investment trusts could offer a way in at a significant discount. But you might pay higher fund charges for the privilege, and bear in mind that this part of the market comes with its own risks.