Still waiting for the private equity recovery

What does the Chancellor know that the stock market doesn’t? In recent days, Jeremy Hunt has unveiled plans to push pension funds into investing around 5% of their assets in early-stage businesses yet to list on the stock market. He argues this will be a win-win, providing much-needed funding for growing companies and potentially outsized returns for the pension funds. Tell that to shareholders in investment companies in the private equity sector, where the market is hugely sceptical right now.

Sceptical, that is, in that the market as a whole currently says the assets of these funds are worth a third less than the funds themselves claim. The discount at which shares in private equity investment companies are trading relative to the value of the underlying assets currently stands at 33%, up from 15% just 18 months ago. That’s just an average figure; at some funds, the discount is substantially wider.

This is really a story about sentiment. Over longer periods – say five to ten years or more – private equity investment companies have an outstanding track record. On average, they have comfortably outperformed rivals investing in many listed stock markets, including the UK. This is one reason why Mr Hunt believes pension funds should not be afraid to finance more early-stage companies.

In the short term, however, investors are fearful. A challenging economic and geopolitical backdrop makes them anxious about uncertainty. And early-stage companies, where investors don’t get a constant read-out of their performance from a live share price, come with plenty of that. Better to mark the value of these companies down, investors appear to think, in case bad news materialises.

Such risk aversion may be understandable, but it isn’t necessarily rational. Anxiety about the true value of the holdings in private equity investment trusts has been elevated for more than a year. Yet each time these funds have updated investors on the performance of their portfolio businesses, the news has been better than discounts imply. There may be some looming disaster to come, but there is no evidence of it yet – quite the opposite, in fact, with some funds selling certain holdings at a premium.

The good news is that this creates opportunity for braver investors. If you’re prepared to take a long-term view, the chance to buy into a business at a price undervaluing it by a third is worth at least considering. It’s difficult to know when sentiment might recover, but when it does, investors in these funds can look forward to a free ride.

Some in the pensions industry are nervous about the Chancellor’s proposals. They worry losses on private equity holdings will jeopardise savers’ retirement plans. Mr Hunt’s view is that even if some early-stage companies fail, the returns on offer from the winners will offer plenty of compensation for that. He is also banking on broader benefits for the UK economy from encouraging entrepreneurship and wealth creation.

Do you agree? If so, for most of us, the investment company sector is the only way to get targeted exposure to private equity managers that specialise in identifying and supporting early-stage companies. Even better, an investment company offers liquidity – you can trade in and out of the fund at any time, even though that’s much harder to do with the underlying unlisted businesses.

None of which is to suggest that private equity investment trusts are guaranteed to deliver. Investing in private companies can be risky, especially when they are at an early stage of their development, and some funds will inevitably make smarter decisions than others. And, to repeat, there is no knowing when market sentiment will turn positive. Still, opportunity knocks – for the UK’s pension funds, but for investment trust shareholders too.