The case for private equity and LTAFs

That could be about to change, however. The government is keen to make it easier for private companies – particularly early-stage businesses with strong growth prospects – to raise money. It has therefore just announced that investments in long-term asset funds (LTAFs) will be permissible holdings for tax-free individual savings accounts (ISAs). The idea is to encourage more retail investors to put money into LTAFs – and therefore to grow the sector as a whole.

For the uninitiated, LTAFs are authorised funds – regulated by the Financial Conduct Authority – that invest in illiquid assets, including private companies. They’re structured more like unit trusts and Oeics; that is, the funds are open-ended, with managers creating or cancelling units in the fund as investors buy or sell. That’s quite different to the closed-ended structure of a stock market-listed investment trust.

The open-ended structure isn’t usually considered appropriate for illiquid assets. The concern is that if too many investors want to get in or out of the fund in a hurry, the manager will be forced to make potentially expensive investment decisions to meet supply and demand; they may have to sell assets at knockdown prices to cover the cost of redemptions, for example.

LTAFs aim to confront this problem in a couple of different ways. First, they usually come with restrictions on redemptions; investors may only have the right to take money out during set windows – every quarter, perhaps. Managers also tend to hold chunky amounts of cash in the fund’s portfolio, to provide a buffer to cope with demands for withdrawals.

That’s fine, but many investors won’t want to lock up their holdings in this way. Advisers will naturally want to ensure clients are taking a long-term view – and not committing cash they may need back in the short-term. But many investors prize liquidity. As for cash buffers, these can work well, but this is money that is not invested in line with the LTAF’s objectives – and not generating investment returns.

Against that, there are upsides to the LTAF structure. In particular, investors don’t have to worry about the value of their holdings getting out of sync with the value of the underlying assets, because they have a direct exposure to the portfolio. By contrast, in an investment trust, investors buy shares in the fund to get that exposure, these shares often trade at discounts to the value of the assets, because their price depends on market demand and supply.

The pros and cons of LTAFs versus investment trusts will now be of real interest to many advisers, given that both will be eligible ISA investments. The Association of Investment Companies (AIC) recently published this press release highlighting private equity managers’ views on the topic. But while there is no single right answer, it seems likely that the more familiar – and more liquid – nature of investment trusts will continue to appeal to many of those with a desire to get into private equity.

The strong performance of funds in the sector will certainly help. And discounts across private equity investment trusts do now appear to be coming down. That reflects a broader upturn in sentiment towards the asset class, where lower interest rates and increasing deal activity have the potential to drive improving returns.