The cycle’s right for private equity

Professionals in the private equity world often talk about “the cycle”. There’s a natural order to the way in which private equity firms manage their money. They tend to go through periods of high activity, making lots of disposals and new investments into small or growing firms, then calmer times, where they focus on working with their portfolio companies.

The broader economic backdrop naturally has an impact on this cycle. The second half of 2020 was a particularly busy period for private equity dealmaking, as the markets opened up again after the first Covid-19 lockdown. That spurt accelerated over much of 2021, but more recently, the higher interest rates of 2023 and the first half of 2024 have put the brakes on. Higher borrowing costs make it harder for private equity funds to dispose of portfolio companies at the prices they hope for, since buyers often rely on debt. That limits their ability to make new investments. The cycle gets stuck.

All of which brings us to the present moment. Many believe the private equity industry is on the verge of another period of rapid growth as interest rates start to tumble in the UK and Europe, as well as in other global economies. PitchBook, one of the pre-eminent analysts of the private sector, thinks this period is already underway. Its data, released in recent days, suggests the European private equity industry averaged 27.5% year-on-year growth in deal value during the third quarter of the year, as lower interest rates and deployment of surfeit cash bolstered activity.

For retail investors, the investment trust Private Equity sector provides the easiest route into this asset class, which has traditionally been the preserve of large institutional investors with sizeable sums to commit, and the ability to tie up their cash for an extended period. Private equity-focused investment trusts offer liquidity and an affordable entry point – you can buy or sell as many or as few shares in each fund as you like, as often as you like, on the stock market.

However, retail investors have not traditionally been enthusiastic buyers of these funds. They own about 10% of the shares issued by private equity investment trusts – compared with around 50% of investment trust shares in most other sectors. It’s an asset class often associated with higher levels of risk, as well as more expensive charges, though recent regulatory changes have addressed problems that made some funds’ fees look artificially high.

The good news is that if you’re prepared to take the time to investigate the sector, there are plenty of bargains to be had. Shares in almost all private equity-focused investment trusts currently trade at a discount to the value of their underlying assets, offering a potential opportunity to get in on the cheap. In some cases, those discounts are unusually wide – the market as a whole does not yet appear to have caught up with the recovery story in the sector. The Association of Investment Companies surveyed some financial advisers and analysts last for their favourite high-risk investments and some highlighted private equity funds in their responses.

There has been some concern about whether funds’ valuations of their current investments are realistic. But in practice, where funds have announced exits, these have often been at prices ahead of market expectations – and falling interest rates should ease the way for more good news in this vein. Over time, that should result in discounts narrowing, providing investors with a handy uplift.

Don’t be under any illusions. Private equity funds do come with certain challenges – you’re investing in companies where the true value is not always clear; that can lead to volatility. Still, if you’re looking to add some spice to your portfolio, this is a sector to consider. And its long-term record is outstanding – the average private equity fund has delivered a return of 655% over the past 10 years, getting on for four times the return achieved by the investment trust industry as a whole.

It should be acknowledged that a good chunk of that performance is accounted for by stellar returns from 3i, the biggest fund by far in the sector. But there are also plenty of other investment trusts that have generated exciting and enduring returns from private equity.