Window of opportunity in private equity

The sale season does not last forever, as all savvy shoppers know – eventually prices must go back up again. And when it comes to investment companies in the private equity sector, that moment may not be too far away. Many such funds currently stand on cut-price valuations, but there is good reason to think that the days of these bargains are now numbered.

First, a quick recap on where we stand today and how we got here. Private equity funds, remember, invest in privately owned companies not listed on a stock market – often small, early-stage ventures. With no share price to offer a read-out, it is not always easy to work out what these companies are worth; managers publish valuations periodically, but in the meantime, investors must make their own estimates.

Over the past couple of years, a tough period economically and for financial markets, investors have naturally been averse to risk. One symptom of that is that shares in investment companies in the private equity sector have slipped to very wide discounts to the stated value of their underlying assets. Investors, in other words, have assumed these assets – all those privately-owned companies – are worth much less than reported.

When shares in investment companies trade at discounts of 25%, 30% or 40% to the value of their underlying assets, as they do now, investors may take two different views. They may decide to steer clear, on the grounds that the fund will in time adjust its valuations down, in line with the market’s estimates. Or they may see these discounts as an opportunity to buy exposure to the underlying assets on the cheap.

Investment company analysts increasingly think the second view of the private equity sector makes more sense. Stifel, for example, has just published detailed research into the sector, which it rates as a buy. The analyst concludes: “We expect continued growth in net asset values and share prices, with any increased buying interest potentially narrowing discounts.”

Two factors are driving such reasoning. First, in the coming weeks, many of these investment companies are due to publish the latest valuations of their holdings. Stifel, like other analysts, expect these valuations to tell a much more positive story than the market has previously expected; earnings and growth at many of these unquoted companies have been robust, it argues. The discounts at which investment company shares trade will therefore look unreasonable.
 

Also, points out Stifel, many of these funds are getting to the stage where they are ready to sell a sizeable chunk of their portfolios; they’ve been holding on to businesses because the market climate has not been supportive of exits, but with the economic outlook now improving, realisations should pick up. Funds should be able to cash in on many of these businesses, boosting returns for investors.

All in all, then, we may now be reaching a point where the bargain-basement valuations in the private equity sector are set to recover. The discounts at which many funds currently trade may soon begin to narrow considerably. A broader shift in the market mood, with investors’ risk aversion easing as the economic backdrop improves – particularly given expectations of interest rate reductions later this year – could also contribute to this effect.

There are no guarantees, particularly given the ongoing geopolitical tension that presents so much economic risk. And it’s fair to say some analysts have been predicting a marked upturn in these funds’ fortunes for some time, which has so far been piecemeal. Still, the window of opportunity for investment in private equity-focused investment companies may now be beginning to close. The sales do not last forever.