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“An opportunity overlooked is an opportunity foregone”

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15 November 2016

David Prosser examines why the Private Equity second could be worth a second look for advisers.

To those with shorter memories, it may come as a surprise to discover that banks have not always been public enemy number one. Yet as recently as a decade ago, before the financial crisis changed everything, MPs, the press, trades unions and public opinion had a different target in their sights: the private equity sector stood accused of paying lavish salaries to asset stripping opportunists and pouncing on our most-loved companies in search of a quick profit.

What really irked many commentators was the perception that private equity funds were the preserve of the already wealthy – set up as secretive limited partnerships with minimum investments of hundreds of thousands of pounds, or even millions, they did not share the spoils with ordinary investors.

Even then, however, such criticism overlooked the listed private equity sector, which has long offered retail investors a route into private equity via investment company shares; that oversight was unfair then – particularly as MPs investigating the industry had singled out 3i Investment Trust for praise given its high standards of transparency – but continues to some extent today. Even now, the public discourse about private equity often excludes the 15 or so closed-ended funds that are such an important part of the sector.

The danger is that an opportunity overlooked is an opportunity foregone. A note published this week by Alan Brierley and Ben Newell, investment company analysts at Canaccord Genuity, warns that advisers and investors are missing out on a very positive story. “Listed private equity has delivered superior returns in recent years,” Brierley and Newell say. “However, many investors remain indifferent.”

The result of this relative lack of interest is that while private equity funds’ net asset values have delivered substantially better returns than the UK stock market over the past seven years, their share price outperformance has been more modest. Shares in the 10 funds featured in Canaccord Genuity’s note currently trade at an average discount to the value of the underlying assets of around 20 per cent.

Brierley and Newell argue that it is now time for advisers and investors to pay more attention to private equity funds – their own position is a “high-conviction overweight view”. Attractive valuation levels aside, they point to a series of compelling reasons to consider the sector.

The first of these is the underlying quality of private equity funds’ portfolios – the whole point of the sector is to take active positions in businesses where engagement with management can deliver operational improvements such as increased revenues and lower costs. Many funds now have high quality portfolios that are maturing well, Canaccord Genuity says.

Meanwhile, the funds’ own balance sheets look healthy too. Having been somewhat caught out during the financial crisis, the sector now has only modest levels of gearing, with many funds running net cash positions.

Then there is the continued corporate interest in the sector. The lowly valuations of funds in the sector has attracted interest from corporate investors – we’ve seen, for example, HarbourVest acquire Conversus and SVG Capital, while Electra is changing structure following a campaign by activist investors. These actions can underpin valuations in the sector.

The bottom line, argue Brierley and Newell, is that for some time now, investors have had difficulty finding companies capable of delivering earnings growth – that has been true across much of Europe and in the US, where company earnings have now fallen for five quarters in a row. The attraction of listed private equity funds is that they confront this problem head on, working with their portfolio businesses to drive earnings forward.

This is not to say the sector always succeeds in this endeavour. Nor are listed private equity funds necessarily suitable for all investors. At the very least, however, it’s time to consider the sector with a fresh eye. This could be a story of “from zero to hero”.

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