David Prosser explains why investors should choose investment companies for unquoted exposure.

Let’s not learn the wrong lessons from the rumpus surrounding the funds of Woodford Investment Management. Since the announcement of the “gating” of Neil Woodford’s Equity Income fund, there has been some increasingly hysterical talk about the unsuitability of unlisted companies for retail investors. To be clear: there is nothing wrong, per se, with unlisted companies as an asset class; the challenge is to access them in the right way.

In fact, institutional investors are raising their exposure to the unlisted sector. Research just published by the Family Office Exchange, whose members in the US, the UK and a number of other markets invest on behalf of wealthy families, shows a sharp increase in appetite for such assets. In some cases, these offices have invested a third of their clients’ assets in unlisted businesses.

Their reasoning is simple. They figure the best younger, earlier-stage businesses will grow more quickly than their more mature counterparts, generating superior returns in the process. Such businesses may also be more prone to failure, which is why you want a diversified portfolio of holdings that spreads risk, but the upside potential is exciting.

The challenge for advisers is identifying the right vehicles for clients seeking exposure to this asset class; most do not have the same level of wealth as the Family Office Exchange’s members and find that traditional routes into the unlisted sector are therefore out of their reach.

Enter the investment companies sector. Mr Woodford’s Patient Income Trust is one of several dozen closed-ended funds allocating a portion of their portfolios to unlisted companies. The structure of a closed-ended fund, with no inflows and outflows of investors’ cash, protects it from the problems that have dogged Equity Income.

In addition to these diversified funds, the investment companies industry also includes a sector dedicated to unlisted companies. The average Private Equity fund has delivered a return of close to twice what the FTSE 100 Index has produced over the past five years. The sector gives retail investors access to an asset class that used to be off limits, with traditional private equity funds set up as limited-life partnerships open only to institutions or very high net worth clients.

Instead, private equity investment companies issue shares that are traded on the stock market. The shares offer exposure to the funds’ underlying assets – the same sort of portfolio of private equity holdings as the partnerships are buying.

Managing private equity requires a particular skillset. The manager often hopes to be the catalyst for a rapid acceleration of the growth of the business in which he or she invests. Private equity managers take a seat on the board and work with the company to address issues ranging from the strategic direction of the business to its operational effectiveness. Their aim is to help businesses achieve their full potential – to polish up what are currently rough diamonds.

That’s not to say the work always pays off. Investors in listed private equity funds need to understand this is a riskier asset, particularly as some private equity funds deploy gearing, borrowing some of the funding needed to finance their investments in companies. This debt is repayable by the companies themselves, so the private equity fund gets more bang for its buck from the money it puts into the business. Gearing enhances the returns on profitable investments, but also exaggerates the losses when companies fail.

Some protection for investors comes in the form of diversification. Since a private equity fund has a number of holdings, a poor performance from one of them is disappointing rather than disastrous. Nevertheless, private equity fund performance is rarely linear – returns can often be lumpy.

A crucial part of the private equity fund manager’s job is therefore to identify and manage risk – for example, by conducting thorough due diligence before investing and by remaining closely involved in the business so that problems can be resolved before they get out of hand.

Listed private equity funds also carry one additional risk, which can be harder to manage. The price of shares in the fund will depend on demand and supply for those shares on the stock market. That will be influenced by the performance of the underlying assets, but sometimes demand and supply doesn’t accurately reflect this performance. This is why shares in listed private equity funds often trade at a discount to the value of the underlying assets.

However, for investors comfortable with the risk profile of listed private equity funds – especially those able to invest on a long-term view – the compensation is the potential for superior long-term performance. Institutional investors increasingly recognise that potential and are adding private equity holdings to their portfolios in order to boost overall performance. It would be a shame if the Woodford affair means retail investors are deterred from considering the same opportunities.