Playing the waiting game in private equity

David Prosser assesses whether the sector’s deep discounts are justified.

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Investors and advisers spend a great deal of time thinking about whether the price of a particular asset reflects its true value – if the price is low, perhaps that provides a window of opportunity. The problem, however, is that ultimately, the value of an asset is what someone else is prepared to pay for it; if there’s no market for an asset at what you think is its true value, capitalising on the opportunity is impossible.

So to private equity focused investment companies, where there is ongoing concern about the very wide discounts at which shares in these funds trade relative to the value of their underlying assets. The majority (12 out of 17) companies in the Private Equity sector trade at discounts wider than 30%. Only two companies trade within 10% of their net asset value.

The explanation commonly given for deep discounts is that investors are worried about what’s going on in the portfolios of these investment companies. Since their holdings are not listed on the market, assessing their value is a subjective exercise – and revaluations take place periodically rather than continuously. A 35% discount on the fund tells you that investors think the current stated value of its assets does not fully reflect all the economic travails of the past year or so.

The problem with this thinking is that the evidence doesn’t support it. Discounts have now been at these elevated levels for some time. We have seen all the funds in the sector revalue their portfolios without marking assets down in the way the market seems to be expecting. Indeed, analysis from the broker Numis points out that funds selling out of their holdings last year managed to secure an average uplift of more than 30% on their portfolio values.

Moreover, history tells us that private equity portfolios tend to manage the ups and downs of the market cycle relatively well. Managers tend to be conservative with valuations – they don’t mark investments up aggressively even when public markets are soaring. This tends to protect on the downside.

It’s also worth noting that direct private equity investments are not currently suffering from the same levels of negative sentiment. In that part of the market, discounts are running at around 25% according to Numis, much closer to the ten-year average of 19% or so. There is, in other words, a particular issue around the valuation of private equity investment companies.

The long-term record of these funds, by the way, is very strong. Data from and Morningstar suggests they have delivered more than 400% of total returns over the past ten years, compared to 156% for the average investment company. That’s as it should be – the raison d’etre of the asset class is superior long-term performance.

All of which brings us back to where we started. On the face of it, this sector of the investment company universe currently offers a real opportunity – advisers and investors have the chance to get into funds with a high-quality track record at a time when they are significantly undervalued. But the question of whether and when that opportunity will play out remains.

What we need here is a catalyst for change – something that provides the market with more confidence in the valuations of funds’ portfolios. That catalyst may come suddenly, particularly if the economic backdrop improves markedly, or over time, as negativity slowly eases away. But patience may be required.

Still, for advisers prepared to be brave, this has to be an interesting area. Private equity has a long history of delivering excellent returns. And investment companies provide an entry point for anyone in this asset class. For those able to wait for discounts to unwind, the rewards could be considerable.