A number of private equity investment trusts were highly indebted and unable to provide funds to their investments as the financial crisis set in, with the result that some had to resort to rights issues. As a result the whole sector went out of favour and endured massive share price falls and traded at huge discounts to net asset value (NAV).
Now the picture is very different: the increasing value of many private equity trusts' underlying portfolios has led to a lift in share prices with the average private equity trust rising 23 per cent over the past year, in contrast to 12 per cent for investment trusts in general, according to the Association of Investment Companies (AIC). Discounts to NAV have tightened considerably and on average are between 20 and 25 per cent in contrast to the 70 or 80 per cent discounts some trusts hit in 2009.
So far this year private equity investment trusts are one of the sectors for which discounts to NAV have tightened most.
This rebound looks set to continue. "With the ongoing recovery in the global economy and sanguine equity markets presenting strong tailwinds, we expect the listed private equity sector to deliver superior NAV returns," says Alan Brierley, director, at broker Collins Stewart. "The underlying portfolios are in good health and maturing well and this represents a solid foundation for earnings driven revaluations and realisations."
Following the financial crisis, managers of private equity investment trusts have spent the past couple of years protecting and enhancing the value of their investments, rather than seeking aggressive growth. But this means their investments are now delivering strong revenue and earnings growth, and are relatively mature and with many ready to be sold. "A healthy level of realisations at a solid premium to carrying value has been a feature and the managers expect this trend to gather momentum," adds Mr Brierley.
Increased mergers and acquisitions levels should provide a better environment for selling underlying investments according to Alex Barr, manager of Aberdeen Private Equity Fund, while the improving value of the investment portfolios means that realisation proceeds could be higher than last year, with some sales already at good premiums to holdings values.
These realisations are likely to take place over the next two to three years.
Many private equity investment trusts have also strengthened their balance sheets, cutting their levels of debt and reducing their unfunded commitments to investments.
Private equity trusts have not made many investments over the past couple of years, but some are starting or planning to, as there are good opportunities. These include Standard Life European Private Equity Trust and Pantheon International Participations.
"Investing selectively in these private equity trusts there is potential to benefit from an extended recovery over the next couple of years," says Gavin Haynes, managing director at Whitechurch Securities. "However, returns will not be as strong as the exceptional bounce experienced from distressed levels over the past two years."
Private equity trusts offer private investors access to assets they couldn't buy directly. "It is often the case that companies experience the greatest levels of growth during their infancy before they decide to list on the stock market and this is where private equity can make some exceptional returns," says Mr Haynes. "Unlisted companies are not as widely researched, so the market is much more inefficient and provides greater opportunities to make strong returns and take advantage of pricing anomalies."
Historically, private equity investment trusts have delivered strong returns. For example, over 20 years Graphite Enterprise has outperformed the FTSE All Share by 6.3 per cent annualised, while Pantheon has beaten the MSCI World and FTSE All Share indices by 3.3 per cent and 2.6 per cent compound respectively.
Discounts to tighten
Although the discounts to NAV on private equity investment trusts are wide, this is generally a reflection of investor antipathy towards the asset class following the problems of the financial crisis, and does not reflect the current state and potential of the trusts. Some of these trusts could represent a rare bargain buy. "With many parts of the investment trust sector looking fully valued, we believe that listed private equity is one of the few sub-sectors to offer genuine value and the discounts certainly do not reflect the superior long-term growth characteristics," says Mr Brierley. "Somewhat paradoxically given the NAV growth potential, these companies continue to trade on wide discounts. We expect an ongoing improvement in ratings to compound these NAV gains, and this will result in further significant out performance of quoted equities."
Discounts in this sector have been historically wide, but could now come down to between 10 and 20 per cent.
"It is probably not as good a time to invest now as at the end of 2009 when we started to invest. The easy money is made," says Alan Borrows, chief investment director at MAM Funds. "But as some of these investment trusts are still on discounts of between 20 and 30 per cent there is still considerable catch up for them with their underlying holdings. There have been good NAV mark ups, and with growth still pretty strong I expect that to continue."
High risk
Like many higher-return assets, private equity is also higher risk "The volatility of this area of investment can be one of the greatest and it is only suitable for investors with a higher-risk appetite," says Mr Haynes. "Private equity should only account for a small part of a well-diversified portfolio."
Private equity trusts invest in unlisted companies which can be hard to sell, in turn affecting the trust's shares. Private equity investment trust shares are typically harder to sell than more mainstream sectors, hence the wider discounts to NAV.
It is difficult to get a true reflection of the current realisable NAV of the trust, while if private equity falls out of favour the trusts can fall to significant discounts NAV very quickly.
Due to these trusts taking on debt, volatility can greatly increase. Conversely, if a private equity trust puts too many of its assets into cash, its returns could lag because the cash is not making as much as if it was invested. But this is not generally a problem just now as trusts tend to have modest unfunded commitments, according to Mr Brierley.
If there is a sharp slowdown in economic growth or a long fall in equity markets the trust's underlying investments could fall in value or experience slower growth. This could also reduce the number of buyers for the underlying investments and make it harder to float them on the stock market.
Private equity is a cyclical and volatile asset class so will go up and down, even if returns are eventually good over the long-term.
Because private equity is a more unusual and illiquid asset, the total expense ratio (TER) on private equity investment trusts is typically higher than on those invested in mainstream assets.
Some of private equity trusts, although listed in London, have shares denominated in euros or US dollars, adding currency risk.
