Private equity offers value

"The challenge is to find niches and crucially the right companies within those niches that will prosper against the wider odds," says LPEQ, the trade body representing listed private equity investment companies. "Many of tomorrow's leaders are not yet listed on stock exchanges. There are hundreds of thousands of privately-held companies in these countries, and millions across Europe."

Direct investment in private equity requires deep pockets and is typically only available to large institutional investors. But smaller investors can access it via private equity investment trusts. Longer-term returns are good: over 15 years the average share price of a private equity investment trust has risen 230 per cent against 123 per cent for the FTSE All-Share, and despite problems in the financial crisis this sector seems to be bouncing back - up 69.7 per cent over three years against 52.2 per cent for the All-Share.

Some of these trusts offer value: despite enjoying decent net asset value (NAV) growth over the past few years, many trade at discounts to NAV in excess of 30 per cent. Between 2000 and 2007 average discounts were between 5 and 10 per cent, according to Henry Freeman, an analyst at Investec Securities.

"We think this is one of the few investment trust sectors that offers significant value," adds James Brown, an analyst at Winterflood. "They have remained out of favour because investors are spooked after their dramatic falls in 2008. But these are in a very different position now for a number of reasons including repaired balance sheets, so even if there is another market jilt they are better positioned. Also, a number of the trusts have very strong records of generating value and this is a buying opportunity if you can take a potentially bumpy ride and hold it for the medium to long term."

Before the financial crisis, a number of private equity investment trusts had high levels of debt, and some of the funds had made more commitments than they could fund, most notably SVG Capital, which had to tap its investors with a rights issue to shore up its capital. But four years on things are very different: trusts have paid down debt and or renegotiated banking facilities to extend the maturities, and over commitment to investments has been reduced.

Despite the recession having a negative impact on some companies, private equity fund managers say they are finding decent investments.

"In the aftermath of a recession or stock market crash, private equity funds are usually able to buy well and this remains the case - it's a buyer's market," says Hamish Mair, manager of F&C Private Equity Trust. "This cyclical opportunity will continue to exist for the next two or three years. We are also finding opportunities across Europe, and further afield, where the use of private equity to finance the growth of smaller- and medium-sized companies is growing. The mid-market of Europe presents a longer-term secular buying opportunity and is being enhanced by the stage we're at in the economic cycle. In addition, we are starting to see an increased level of mergers and acquisitions which is providing better exits and improved valuations."

"The current economic climate is providing the industry with plenty of fruitful investment opportunities," adds Jock Green-Armytage of JZ Capital Partners. "Distressed prices in Europe - particularly Spain - and the exceptionally positive demographics across Latin America have provided us with interesting opportunities. The current dislocation in the real estate market has also led us to some quality investment opportunities in secondary mortgage loans. These assets have the potential to provide a high yield and capital appreciation, so fit nicely within our risk-reward profile."

Private equity managers are able to buy underlying assets at discounts of up to 15 per cent even for high-quality assets, according to Tim Spence, finance director at Graphite Capital Management. This potentially gives private equity investment trust investors the opportunity of a double re-rating effect: at trust level, and with the underlying assets.

He adds that banks have taken control of some underperforming companies but they have not yet started in earnest to sell these stakes. "Both of these factors could change, which would create more opportunities."

Re-rating?

However, to benefit from the value, as an investor in a private equity investment trust you need the discount to tighten and the share price to increase as well as the NAV. "I believe that there is scope for a further re-rating," says Gavin Haynes, managing director at wealth manager Whitechurch Securities. "While discounts have narrowed dramatically since the height of the global financial crisis, when the sector plummeted to around a 70 per cent discount, the current sector discount is still wider than the long-term average. Many private equity investment trusts are trading at discounts of over 30 per cent. With current investor sentiment firmly in risk-off mode, we could see some re-rating when optimism over the global economic backdrop improves. In the years up until 2008, the sector was regularly trading on discounts below 10."

A number of investment trust analysts also believe the discounts could come in: when we put our investment trust recommendations for 2012 together six months ago, analysts recommended Pantheon International Participations for reasons among others that it could re-rate. Read the recommendations.

But discount tightening could take some time despite good underlying performance, because of investor caution. "For a re-rating we need more good realisations above valuations to demonstrate good value," adds Iain Scouller, head of the investment funds team at broker Oriel. "There is a bit of activity but it is limited and we need more confidence, as there is a lack of enthusiasm for equity markets generally."

When we last wrote a big theme on private equity investment trusts about a year ago (read the article) the situation was the same: things looked potentially good for private equity investment trusts, underlying investments generally doing well and the potential for a re-rating. However, this has not yet happened as market sentiment is not mirroring what is going on inside the trusts.

Discounts could get wider if markets plunge or there are further problems, although analysts and managers generally don't believe that they would fall to around 70 per cent as in the financial crisis.

Funds

Because of the high-risk nature of private equity, advisers suggest that you hold it as part of a diversified portfolio, and that it should not account for more than 10 per cent. Picking the right fund is very important as well. For example, 10 trusts' net asset value (NAV) has outperformed the FTSE All-Share since the start of the financial crisis, but others have massively underperformed it.

There are two main types of private equity investment trust: those that invest directly in companies and those that invest in other private equity funds.

Among those that invest directly, stronger performers over the years have been HgCapital, an IC Tip. It is on a discount of nearly 16 per cent (also read Best of breed IT tips)

Electra, another IC Tip, has a strong balance sheet and around a £100m in cash, helped by the fact that it has recently sold on investments. It is on a discount of 31.1 per cent.

However, some analysts suggest buying into a fund of funds, because this diversifies risk. A fund of funds will have exposure to hundreds or thousands of investments.

Gavin Haynes, managing director at Whitechurch Securities, suggests Graphite Enterprise on a discount of -33.95 per cent discount to NAV. "The trust is run by a highly experienced management team and NAV performance has been very good in the recovery phase," he says.

He also likes Standard Life European Private Equity Trust, an IC Tip. "This trust aims to provide long-term capital growth by gaining exposure to a variety of sectors, countries, and ages investing predominantly in UK and Europe (but also in the US, around 20 per cent of assets) focusing on mid- to large-sized buyouts," says Mr Haynes. "This trust is trading on a discount of more than 41 per cent and is well diversified, with around 500 underlying companies."

Mr Scouller suggests HarbourVest Global Private Equity. "This trust has a diversified portfolio by geography and deal type, and NAV performance has been strong over the past year. The mature portfolio suggests strong cash generation from the portfolio will continue while leverage (debt) has fallen from 16 per cent of NAV in January to 11 per cent."

Meanwhile, analysts such as Henry Freeman of Investec Securities believe 3i, on a discount of 31.2 per cent, might provide a good turnaround opportunity. This investment trust has performed very poorly but has recently appointed a new chief executive officer who is drawing up a new investment strategy, and is expected to cut debt and costs which could change 3i's fortunes.

For more places to find growth in today's markets read Four great growth investments.

NAV and share price performance from 31 December 2007 to 18 May 2012

Source: Morningstar.

Private equity investment trusts.

Source: Morningstar.

Performance data as at 25 June 2012