After years of struggling with discounts to net asset value (NAV), this year private equity investment trusts have enjoyed a sharp tightening. In part, this is due to better investment sentiment as markets rallied, as well as a number of these trusts selling on their investments (making realisations) for a profit. The year 2013 has seen the narrowest discounts in the private equity sector since before the credit crunch in 2008, according to the Association of Investment Companies (AIC). The average private equity discount reached the narrowest average level of -13.8 per cent at the end of February 2013, and the average discount was -18.4 per cent at the end of June 2013. In February 2009, by contrast, the average sector discount reached its widest level of -61 per cent.
But if the market has recognised the value of some of these trusts, is it too late to invest?
Private equity typically invests in unlisted companies, sometimes at an early stage, which can be hard to sell. Some of these are turnaround situations that rely on the manager's ability to improve trading. 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. So, while private equity investment trusts can make very strong returns, like most high return investments they are also high risk and can be volatile.
"The majority of private equity held in investment trusts is priced off quoted comparatives, therefore any strength or weakness in quoted equities should be reflected, in time, in private equity," says Mick Gilligan, head of research at broker Killik. "We remain fairly optimistic about equity markets over the next year or so and in that respect I think no, investors have not missed the boat on private equity. There is some scope for further tightening, but the sector is towards the top end of its recent range and so I think anyone investing now is much more reliant on NAV improvement to drive their returns."
Iain Scouller, head of the investment funds team at Oriel, says that exits have improved considerably over the last two years and if they continue share prices will reflect this. "There might be more narrowing [of discounts] but most has come through," he adds.
But Andrew Lebus, manager of private equity investment trust Pantheon International Participations (PIN), says: "The listed private equity sector over the past 12 months has seen discounts narrow significantly from the levels that persisted following the global financial crisis. Even after these price improvements, the sector offers excellent opportunities for long-term investors."
Meanwhile, Tim Spence, finance director at Graphite Enterprise Trust (GPE), recently told Investors Chronicle that the long-term average discount in the 15 years prior to the financial crisis was 10 per cent, so discounts could go tighter. (Read the full interview)
But some trusts are on high ratings. "Some ratings have got ahead of themselves, for example 3i (III)," says Peter Walls, manager of Unicorn Mastertrust (GB0031269367), a fund of investment trusts which holds private equity trusts. "3i has made some good realisations lately and an activist investor holds shares in it, but it is on a premium (of 19 per cent) and there is not much scope for a re-rating.
"However, some of the trusts which have seen the greatest narrow discount narrowing have seen the greatest re-rating, for example Electra (ELTA). It is not outstanding value but there is scope for further narrowing, as is the case with HgCapital (HGT).
"Although discounts are generally tight, especially among trusts which invest directly in private equity rather than funds of private equity, they still offer a good way to access this asset which has historically made good returns relative to equities."
Other reasons to invest
The average private equity investment trust share price is up 25 per cent on average over one year to 30 June 2013, and 72 per cent over three years, outperforming the average investment company by 9 percentage points and 39 percentage points, respectively, according to the AIC.
Even if discounts don't tighten, investors could still benefit from share price appreciation.
For private investors, there is virtually no other way to access private equity, as to invest directly you need to inject very large amounts of money.
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 (SVI). But now many trusts have paid down debt and/or renegotiated banking facilities to extend the maturities, and over commitment to investments has been reduced.
Maturity profiles on private equity trusts are quite supportive for further realisations in buoyant markets, while the underlying businesses are doing quite well, according to Mr Walls.
"By investing in private companies, private equity investors can gain access to a much larger universe of opportunities worldwide than can be obtained through public markets," says Mr Lebus. "Investment activity has increased while the exit environment remains healthy, driven by trade sales as cash balances on corporate balance sheets remain high."
Private equity investment trust shares are typically harder to sell than those of mainstream investment trusts.
If markets do not do so well discounts could widen again.
The lack of visibility on valuations combined with delays in the reporting of results can also cause wide discounts at times of market volatility.
These trusts may take on debt, and there can be substantial debt involved with their underlying investments. Just as debt enhances returns in good conditions it can magnify losses when things are not going so well.
But 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 investments.
The underlying assets to some extent relate to the fortunes of the broader equity markets as one way for a fund to exit an investment is to do an initial public offering (IPO), although trade sales are another option.
But even if their NAV is doing well their share price may not reflect this - and it is the share price return that you get as an investor.
The total expense ratio on private equity investment trusts is typically higher than on those invested in mainstream assets.
What to look for when choosing a private equity trust
■ Past performance - this varies considerably between different trusts
■ Longevity and experience of managers
■ Portfolio maturity: if you get a lot of investments of four years or more there should be scope for exits
■ Number underlying investments
■ Direct investment or fund of funds?
■ Geographic and sector exposure
■ Kind of underlying investments - e.g venture capital, buy-outs
■ Level of outstanding commitments, debt and cash
■ Has the trust been shareholder-friendly in the past few years - e.g returned money to shareholders or taken action to reduce debt?
