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Private equity is a deeply unloved asset class. For many, it embodies all the ills of high-tech capitalism: returns earned through a smokescreen of debt, financial engineering and rising valuation multiples rather than productivity or innovation. In the new age of austerity and transparency, it looks distinctly passé.
But that perception also gives it classic contrarian investment potential. Smaller investors can access the asset class through investment trusts that buy into a range of ‘limited partnership’ schemes otherwise backed by endowments and pension funds. These trusts did bounce with the stock market last year, but are still trading at distressed levels by historical standards (see chart below). For those willing to overlook the swings of fashion and the scars of history, they could be one of the few remaining pockets of deep value left by the receding crisis.
Private Equity Investment Trusts - average discount/premium ex 3i
That depends on whether you think the crisis really is receding, of course. Private equity's reliance on debt and its use of stock market multiples as a basis for valuation make it highly cyclical, so in a renewed downturn scenario it would suffer disproportionately (its common classification as an 'alternative' is somewhat misleading). It's not surprising that fears of more rot in the European banking system have darkened sentiment towards the sector in recent weeks and pushed discounts back out.
But if the recovery in corporate earnings maintains its current course, private equity investment trusts still look too cheap. There may be no immediate catalyst, but with a two- or three-year time horizon, investors can reasonably expect double-digit returns as asset values rise with profits and discounts close.
Research by LPX Group shows that when listed private equity companies traded at a discount over the past 16 years, they tended to outperform the MSCI over the following three years – as one would expect. Debt is now dearer, so asset values will not grow by the 20-30 per cent a year once considered almost normal. But at least some of the difference should be made up by narrowing discounts, even if they don't reach a premium this time around. Iain Scouller at brokerage Oriel Securities says the "natural discount" of private equity trusts could be as much as 10-20 per cent – but that still implies a big bounce in valuations.
It's true that investors need to be wary of discount figures in sectors like private equity, where the value of holdings is estimated. Valuations are typically only updated every quarter or half-year, creating a lag effect in a downturn as investors anticipate reductions in estimates of net asset value (NAV). Yet now the cycle has turned, that lag should act in investors' favour. Valuations have been aggressively downgraded and are now looking cautious, says John Newlands at Brewin Dolphin. When this caution becomes clear – which will inevitably be when asset sales are realised – discounts should normalise.
Debt fears exaggerated
Debt levels were another major concern last year, as investors feared trusts wouldn't be able to meet their top-of-the-market commitments to existing holdings without dilutive rights issues or fire sales. Even after a year of hard work restructuring balance sheets, gearing and commitment levels remain mixed and all the trusts have further leverage at the individual holding level because buyouts are generally backed by bank debt. But investors' fears look a bit exaggerated. Commitments will only be called gradually over a period of years, by which time the trusts should have raised cash from distributions or disposals. The current discounts more than account for any uncertainty.
The key to unlocking the sector's value is deal activity. This can take three forms. Private equity companies can offload a holding by a) taking it public, b) selling it to another private equity company on the so-called secondary market or c) finding a trade buyer. Flotations were popular in the technology boom but burnt sellers in the bust. This paved the way for secondary market sales to become the norm last decade, when managers made fabulous returns – and then steep losses – by bidding each others' assets up to quite unsustainable multiples.
Secondary market subdued, flotations risky
Managers are wary of repeating the mistakes of the immediate past, so the secondary market has been subdued over the past 18 months. KKR's acquisition of Pets At Home from Bridgepoint is a lone example of activity – and one below KKR's usual capitalisation range. But many private equity schemes have so-called 'equity overhangs' – capital raised in the boom years that managers are contractually obliged to deploy – suggesting activity may pick up after the summer.
Flotations look risky, too, now the stock market has turned. BC Partners and Cinven sparked hopes of a return to the glory days when the travel booking company Amadeus raised E1.3bn in Madrid in late April – 6-7 times their original investment in 2005. But other plans have been put on ice. The risk is there for all to see in the case of Gartmore: Hellman & Freidman took the fund management group public in December, but its 24 per cent stake has since shrunk to just over half its opening value.
After a strong year for corporate cash-generation, trade sales look a safer bet. Apax Partners sold Tommy Hilfiger to the Phillips-Van Heusen Corporation in March for 4.5-5 times its original investment price. Such examples remain a relative rarity, however, and earnings growth will have to settle into a pattern before industry embarks on a major buying spree.
So the catalyst for a mass re-rating is not immediately visible. But if it were, discounts would probably be narrower. High yields pulled property trust discounts back from the brink last year, while a year of strong performance has helped listed hedged funds. In time, deal activity should do the same for private equity – and past experience suggests it's better to buy before the action.
Besides having a little patience, investors also need an ability to avoid the duds and the dullards, of course. Hg Capital is without doubt the highest-quality name in the sector, and it has an exceptional track record that is based on zero leverage at the trust level – clear evidence that, done well, private equity can be a very powerful tool of wealth creation.
But on a discount of 10 per cent, the good news is priced in.
In part two, Stephen Wilmot has picked six deeply discounted trusts that look set for a rebound.
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