Look to private equity for high-risk value

"I think this in part reflects a broader picture of widening discounts on risk assets, especially illiquid assets, due to cautious sentiment from investors because of the cocktail of uncertainties hanging over the markets in 2016," says Jason Hollands, managing director at Tilney Bestinvest.

Broker Numis Securities also argues that private equity trusts are on wide discounts to NAV due to recent market volatility and because investors are questioning their NAVs. It is more difficult to get that information with unlisted assets - they are typically valued two to four times a year rather than every day.

Traditional buyers of private equity trusts such as wealth managers, multi-asset managers and private investors have been buying this asset less. Private equity trusts are not typically a good source of dividends, and trusts that offer an attractive income tend to trade at a premium or tight discount.

Some large institutional investors have also been selling private equity trusts, although generally shares in these are not traded much which can also contribute to wider discounts.

However, Numis says there is a significant gap between the pricing of private equity investment trusts and transactions in the secondary private equity market.

James Hart, investment director at Witan Investment Trust* (WTAN), which invests in private equity trusts, doesn't expect their discounts to get much wider over the short term and, although he doesn't expect a rapid tightening, says that if markets appreciate they should narrow over time.

Numis thinks there are catalysts for private equity trust discounts to tighten.

Still doing well

The NAV returns of many private equity investment trusts are making good positive returns in excess of broad market indices such as the FTSE All-Share. Numis says recent results show the investments of listed private equity trusts continue to experience growth in revenue and earnings, helped by the fact that they have little exposure to energy, mining, banks or emerging markets. Charles Cade, head of investment companies research at Numis, believes that overall the environment remains supportive for private equity trusts.

"Despite the volatility seen in the global markets at the beginning of the year, and the ongoing macro headwinds, we continue to see good quality transactions across all investment types in the private equity sector, both through the primary and secondary markets," adds Andrew Lebus, partner at Pantheon International. "Fundraising in the sector continues apace, which we believe is an indicator that private equity continues to generate interest."

Private equity funds typically make their returns by selling on their investments at a profit, and Numis says recent exits made by private equity trusts have been well above carrying value.

During the financial crisis a number of private equity trusts had high levels of debt and some had more commitments than they could fund. Some of them had to resort to extreme measures such as rights issues - asking their shareholders for cash - which had a detrimental effect on their share prices. But private equity trusts now typically do not have such high levels of debt or unfunded commitments.

Private equity can deliver strong long-term growth. "One of the advantages afforded to private equity managers, in contrast to their peers in the listed equity space, is their ability to sit out periods of volatility or uncertainty, and await the most favourable opportunities both to make new investments and, later, to sell assets and distribute cash to their investors," says Richard Hickman, director of HarbourVest Partners .

There are thousands of unlisted companies, so accessing these can increase diversification and value. These companies can be faster growing and private investors typically cannot invest in them directly, because of the minimum investments required, so private equity trusts are one of the few ways to get access.

Choosing a trust

Because of the high risks advisers suggest you hold private equity investment trusts as part of a diversified portfolio, and that they do not account for more than 10 per cent.

There are two main types of private equity investment trusts: those that invest directly in companies and those that invest in other private equity funds. Funds of funds are typically lower risk because they have exposure to thousands of investments rather than tens or hundreds. Directly investing private equity investment trusts can have a high concentration of investments, so if one goes wrong it could have a significant impact on returns. However, funds of funds do not get as much uplift from a single realisation as a directly investing fund.

Funds of funds can have higher charges because they involve a double layer of fees: at the trust level and on the underlying funds.

When choosing a private equity trust you should consider its past performance, the track record of its managers, how long they have been working in this area and what their experience is. You should also check the trust's outstanding commitments and cash levels.

Check how many underlying investments it holds, especially with a directly invested trust: if this is very concentrated it raises the risk.

Other things to consider include geographic and sector exposure and the type of deals it makes, for example venture capital or buyouts.

Fund of funds Pantheon International Participations'* (PIN) assets are spread across different investment styles and stages including buyout, venture, growth and special situations, with the aim of reducing volatility of returns and cash flows. Its diversified maturity profile means it is not overly exposed to any one vintage.

Around 60 per cent of its assets are in the US and 26 per cent in Europe.

The trust has a good long-term performance record, beating other private equity funds of funds over longer periods and broad indices such as the FTSE All-Share.

But its ongoing charge of 1.18 per cent could rise because of its performance fee.

Mr Hart likes SVG Capital (SVI). He says its discount to NAV is in part due to institutional selling, but it has a good underlying business.

After the financial crisis, the trust made substantial changes so is no longer overcommitted and has a more diversified portfolio. Since the start of its capital return programme in 2011, it has returned £626m to shareholders.

In the trust's last financial year to 31 January 2016, it reported NAV growth of 11 per cent and a share price return of 14 per cent, compared with a decline of 4.6 per cent in the FTSE All-Share and a rise of 1.1 per cent in MSCI World. "This represents the sixth year of double-digit NAV growth for SVG," says Mr Cade.

Standard Life European Private Equity Trust's* (SEP) revenue and earnings continue to outperform the FTSE 100 and MSCI Europe indices, while it has a mature portfolio - around half the investments are five years old or more. The trust's managers say increasing buyer interest should see a continuing flow of realisations.

The trust is focused on managers in Northern Europe favouring buyout deals. Most of its assets are in continental Europe, with just over a third in the US and UK.

The trust says its underlying managers are reporting strong new deal pipelines against a strong background of mergers and acquisitions in Europe, and strong valuation increases are being driven by underlying earnings growth, free cash flow generation and comparable listed equity multiples.

It has net cash of £41m plus £38m invested in UK & European Index trackers, which are a potential liquidity source.

HarbourVest Global Private Equity (HVPE) has one of the strongest performance records among private equity funds of funds, and in September last year moved its listing from the specialist fund market to the main market. Although its discount is relatively wide at the moment, it has been much tighter in the past, and the relisting could help with this.

"The balance sheet is strong, with 16 per cent net cash and a significant medium-term debt facility in place," says Alan Brierley, director, investment companies team at Canaccord Genuity. "Meanwhile, the maturity profile of the portfolio is attractive and this bodes well for ongoing realisations, while the healthy uplifts on carrying value (around 41 per cent in recent years) are symptomatic of a conservative valuation policy. These attractions are enhanced by the discount."

Among directly investing trusts, HgCapital Trust (HGT) makes solid NAV returns over one, three and five years, well ahead of the FTSE All-Share.

It has an ongoing charge of 2.25 per cent, but this is a typical level among trusts in this sector. Around a quarter of its portfolio is in maturing investments and its managers have developed exit plans to realise value over the next 18 months.

*IC Top 100 Fund

Private equity investment trust performance

Source: Winterflood as at 3 May 2016, *Association of Investment Companies/Morningstar