Deals! Deals! Deals!

However, the way in which private equity works is a little opaque. Over the past year, a lot has been written on the ins and outs, illustrating how its participants pay tax, its advantages and its drawbacks. But hard advice for private investors wanting a piece of the action is still thin on the ground.

The main problem is that private-equity players are even less interested than hedge-fund groups in getting money from private investors. In reality, many have so much money to invest on behalf of big institutions that they don't give private investors a second thought. But that's not to say that private investors need to exclude themselves from the private-equity investment trust (Peits) scene. There are a dozen or more listed investment trusts that invest in private equity, including some of the biggest names. What's more, buying and selling their shares is a simple matter, and some of the shares offer an interesting value proposition after recent market declines.

Getting a Peit of the action
Investors generally aren't too aware of publicly listed private-equity investment trusts, perhaps because some have confused them with venture-capital trusts (VCTs). Peits are quite different from venture capital trusts, which have special tax breaks for investing in start-ups. Peits quite simply allow you to buy in to an established private-equity portfolio run by an experienced management team. More often than not, it will invest in a spectrum of deals, including large-scale buyouts, management buy-ins, venture capital deals and even in other private-equity funds.

The sector splits neatly into two groups. First, there are those that invest directly in private-equity transactions, but have the listed investment trust status that allows private investors to buy a share in that portfolio. Examples of this type include Candover, Dunedin Enterprise and HgCapital.

Second, there are trusts that act for the most part as funds of funds. They mainly invest in private-equity portfolios rather than individual transactions, often acquiring stakes in funds from professional investors who require an early exit, or getting into new funds at the outset. Some also co-invest in individual deals.

From a private investor standpoint, this type of trust places an extra layer of professional management between a private investor and the portfolio of private-equity deals, offering a bit less risk, but charging an extra layer of fees in the process. Examples include Mithras, Graphite Enterprise and Pantheon International Participations.

Funds of funds have some advantages. Andrew Lebus, CEO at Pantheon, one of the leaders in this area, says: "Barriers to entry are high. Negotiations can be complex because of the different legal jurisdictions involved."

Ian Armitage at HgCapital has a slightly different take on why funds of funds can be a good bet. He says: "Buying limited-partnership interests in the secondary market is a good business. People are selling for a reason and pricing can be imperfect. And, from an investor's standpoint, you are buying into an established portfolio. What you see is what you get. Funds of funds also give you access to managers who may not have a publicly listed vehicle."

Although there are only around 18 or 20 Peits, they range from those that might invest directly in a handful of private-equity transactions in the UK, to funds of funds with scores of holdings in private-equity funds worldwide.

So what are the advantages? The biggest is liquidity. You simply buy and sell the shares as you wish in the normal way, although remember that the underlying private-equity investments are long-term in nature, so you need to have an investment horizon that matches the two-to-five-year cycle that's typical in many private-equity deals.

The other big feature of Peits is that capital gains on the private-equity deals themselves are not taxed if they are not distributed to shareholders. In effect, they accumulate within the fund and are reinvested in new transactions. What shareholders see is a steady increase in net asset value as the fund's holdings come to fruition. But while much of the focus today is on how much money is being generated by buyout transactions, how rapacious private-equity investors are, and how ruthless their methods, private equity isn't a guaranteed way to make money.

In the past, there have been instances where the private-equity market came seriously unstuck by overleveraging big buyouts (in the late 1980s, with deals such as the bid for the Gateway supermarket chain) or by following the latest fashionable bandwagon (the late 1990s internet boom). At times like this, as many as a third or more of private-equity deals end up in the hands of the receiver or undergo major financial restructuring.

What most players hope for is that they make multiples of their original investment on the deals that do go well, and that this offsets the occasional mistake. Nonetheless, private equity is a high-risk business, and the sheer amount of money raised by private-equity funds looking for deals means that bidding for the big deals is fast and furious and the unwary can end up overpaying.

Ross Marshall, chief executive of Dunedin Enterprise, observes: "Prices for quality businesses have definitely increased, but experienced practitioners are maintaining their pricing discipline." HgCapital's Ian Armitage, however, says: "On those deals with a value of over £250m, prices are demanding and financing structures are very aggressive."

One reason for this is that, with the bigger deals, the debt providers are typically investment banks who securitise the loans and then pass them on. By contrast, debt in mid-market deals is typically provided by banks. They tend to keep the loans on their books and therefore have an incentive to make sure that leverage doesn't get too out of hand.

Like other investment trusts, shares in Peits move independently of movements in net asset value (NAV). But, with Peits, there is an extra dimension to this because their investments are not listed companies, and so putting a value on the portfolio is guesswork.

The British Venture Capital Association has guidelines on valuation that most companies follow. Even so, this inevitably means that changes to NAV are ‘lumpy', and that it may take some time for funds that are operating in the wake of some big realisations, and have lots of cash, to show meaningful further increases in NAV because of the time taken for new deals to be found and to come to maturity.

Most funds value their portfolio constituents on the basis of comparable multiples in the quoted sector, but apply a big discount to reflect the fact that they are investing in unquoted companies with high levels of debt. If trading falls short of expectations, it's normal for this to be reflected in valuations immediately. HgCapital's Mr Armitage notes: "If forecast earnings are dropping, we hit the valuation hard. We try to lock in some conservatism."

Peit performance
Peits do well in a bull market. They have performed extremely well relative to the market in recent years, after underperforming sharply between late 2000 and late 2002. Over 10 years, the Peit sector average has risen 295 per cent compared with the FTSE All-Share's gain of 110 per cent. Over 15 years, the gain is 860 per cent versus the All-Share's 332 per cent. The Peit average excludes 3i, though, which is so large that it would otherwise dominate the numbers, and is in any case now included in the ‘general financial' sector rather than considered a Peit.

Gains like this raise the question of whether private investors have missed the private-equity investment boat, and whether or not an unsustainable new boom is in the making. It will undoubtedly pay to be selective and to think carefully about whether you want to make the type of long-term commitment that private-equity investment requires, even investing in it at one stage removed.

Most practitioners appear pretty sanguine about the prospects for the industry, notwithstanding worries about higher inflation, rising interest rates and a slowing economy. "Private equity is an absolute-return class - the discipline is to make money come what may," says Pantheon's Mr Lebus. "And the best managers make money at all stages of the cycle. What private equity gives you is access to a business process that you simply don't get access to in the listed sector. But you have to be selective. There are plenty of managers out there that get it wrong," he says.

Picking stocks in a sector of this type is a matter of reconciling a track record in long-term NAV growth with a trust's valuation, particularly its premium or discount to NAV. But one overriding point to bear in mind is that shrewd fund-of-funds managers can do well and that, on the whole, those managers specialising solely in the larger end of the market, where prices and funding structures are stretched, might be best approached with caution. Five-year NAV growth shows surprising disparities in performance. With private equity, you can't necessarily assume that a poor NAV performance in one year will be repeated in the next, because of the haphazard incidence of realisations. But, over five years, these trends should even out.

At present, the sector sells at close to parity with NAV. The five-year change in NAV for the sector averages out at 67 per cent. Eliminating those trusts with below-average NAV and a higher-than-average premium to NAV, or those trusts showing a NAV decline over five years, knocks out 3i (which stands at a 16 per cent premium to NAV, despite a fractionally below-average NAV performance), plus Candover, Standard Life Private Equity, Private Equity Investor and Prelude Trust.

Trusts that stand out as offering an interesting value proposition on the basis of the statistics include Mithras (an 84 per cent uplift in NAV over five years, but standing at a 15 per cent discount) and SVG Capital and Electra Private Equity, both of which stand on small discounts.

Rutland Trust, recently merged with August Equity Trust and with new managers, is a turnaround specialist that has also seen a near-doubling of NAV over five years and stands at a small

single-figure discount to NAV. But the likely impact of new managers is hard to assess at this stage, and it is probably best avoided for the moment. The best of the rest are Graphite Enterprise, with five-year uplift in NAV of close to 90 per cent and a discount of around 7 per cent, and Dunedin, with growth of 74 per cent and a discount of 14 per cent. Brief details of the best buys among these trusts are given below, as well as in the table on page 21.

SVG Capital (SVI)
With a market value of approaching £1.2bn, SVG is easily the second largest player in the quoted private-equity sector, after 3i. The trust provides the only undiluted access for private investors to the funds of Permira, formerly Schroder Ventures - which is regarded as one of the most astute players in the business.

SVG's NAV has increased by 117 per cent over five years and its one-year and three-year growth numbers are consistent with this performance. Despite its size and international scope, SVG is generally an investor in mid-market deals. Its largest investment currently is Freescale, a specialist US semiconductor business that it bought last year, but investments are typically more in the £50m to £100m range. Other investments last year included Iglo Birds Eye, the frozen food business, and past or present portfolio companies in the UK include The AA, Gala Coral, Travelodge and New Look.

We reckon that Permira has proved itself a steady and cautious player in the market and that the current minute NAV discount on SVG's shares is a small price to pay for access to its expertise and track record. Buy.

Graphite Enterprise Trust (GPE)
Formerly known as F&C Enterprise Trust, Graphite Enterprise is essentially a fund of funds, but it also invests direct, mostly through co-investment opportunities. Most of its focus is on mid-market buyouts, but it does have exposure to some larger buyouts, and to other parts of the private-equity scene. It has a portfolio of more than 15 funds, including some of the best-known and most highly regarded.

It looks at its portfolio in terms of the underlying companies in which it invests - whether directly or through a fund - and these currently include Cinque Ports, Standard Brands, Wagamama, Intermediate Capital, Weetabix and Kwik-Fit.

Its blue-chip portfolio of private-equity funds is probably its biggest attraction, and its record is solid. The shares currently stand at a small (7 per cent) discount to NAV. Buy.

Mithras Investment Trust (MTH)
Mithras is a fund-of-funds trust that is best viewed as a way of gaining access to the funds managed by L&G Ventures, the private-equity offshoot of Legal & General. The fund's portfolio is a bit of a hotchpotch, with a number of fixed-income investments, plus participations in a number of L&G Ventures funds, as well as stakes in listed private-equity vehicles such as 3i, Eurazeo and SVG.

It also acquired a small specialist fund-of-funds management business earlier this year as a way of improving its management in this area. Seven fund-participation acquisitions have been considered since then, and commitments made to two: Doughty Hanson V and OCM Principal Opportunities Fund IV. This should avoid the charge that Mithras is simply a passive investor in L&G funds.

Not that this has been entirely a bad thing. L&G funds in which the company has invested exited from three investments during the year, including Tragus, which generated a whopping internal rate of return of 155 per cent, and Vue Cinemas. Two new investments have been recorded, in Integrated Dental Holdings and in South Lakeland Parks, a caravan and holiday lodge park operator.

But the primary attraction of Mithras is its relatively low rating - a 15 per cent discount to NAV for a fund that has seen an 85 per cent uplift in NAV over the past five years is well above the average. This valuation anomaly is probably down to the trust's relatively low profile and the paucity of readily available information on its activities. The recent move to more active fund-of-funds management suggests that this could be changing, and so there could be scope for a rerating. Buy.

Electra Private Equity (ELTA)
Electra, a long-standing private-equity player, is something of a hybrid, investing not just directly in buyouts and similar transactions, but also in other types of investment - property and listed companies, for example, where these can be approached from a private-equity standpoint. The trust also invests in fund participations in both the primary and secondary market, especially where these can be used to provide co-investment opportunities.

And this approach has been successful, producing a near-doubling of net assets over five years. Unlike some other funds, though, a bunching in realisations has produced a substantial uninvested cash position, which might mean slower growth in the future. Share buy-backs and returns of capital to shareholders are likely to continue to soak up some of this cash, but the group is also firm in its intention to reinvest fully in private equity and has beefed up its investment team.

The latest realisation is the £87m proceeds from the sale of Capital Safety Group a substantial uplift on the original investment of £24.1m. The group has invested in the Candover-backed vehicle making the bid, so continuing its involvement. Another recent investment was the £34m secondary buyout of Nuaire, a ventilation business. Electra also has an existing investment in Vent-Axia. Other investments currently in the portfolio include Amtico, Baxi, Bizspace, Freightliner and two businesses in India: a software operation and a manufacturer of recordable CDs.

Growth may slow in the short term while Electra invests its cash, but the shares look a worthwhile long-term buy.