Regular readers will know I have long maintained that this is an unusual economic downturn characterised by high debt. One of the consequences is that central bankers are increasingly frustrated in their efforts to stimulate economic growth. Measures once considered radical – prolonged low interest rates, quantitative easing (QE), negative interest rates – are now the norm. Time will tell how well the financial system copes.
As for equity markets, I leave market timing to wiser investors. But tried and tested strategies can help steer portfolios through uncertain times. I have recently highlighted the importance of diversification. An additional strategy is to seek value – to ‘go deep’ to shelter from choppy waters. The private equity sector ticks both boxes, and I have introduced a new holding to the Growth portfolio during March.
Unquoted attractions
The sector offers access to many thousands of companies that are not quoted on the market, and therefore assists with both diversification and in accessing value. At a time when the present low-growth environment is tough going for large companies in particular, private equity could very well come into its own at a time when sector discounts are at above-average levels.
The asset class has a very good long-term track record when compared with wider equity markets. The reasons are various. By their very nature, private equity firms often take a longer-term view than shareholders in quoted companies – typically four to seven years. This is a positive when investing in equities, in part because a company’s potential can sometimes take time to crystallise but then more than make up for lost time when it does.
Their strategy is to buy into undervalued companies with potential and then, typically, work with an incentivised management to improve efficiencies and fund investment and acquisitions. Often these stakes are acquired at attractive prices because the underlying market is less liquid, less transparent and therefore less liked than quoted companies. But there lies the opportunity.
However, at the moment, sentiment trails fundamentals. The private equity sector has not escaped the wider market weakness. Investment trust discounts have widened, with some trusts recently standing at three-year highs – at least in part because the market does not believe the net asset values (NAV). In these uncertain times, leverage and the possibility of recession are seen as big negatives.
But I suggest the market’s risk perception is wrong. History has shown the sector to be good at managing leverage. Furthermore, the profit growth of the sector’s underlying companies is stronger than the wider market – in 2015, it came in at 8 per cent. And the exit environment remains strong, with private equity managers saying investment opportunities abound.
Standard Life European Private Equity Trust (SEP)
The Standard Life European Private Equity Trust (SEP) provides access to a concentrated range of leading European private equity funds investing in mid to large buyouts – enterprise values of around £100m to £2bn. While the aim is to invest in 35-40 active funds, SEP is unusual in that it has a very focused portfolio with 11 funds presently representing around 80 per cent of NAV. Large shareholdings encourage managers to know their investments well.
Speaking with Graeme Gunn, one of the managers, the team’s bottom-up approach in identifying fund opportunities is complemented by a top-down process highlighting attractive themes and strategies. As such, this makes for a diversified portfolio helped by self-imposed limits of no more than 12.5 per cent of NAV in an individual fund and 20 per cent in any one manager.
Although just under 20 per cent of the portfolio value is held in the US on a ‘see through’ basis, the managers believe Europe offers better value and profit growth prospects given the signs of improvement from a low base. There has been an increase in transaction activity, and the exit environment for private equity investments has remained strong – helped by rising prices, with corporates in particular keen buyers.
This is especially good news for SEP because it has a relatively mature portfolio, with 50 per cent of its NAV being around five years in duration and over. The greater an investment’s maturity, the closer it is to realising financial value. SEP’s realised returns relative to acquisition cost since 2010 have increased from 1.78 to 1.94 – ie, to a near doubling of its original investment.
SEP has tended to conservatively value its portfolio in the interim. During 2015, it saw a 14 per cent valuation uplift on completed exits or realisations. On that basis, the latest NAV estimate of 301p would equate to over 340p. After all, this is a sector where there is no incentive to inflate estimates – quite the contrary, given the potential loss of credibility. Remuneration is often based on 10-year cash-on-cash returns.
Space does not allow more detail – such as SEP’s gradually increasing exposure to the lower-risk secondary market. Suffice to say, an excellent track record relative to the market, a 32 per cent discount to estimated NAV and a yield of 2.5 per cent when bought at 204p, coupled with depressed sentiment and yet positive outlook for both the sector and SEP’s conviction approach, all suggest support. Having bought a 4 per cent weighting for the Growth portfolio, I have also introduced a 6 per cent weighting to my website’s Thematic portfolio.
Other portfolio changes
To help fund the purchase of SEP within the Growth portfolio, I sold Acorn Income Fund (AIF) when standing close to NAV after a strong run. AIF retains its position in the Income portfolio, but taking profits are seldom the stepping stones to ruin.
Other changes during March continued with the themes of diversification and value. Within the Growth portfolio, the existing holding of New City High Yield (NCYF) was added to when yielding 8 per cent and standing at NAV. The existing holding of Ecofin Water & Power Opportunities (ECWO) was also topped up when yielding 6.6 per cent and standing on a 20 per cent discount.
In addition, I top-sliced JPMorgan Japanese (JFJ) and used the money to add to JPMorgan Japan Smaller Companies (JPS) when standing on a slightly wider discount. While remaining very positive on Japan, I suggest growth-orientated portfolios will benefit from a smaller company focus.
As for the Income portfolio, the only activity during March was adding to the existing holding of City Natural Resources (CYN) when yielding 6.4 per cent and standing on an 18 per cent discount. I remain positive on the sector but this will not be a smooth path.
ABOUT THE AUTHOR:
John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned. For more portfolios and commentary please visit John's website at: johnbaronportfolios.co.uk
