Private equity trusts: bargains or traps?

In the fund space, private equity investment trusts are a seemingly straightforward route into this market. Such vehicles have racked up big wins in recent years: as the chart shows, the five trusts with the strongest share price total returns over the decade to 14 August 2020 have outpaced the S&P 500's gains in sterling terms.

The long-term story can look compelling, and so do recent valuations: while 3i Group (III) and HgCapital Trust (HGT) shares traded at premiums to the value of underlying assets on 17 August, all other private equity trusts have seen their shares languish on double-digit discounts (see table). The sector can also provide exposure to some resilient industries, with private equity's growth focus leading it into areas such as tech and healthcare. On top of this, analysts have noted that such trusts' portfolios tend to outperform public markets in times of stress.

But a lack of recent portfolio detail means judging the best entry point looks difficult for now. On top of that, it is important to consider how different private equity trusts work, how they are positioned and what may best suit your appetite for risk before diving into what can be a volatile sector.

A lack of clarity

Wide discounts on private equity trusts can be attributed to a handful of factors, including the fact that some struggled when the financial crash hit. The sector arguably looks stronger than it did then, but other issues may be of greater concern for investors wondering whether to buy now.

Most importantly, there is little clarity about how trusts' underlying holdings have held up. Private equity trusts tend to provide net asset value (NAV) updates on a delayed basis – meaning that many of the latest figures are mainly based on information from the end of March and do not show how privately owned companies have fared during lockdown. In a note from 11 August, Stifel analysts warned that visibility remains "unusually low", and the pandemic's hit on private equity-owned businesses could be staggered.

“Rather than see a dramatic fall in H1 NAVs, our central assumption is that there will be more of a delayed reaction and the possibility of a stepped decline in NAVs over 2020,” they said.

As such, assessing whether you can spot a bargain in this sector, or whether difficulties are correctly priced in, remains a difficult task, and some investors may be tempted to wait for greater clarity to emerge over the coming months. Stifel’s team have argued that they would rather be holders of such funds than buy in for now, given the lack of visibility.

Big tent

Whether you are minded to wait for greater clarity or feel more adventurous, private equity is arguably an effective long-term growth play rather than an easy trade or a source of diversification from listed equities. The volatility involved, and the fact that some investments will take several years to come good, makes this an asset class for patient investors.

Private equity teams tend to invest in unlisted businesses and guide them to different extents, and trusts with a focus on this asset class will vary by investment strategy. But splitting private equity trusts into two or three simplistic groups can be a useful way of initially viewing them. While some predominantly invest directly in companies, others will instead invest in other private equity funds. Some such as ICG Enterprise Trust (ICGT) will do a mixture of the two. Very generally speaking, trusts with a tendency to invest directly should be less diversified, meaning the risks and rewards on offer are both elevated. Fund of fund and hybrid names can offer a broader spread of underlying holdings but may have higher overall charges – something that can drag on NAV returns – by building up a layer of fees from the funds they hold. Other nuances exist: funds investing directly can do so on their own or alongside other private equity specialists, for example.

Generally, those with the most diversified approach look better suited for investors who are new to the sector or want broad exposure with less company-specific risk. As William Heathcoat Amory of Kepler Partners puts it: "The big diversified fund of funds and hybrids are good for long-term investors not trying to be too cute and wanting the compounding capital growth." The offerings here include Pantheon International (PIN) and Harbourvest Global Private Equity (HVPE).

As the names suggest, both have a global remit, though each had at least half of their assets in US companies according to their latest updates. In terms of sector, each trust had a good level of exposure to tech (see chart) and healthcare - something that could serve each well amid the current pandemic. Each had a mixture of exposure to primary investments (newly launched funds), secondary investments (existing funds acquired from other investors) and forms of direct investment. Both trusts have delivered significant share price returns over the last decade. But while shares in each trade at a big discount to NAV, clarity is still needed on how their holdings have done this year.

Going direct

Trusts that predominantly invest directly can be highly concentrated, creating a greater chance of things going very well or very poorly. Any such trust requires greater due diligence – though assessing the merits of a concentrated portfolio can in fact be easier than making a call on a diversified fund with more underlying holdings.

As with Pantheon and HarbourVest, private equity's focus on growth trends has led many trusts to sectors such as tech and healthcare, where innovation is rife. This could serve investors well in the wake of the pandemic, but investors who already heavily back tech and healthcare in their listed equity exposure should remember the need for overall sector diversification.

HGCapital has evolved into a focused play on software and services companies, something that likely explains its shares recently trading at a premium to NAV of nearly 6 per cent. This is a relatively concentrated portfolio and a play on one sector, leaving investors more exposed to industry-specific risks. But some diversification does come through from the variety of different industries served by the trust’s holdings. Recent investments completed by the team include Argus Media, a provider of energy and commodity price reporting, medical imaging software specialist Intelerad Medical Systems, and smartTrade Technologies. The portfolio also covers different geographies and levels of maturity. 

As noted, the only other trust whose shares command a premium is 3i Group. As our first chart shows the trust’s shares have performed tremendously well in the past decade, but even beyond the hefty premium there are issues to be aware of with this name. Mr Heathcoat Amory notes that it is often viewed as a proxy for private equity with exchange-traded funds (ETFs) buying in and out – potentially subjecting shares to higher levels of volatility.

The trust is also reliant to a large extent on the performance of its major holding Action, a non-food discount retailer in Europe. Action has, by the trust's account, executed a "very impressive recovery" in the wake of lockdown, with strong cash generation since its stores reopened in mid-May. As such, 3i Group has attributed an enterprise value to the company similar to that of March 2020. But backing this trust, especially at a premium, leaves you fairly reliant on this one company’s continued success.

Bargain hunt

Of the trusts with a tendency to invest directly, Oakley Capital Investments (OCI) and Apax Global Alpha (APAX) have both traded on hefty discounts but show possible signs of resilience.

Oakley had around a third of its assets in technology, media and telecom names at the end of 2019, but weaknesses lurk elsewhere. The trust had a level of consumer discretionary exposure which could prove vulnerable in the pandemic, with some of its holdings looking exposed. Time Out, the publisher with a focus on many events that will have been curtailed by the lockdown, was among its biggest holdings at the end of last year. Encouragingly, Oakley sold some assets earlier this year, freeing up extra capital. In the hybrid space the same applies to ICG Enterprise Trust, which recently realised a position in Roompot at a significant premium despite its focus on holiday parks.

Apax has so far presented an image of some resilience: 37 per cent of assets were in tech and telco names at the end of March 2020, while some of its services and healthcare holdings have held up well. But the portfolio has seen “mixed impacts”.

Princess Private Equity (PEY) may be another potential buy. The trust cut its dividend payments earlier this year, something Stifel’s analysts believe has resulted in the shares being oversold. Notably the trust has a strong balance sheet, which could serve it well in unpredictable times.