Private equity rewards with less risk via ICG Enterprise

Loudly as they might protest, private equity investors have struggled to shake off a reputation as the face of predatory capitalism. This has become clear in the case of WM Morrison (MRW), whose major shareholders recently warned that any takeover must not allow private entities simply to load the supermarket chain with debt or sell off its property portfolio. Elsewhere, angst continues to build about the consequences of a private equity 'feeding frenzy' in the UK.

This unpopularity might help to explain the bargain-basement prices of private equity investment trusts. With the exception of a few names, private equity trust shares remain on double-digit discounts to stated net asset value (NAV). This is in stark contrast to a bumper year for NAV and share price returns in the sector, even for trusts that made more moderate gains. Pantheon International (PIN) has delivered a share price total return of 23.9 per cent over the 12 months to 16 July, putting it ahead of the FTSE All-Share index. At the racier end of things, Oakley Capital Investments (OCI) made a 70.7 per cent share price total return over the same period.

Fund managers in this space argue that the days of predatory behaviour are largely gone, and that most private equity specialists now work to enhance and expand good businesses. For investors that can overcome any concerns on this, the sector still looks appealing: private equity portfolios have proved enormously resilient in the face of the pandemic and successful asset sales at big uplifts to previous valuations have left investment teams with plenty of cash to deploy into new holdings.

We argued last week individual stocks such as MJ Hudson (MJH) provide something of a “picks and shovels” play on the private equity spending spree. Private equity funds give a more diversified form of exposure to this, but your specific choice of trust can make a substantial difference.

The best of both worlds

Generally speaking, private equity funds have one of two structures. Funds such as Pantheon International and HarbourVest Global Private Equity (HVPE) tend to invest in a portfolio of other private equity funds rather than directly in companies, although still have smaller allocations to the latter. This should provide a high level of diversification, although can make these funds' portfolios harder for investors to monitor and understand. For example, Pantheon's latest half-yearly financial report noted that as many as 70 fund managers and 425 companies accounted for 80 per cent of its portfolio.

Funds that invest directly in companies such as Oakley Capital Investments, which has around 20 holdings, can be easier for investors to monitor. But potential losses can be much greater if an individual investment runs into trouble.

But we feel an alternative middle ground is an attractive option. ICG Enterprise Trust (ICGT) combines a high-conviction portfolio containing both direct and secondary investments with a selection of funds run by third-parties. It aims to take enough risk to drive returns while also offsetting the risk of significant drawdowns via diversification.

Its managers look for what they describe as “defensive growth”, favouring companies that seem to have demonstrable growth and limited downside risk, while also avoiding emerging markets and cyclical plays. One portfolio investment theme that fits into this category is the need for companies to navigate regulatory complexity. Holdings which help to meet this need include fire protection regulation specialist Minimax Viking and RegEd, a software provider that helps companies to manage their compliance obligations.

ICG Enterprise Trust had a spread of sector exposures at the end of April, from a 25 per cent allocation to consumer goods and services to an 18.9 per cent weighting in healthcare and 16.8 per cent in technology, media and telecoms. At the time, the top 10 holdings in the portfolio represented 30 per cent of its assets.

As with many other private equity funds, ICG Enterprise Trust’s portfolio held up extremely well last year. More recently, an update for the first quarter has looked especially promising: the trust made its highest ever quarterly proceeds from realisations, thanks to 12 full exits from positions at an uplift of 42 per cent to carrying value. The proceeds represented around 70 per cent of the average annual amount from the past five years and leave the trust's managers well-positioned to seek out new holdings. They anticipate a “very strong year” for investing within the high-conviction segment of the portfolio, with a strong balance sheet providing ample room for such activity.

Yet the trust’s shares are a long way from looking pricey. While they were floored by the sell-off of 2020 and remained broadly flat for that calendar year on a total return basis, its shares have delivered a total return of just over 40 per cent in the 12 months to 16 July. If the shares have outperformed the trust’s NAV gains of around 22 per cent over this period, such stellar gains have done little to dent a discount to NAV of 24.1 per cent, on 19 July. This discount was only slightly tighter than its 12-month average of 25.6 per cent.

If the past decade has taught us anything, it’s that large private equity discounts to NAV can persist – even in the wake of strong performance. A number of factors may be behind this, from the sector’s reputational woes to delays in portfolio NAV updates. But while there may not be a sudden sharp recovery, investment trust shares can still perform well even if they are trading at a discount to NAV.

Boom and bust

Private equity trusts performed well over the past year in part due to their focus on structural growth stories in less cyclical sectors. But they are not immune to broader market shifts. As we saw in the sell-off of early 2020, shares in trusts like these can fall hard when volatility strikes. A big drop-off in risk appetite could again spell trouble, although the longer-term prospects look stronger.

Having held on to some holdings that have listed, ICG Enterprise Trust is also exposed to share price volatility in other ways: its position in US pet products retailer Chewy (US:CHWY) proved painful in the first quarter, for example. The trust had 42 investments in quoted companies at the end of April, making up 14.3 per cent of its assets. But broader diversification helps to offset this risk.

Large share price discounts suggest that private equity trusts remain out of favour, but their portfolios continue to go from strength to strength. With its hybrid approach, ICG Enterprise Trust offers a mix of risk and diversification that should work well.