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The case for private equity

John Baron highlights the attractions of an unloved sector and reports on Q3 activity
The case for private equity

Last month’s column focused on the importance of the portfolios achieving adequate diversification, relative to remit, to help protect against market setbacks. Over the past year, this has involved a modest shift away from equities toward more defensive ‘alternative’ assets, including those which should benefit from the rise in inflation. Within their equity exposure, it has also involved reducing the overweight exposure to ‘growth’ after strong outperformance, and ensuring a better balance within the larger ‘value’ component.

A further nuancing of this approach is the scrutiny of investment trust discounts, while remaining focused on the long-term. This can involve adding to sectors that look attractive relative to prospects and the regular questioning as to whether tight discounts or premiums remain justified. This helps to explain recent portfolio changes over the third quarter.

 

An undervalued sector

As highlighted in previous pieces, private equity is assuming greater importance across the investment landscape as fast-growing companies find they have less need to go public in order to access capital for expansion. They may also not want the regulatory burden of listing. As such, the sector offers an increasing number of attractive opportunities – for example, the number of ‘unicorns’ (private companies valued at over $1bn) has risen 10-fold over the last decade.

Meanwhile, for reasons including M&A and major shareholders taking companies private, the number of listed companies has declined by just over 2 per cent a year over the last decade according to a recent report. This trend looks set to continue for various reasons, particularly in those markets looking cheap to bidders.

The sector’s modus operandi is to buy controlling stakes in good companies and then, through engagement and financial/investment discipline, turn them into better companies. Due diligence and detailed research are integral to the process. The interests of the management are aligned to that of the private equity managers, with rewards coming only on disposal. This tends to put long-term value creation ahead of short-term profits.

Such an approach suggests prospects continue to offer promising returns. When some public markets are looking fully valued, investing for the long-term in private companies offering more potential, while appearing attractively valued relative to prospects, should continue to produce superior returns.

Of course, bids by private equity companies for strategically important aerospace/defence companies require scrutiny. This is why Kwasi Kwarteng, the Business Secretary, is right to refer the bid for Meggitt to the Competition and Markets Authority on grounds of national security. The same applies regarding the bid for Ultra Electronics. However, overall, the sector’s record cannot be ignored.

For the typical investor, exposure to private equity is best accessed through investment trusts which, because of their close-ended structure, provide the ideal ‘incubator’ environment for such investments to flourish over time. This has helped investment trusts strongly outperform public markets over the decades. Furthermore, following the financial crisis of 2008, these trusts are conservatively financed.

Yet many good performing investment trusts still stand on 20 per cent+ discounts. And these discounts may not be telling the whole story – they are often conservative in that a trust’s NAV will not reflect its full current value because, by the very nature of a private business, a significant element may be valued some months previously at a time when markets have been rising. Such discounts appear anomalous when compared to the wider investment trust sector and given their track record over time.

An example is HarbourVest Global Private Equity (HVPE) which has recently been introduced to some of the other real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk. HVPE stands on an estimated discount of 23 per cent, with 15 per cent of the portfolio valued as at 30 September and the remaining 85 per cent as at 30 June. A further example held by these portfolios is Standard Life Private Equity (SLPE).

 

Portfolio changes

Over the third quarter, the Growth portfolio sold its holdings in Templeton Emerging Markets (TEM) and Henderson Far East Income (HFEL), and reduced exposure to Montanaro UK Smaller Companies (MTU) and Oryx International Growth Fund (OIG). With monies raised, it introduced Apax Global Alpha Ltd (APAX), Edinburgh Worldwide (EWI) and BioPharma Credit Investments (BPCR). The portfolio also supported the successful share offer from Augmentum Fintech (AUGM) at £1.36.

Meanwhile, the more defensive Income portfolio sold its holding in Finsbury Growth & Income Trust (FGT), reduced its exposure to The Mercantile Trust (MRC) and introduced Ruffer Investment Company (RICA) and also BPCR.

The sales of TEM, HFEL, MTU, OIG, FGT and MRC continue to reduce the portfolios’ exposure to equities, while being cognisant of discounts relative to prospects. For example, while TEM has performed well, the pandemic reminded investors of the structural weaknesses in some markets. Poor or non-existent healthcare systems, corruption, and lack of economic support have contributed to supply shortages and high unemployment. Such factors require a market discount – the full extent of which is not always evident.

APAX invests predominantly in private equity funds globally, while also holding debt and equity investments. The company has considerable expertise covering four core sectors which it believes will continue to deliver sustained value across the economic cycles - Technology & Digital, Services, Healthcare and the Internet/Consumer sector. A good track record reinforced by recent interim results, and an attractive dividend policy which distributes 5 per cent of NAV, all add to the investment case.

EWI has a global remit to invest in smaller companies with a market capitalisation of less than $5bn. The portfolio does not seek to track the comparative index and so a degree of volatility against the index is inevitable. The portfolio is actively managed and primarily consists of listed companies – although up to 15 per cent of total assets can be invested in unlisted investments.

BPCR has a successful record as a specialist lender to companies in the life sciences sector. The loans are secured on approved, commercial-stage products, while their servicing and repayment is dependent on the products’ success. The company provides diversification both by way of portfolio returns and predictable income streams, while offering a 7 per cent yield. BPCR’s recent transfer to the LSE’s Premium Segment may encourage some platform providers to no longer mistakenly classify it as ‘complex’, which will help liquidity.

Finally, RICA seeks to deliver positive returns whatever the financial environment. Current assets include index-linked instruments, gold and gold equities, derivatives that hedge against market falls, including put options and VIX calls, and a weighting in cash and near-cash equivalents. Some exposure to value companies and Japan in particular also play a part. The company’s unconventional protective instruments should particularly ensure it is better placed than most to weather any coming storms.

 

Portfolio performance

                                                                Growth                 Income

1 Jan 2009 – 30 Sep 2021

Portfolio (%)                                       436.9                     290.8

Benchmark (%)*                               214.0                     156.7

YTD (to 30 Sep 2021)

Portfolio (%)                                       8.9                          6.1

Benchmark (%)*                               10.5                        6.6

Yield (%)                                               2.7                          3.5

* The MSCI PIMFA Growth and Income benchmarks are cited (total return)

 

Portfolio breakdowns for column 29 October 2021    
      
(Performance figures since inception and for year-to-date are given in the column's accompanying Word document) 
      
      
Portfolio breakdowns as at 30 September 2021    
      
Growth Portfolio   Income Portfolio  
      
Bonds   Bonds 
    New City High Yield (NCYF)4.5%      iShares Index Linked Gilts ETF (INXG)5.5%
    iShares Index Linked Gilts ETF (INXG)2.5%      Henderson Diversified Income (HDIV)3.0%
UK Shares       CQS New City High Yield (NCYF)2.5%
    Murray Income Trust (MUT)5.0%  UK Shares 
    Finsbury Growth & Income Trust (FGT)4.0%      Dunedin Income Growth (DIG)5.5%
    Edinburgh Investment Trust (EDIN)4.0%      Montanaro UK Smaller Cos (MTU)5.0%
    The Mercantile Trust (MRC)4.0%      Invesco Perpetual UK Smaller Cos (IPU)4.0%
    Henderson Smaller Companies (HSL)3.5%      BMO UK High Income (BHI)4.0%
    Standard Life UK Smaller Cos (SLS)3.5%      Edinburgh Investment Trust (EDIN)3.5%
    Montanaro UK Smaller Cos (MTU)3.0%      The Mercantile Trust (MRC)3.0%
    BlackRock Throgmorton Trust (THRG)2.5%      Aberforth Split Level Income (ASIT)3.0%
    Aberforth Split Level Income (ASIT)2.5%  International Shares 
International Shares       Murray International Trust (MYI)4.5%
    Baillie Gifford US Growth Trust (USA)4.5%      Edinburgh Worldwide (EWI)3.5%
    JPMorgan Japan Smaller Cos (JPS)3.5%      Smithson Investment Trust (SSON)3.0%
    AVI Global Trust (AGT)3.5%      Utilico Emerging Markets (UEM)2.5%
    Montanaro European Smaller Cos (MTE)3.0%  Themes 
    Oryx International Growth Fund (OIG)3.0%      Herald (HRI)5.0%
    Edinburgh Worldwide (EWI)2.5%      BioPharma Credit Investments (BPCR)5.0%
Themes       Personal Assets Trust (PNL)3.5%
    Herald (HRI)5.0%      BB Healthcare Trust (BBH)2.5%
    BioPharma Credit Investments (BPCR)4.0%      Ruffer Investment Company (RICA)2.5%
    BB Healthcare (BBH)3.5%  Other Assets 
    Standard Life Private Equity Trust (SLPE)3.0%      Standard Life Property Inc (SLI)4.5%
    Worldwide Healthcare Trust (WWH)3.0%      HICL Infrastructure Company (HICL)4.5%
    Augmentum Fintech (AUGM)2.5%      CQS Natural Resources Gro & Inc (CYN)3.5%
    Apax Global Alpha Ltd (APAX)2.5%      BlackRock World Mining (BRWM)3.0%
Other Assets       WisdomTree Physical Gold ETF £ (PHGP)3.0%
    HICL Infrastructure Company (HICL)4.5%      JLEN Environmental Assets Group (JLEN)3.0%
    BlackRock World Mining Trust (BRWM)3.5%      Regional REIT (RGL)2.5%
    Standard Life Property Inc (SLI)3.5%      GCP Asset Backed Income Fund (GABI)2.5%
    TR Property (TRY)3.0%      International Public Partnerships (INPP)2.0%
    CQS Natural Resources Growth & Inc (CYN)2.0%    
    Cash0.5%
Cash1.0%  Total100%
Total100%    
      
Holdings are rounded to the nearest 0.5%