What next for private equity trusts?

The persistent share price discounts on which most private equity investment trusts still trade have tended to disguise a sector in rude health. That was particularly the case in the earlier stages of the pandemic, when a focus on secular growth stories and sectors such as tech, healthcare and education saw many trusts flourish. Private equity investors have managed to get investee companies through lockdowns and then sell assets at a significant uplift to their original valuations. This helps explain the enormous share price total returns from the sector, with most of its constituents outpacing MSCI World index over the past five years.

Yet a harsher environment looms. Concerns about inflation and monetary tightening helped to drive a sell-off in the private equity space earlier this year. That slump, while brief, means that followers of the sector must closely monitor fund updates in the coming months to see how the underlying portfolios have fared.

Bumps ahead?

Specialists will inevitably take different views, but those with concerns have not been convinced by trusts' performance over recent years. Killik & Co’s head of managed portfolio services, Mick Gilligan, continues to harbour a great deal of scepticism about the sector. He believes investors prepared to pay higher fees for the lower-transparency world of private equity portfolios do so because they expect to achieve greater returns in the process. But he argues this has not always been borne out by reality. While the most recent decade has been an exception, Gilligan notes that the average private equity fund has failed to outperform the FTSE 250 index (a proxy he uses for quoted mid-market companies) over several 10-year periods.

Gilligan also worries that private equity success can sometimes rely on savvy timing, a tactic that may prove more difficult to sustain now the market outlook appears less rosy. “There are certain points in the cycle when listed private equity trusts look more attractive,” he says. “This is typically early cycle, when quoted equities are seeing a strong recovery but private equity has not yet caught up and big discounts are available. I think current conditions are more indicative of mid-to-late cycle.”

He concludes with a stark message: “If interest rates continue to rise at the current pace then that is a tricky backdrop for all growth assets and private equity is no different.”

The sector could therefore be in for a bumpy ride, at least in the shorter term. And while there's a good case for private equity continuing to deliver over a long period, presenting opportunities for bargain hunters, there could be a further widening of discounts in the weeks ahead.

James Carthew, head of investment company research at QuotedData, suggests a potential catalyst for further widening would likely come in a few weeks, via private equity trusts' delayed net asset value (NAV) disclosures.

While end of December NAV disclosures are due from trusts that haven't already made them, it’s the end of March disclosures, not due until April and May, that would show drops in valuations since the January sell-off. “When NAV dips come out, you could see more discounts,” he says. However, the shifts in valuations of private assets should be much less dramatic than the volatility we have witnessed in public markets.

While they share a growth ethos with many of the listed companies that have also struggled this year, private equity trusts can still differ significantly. Some seem more vulnerable to a growth pullback than others – something that may present buying opportunities for those with a long view.

Cracks emerge

There are many reasons to back different private equity funds. To give a few examples, names such as HarbourVest Global Private Equity (HVPE) and Pantheon International (PIN) might appeal because of the sheer level of the diversification they have achieved through use of other funds. Options like Oakley Capital Investments (OCI) are much more concentrated, giving something of a purer play albeit with greater stock-specific risk. Others take a broad investment approach, such as the focus on “defensive growth” at ICG Enterprise Trust (ICGT). A few, like Princess Private Equity (PEY), offer dividends as something of a perk, although effectively paying income from capital can produce its own problems.

When it comes to funds that look more vulnerable in further growth sell-offs, one proxy for such vulnerability could be allocations to tech and digital businesses. Stifel analysts attempted to examine this risk in late January, looking at different trusts’ latest disclosed exposures to tech and healthcare as a proxy for their vulnerability to further market rotations.

In the chart below we have updated these figures where possible and added two names omitted from the original Stifel analysis, Oakley Capital Investments and Apax Global Alpha (APAX). As Stifel noted at the time, comparing the trusts on a like-for-like basis can be difficult because they use different sector categorisations. For example, in the case of ICG Enterprise Trust and NB Private Equity Partners (NBPE) we have taken their stated allocations to "TMT" as an imperfect indication of their tech weightings. Their disclosures also come from different points in time. Nonetheless, the figures give a very rough indication of the extent to which funds might struggle if the technology sector continues to underperform.

Topping the chart by some stretch, HgCapital Trust (HGT) has long been popular as a focused play on software and service businesses, and is one of the only trusts to have escaped the share price discounts plaguing the sector. Its small share price premium and the concentrated nature of its portfolio could make it vulnerable if market rotations persist. The trust’s two biggest holdings, business software providers Visma and Access, made up around a quarter of its portfolio at the end of June 2021. However, fans of the trust might note that while concentrated, the portfolio is still diversified by geography, the vintage of its investments and the industries to which its holdings cater.

Names such as Apax Global Alpha and Oakley Capital Investments also have reasonably high tech exposure, with HarbourVest Global Private Equity and Pantheon International notably exposed to tech and healthcare in aggregate. For this latter pair, significant diversification may well offer some protection amid any market rotations. With more concentrated trusts such as Oakley Capital Investments, it can be useful to look closely at the individual holdings and consider how they might fare in a world of inflation and rising rates.

Some of the trusts with substantial technology exposure also have another short-term vulnerability, in the form of exposure to tech businesses that have listed on public markets and hence may face greater price volatility. Carthew notes that many private equity portfolios, including Apax Global Alpha, have tended to run these winners and therefore could be exposed to these price moves. William Heathcoat-Amory, a partner at research firm Kepler Partners, points out that for NB Private Equity Partners "the percentage [of assets] in listed companies has gone right up". The degree of listed exposure can often be difficult to ascertain from trusts' disclosures, however.

You should therefore consider how much volatility you can stomach when choosing a trust in this sector. But in the longer term, vulnerable names could well post a strong recovery from any fresh lows.