Will private equity trusts weather the storm?

Private equity investment trusts are an interesting example of how discounts to net asset value (NAV) present investors with a conundrum. Even in the bleakest scenarios, it is hard to picture the sector’s giants shedding 40 per cent of their NAV – as the market has priced in. But while this hints at a buying opportunity for the long term, until investor sentiment turns, discounts will not tighten – no matter how preposterous they may seem. And it may be a while before that happens because this asset class faces some challenges.

Perhaps unsurprisingly, private equity managers argue that this presents an attractive entry point to the sector. But some admit that times have changed, and not necessarily for the best.

“We don't expect returns in private equity to be at the levels they’ve been in the past five years,” says Alan Gauld, senior investment director at Abrdn Private Equity Opportunities Trust (APEO). And while he remains confident that private equity will continue to outperform listed markets, he thinks that the road might be bumpy this year.

Colm Walsh, managing director at ICG Enterprise Trust (ICGT), says that volatility is currently his main worry. “We believe that our portfolio has been constructed to be resilient and I remain pretty confident about its long-term prognosis," he explains. "But we spend a lot of time looking at macroeconomics and it's very uncertain.”

Both the trusts are funds of funds, which invest in a range of private equity assets and funds run by different managers. As a result, they hover at the higher end of the private equity discount chart – investors seem to be slightly more optimistic about the prospects of private equity trusts that invest directly into unquoted companies these days. 

ICG Enterprise focuses on 'defensive growth' companies in the US and in Europe. Its managers pick companies that they believe can grow even in difficult economic climates, typically because of an underlying structural trend that supports that growth. They aim to combine a degree of portfolio conviction with the diversification of a fund of funds. The trust's 30 largest holdings account for a fairly significant 39 per cent of its portfolio, but it also has exposure to a range of assets via primary and secondary funds.

Abrdn Private Equity Opportunities Trust’s strategy is to focus on mid-market buyout deals, mostly in Europe, a fairly targeted approach compared with other funds of funds that cover a broader range of private equity strategies. Gauld says that this means focusing on profitable and cash-generative majority-owned businesses that still have growth potential – the “best of both worlds”. While the majority of Abrdn Private Equity Opportunities Trust’s portfolio – 70 per cent – is made up of primary buyout funds, it also has 11 per cent of its assets in secondary funds. And the remainder is in a newer, growing portfolio of co-investments which its managers look to acquire directly together with one of its underlying asset managers, cutting out a layer of fees. 

Leverage trouble

High interest rates are bad for private equity, partly because the industry relies heavily on leveraged deals, which have become more expensive and harder to conclude. Parts of the industry might be having a hard time making peace with the idea that the era of free money is over. Gauld describes it as a disconnect between buyers’ and sellers’ expectations. “Buyers are expecting this to be an opportunity to get things cheaply, and sellers are possibly still dreaming of the valuation they could have got in 2021,” he says.

Even when mergers and acquisitions pick up again, the higher cost of capital will still erode profits, valuations and ultimately returns. Both ICG Enterprise's and Abrdn Private Equity Opportunities' managers say that they stick with prudent levels of leverage in their portfolios, and some companies hedge their interest rate exposure or use fixed-term facilities. But “there is no doubt that there will be additional costs to these businesses”, adds Gauld.

He is still confident that private equity will make “private equity-type returns” and outperform listed markets thanks to trends that are not going away. For example, private equity investors can tap into specialist sectors and companies that are not available on listed markets, and companies tend to stay private for longer. He adds that private equity showed itself capable of making big returns before the financial crisis when interest rates were at a similar level to now.

Whether the sector will always outperform listed markets is debatable, but Abrdn Private Equity Opportunities Trust and ICG Enterprise Trust have strong long-term track records compared with their public market benchmarks, as the table below shows. 

‘Not the Wild West’

Investors’ trust in private equity valuations is somewhat shaky, partly because they can seem less transparent and less immediate than those of companies in public markets. This is because of how private equity operates and is not easy to fix, but managers are keen to push against the idea that valuations are arbitrary.

“It’s not the Wild West at all – it's not that managers are refusing to mark down,” says Gauld, lamenting a lack of understanding of the fact that private equity valuations do not behave like listed equity valuations. They weren’t inflated in the same way at the height of public markets in 2021 so shouldn't come down that much either, he argues. Not all will agree with that claim.

The managers who run the funds Abrdn Private Equity Opportunities Trust invests in use a mix of transaction comparisons and listed comparisons to derive the multiple they apply to the earnings of their companies. Comparisons with listed companies are imperfect because there might be no exact listed equivalent for the private company being valued and the managers typically add discounts to them to act as a buffer if things go wrong. Meanwhile, transaction comparisons based on private deals are more pertinent, but less timely. As a result, private equity companies are often sold at an uplift to their initial valuation. 

Private equity valuations are delayed compared with those of listed companies so it can take longer for a crisis to show. Before ICG Enterprise Trust’s annual results for the year ended 31 January 2023 were recently published, its most recent NAV update was on 2 February and referred to the three months to 31 October 2022. Its annual results are based on the December valuations of the managers who run its funds, which take time to be audited and verified. “We would love to be able to speed that up but it's difficult,” Walsh says.

Abrdn Private Equity Opportunities Trust releases monthly NAV estimates. The latest at the time of writing refers to March 2023 and 97.4 per cent of the portfolio valuations used were dated 31 December 2022. 

Walsh thinks that ICG Enterprise Trust’s discount cannot be traced back to one single reason but is rather due to a combination of factors. "I don't think that there is a holy grail or a silver bullet which will solve it,” he says.

ICG Enterprise Trust is taking a number of steps to address it instead, including starting its first formal share buyback programme and trying to improve its disclosures on underlying investments.

Walsh recognises that transparency is an issue for a private equity investment trust, at least from a communication perspective. “One of the challenges when you run a vehicle for retail investors is being able to remove some of the mystery," he says. "It's quite difficult.”

He maintains that while transparency for institutional investors is “very good”, with detailed information on single companies, this often cannot be shared with the wider public. Although the trust has been trying to provide better aggregated data, he says the “private” nature of what it invests in prevents it from offering more granular information.

Picking the right managers

Managers in the sector like to talk about how much the industry has changed and learned from the financial crisis in 2008. Walsh likes to deal with managers who were around when it happened, backing those with longer experience, including those that generated significant returns when interest rates were higher. That experience shone through on the weekend of the Silicon Valley Bank collapse, says Walsh, when the trust’s managers reacted very quickly by sending detailed information on how they were managing the risk. The trust had no material exposure to Silicon Valley Bank.

Gauld also puts a lot of emphasis on experience and making the most of Abrdn’s (ABDN) network. “The beauty of our model is that we've got a lot of other client mandates that are focused on emerging private equity firms,” he says. “We can start there and establish relationships when private equity firms are very young in their life and, over time, as they become more institutional, they can become part of the trust's portfolio. We don't tend to back managers we've known for less than 10 years.”

However, the Abrdn trust is one of a handful of funds that Fidelity's investment platform has restricted new investments into, citing “the best interests of our customers”. Fidelity has not given more detailed information on why it restricts access to certain funds and the trust's managers are not aware of the reasons either, although they say will “continue to work closely” with the platform.

Gauld also declined to comment on press reports that Abrdn’s private equity arm is up for sale. “All I can really say is that our private equity team has sat in its own division for a long period of time – it's always been treated slightly differently,” he says.

The division was originally part of Standard Life Investments whose parent company merged with Abrdn in 2017.