How to value investment trusts' private assets

The valuations of private assets have increasingly come under scrutiny in the past two years, as inflation and higher interest rates sent listed company values on a rollercoaster but left the likes of private equity relatively untouched. 

Private investors typically get exposure to private assets through investment trusts. Since 2022, discounts to net asset value (NAV) have been especially high for trusts investing in unlisted assets, hinting at a degree of mistrust over the underlying valuations, as well as low demand for the shares.

A degree of mistrust is understandable. Unlike listed shares, private assets cannot be sold at a moment’s notice on the stock market. Fund managers' sense of how much their holding is worth cannot be easily defined by the usual metrics. That is a problem, because as Joseph Rowland, fund selection specialist at Investec Wealth & Investment, puts it: “An asset is only worth what someone is willing to pay for it. It's as simple as that.”

Instead, managers rely on other metrics. These yardsticks vary from asset class to asset class, and to an extent from trust to trust, so comparisons can be difficult. Private valuations are published on a backwards-looking basis, because updating and auditing them takes time. And managers are not always transparent on how valuations are carried out. But, by knowing how valuation processes work in the various private sectors, investors can get a better idea of potential issues and a decent picture of the reliability of a trust’s net asset value (NAV).

Private equity's premiums

Private equity is perhaps the sector that is scrutinised the most for its approach to valuations. The valuation process is carried out by looking at a range of metrics, which typically include the initial cost of the company, comparisons with similar listed companies, and comparisons with similar private transactions. Each metric makes up a portion of the overall valuation, but the balance changes over time – for example, a company that was just acquired might be held at cost value for a year, but afterwards the listed and unlisted comparables make up a bigger portion of its valuation. 

Rowland adds a note of caution, saying: “Methods vary between different private equity managers, so the same company can be valued at different prices. It doesn't necessarily mean either is wrong, it's just a slightly different way of looking at things.”

Private equity valuations are usually carried out quarterly. Some investment trusts that invest in other private equity funds, such as Pantheon International (PIN) and HarbourVest Global Private Equity (HVPE), publish monthly updates, but the underlying valuations are still made on a quarterly basis. For example, in Pantheon’s latest update on 29 January, 9 per cent of the reported valuations were dated 31 December 2023 or later, 83 per cent were as of 30 September 2023 and 8 per cent were as of 30 June 2023. Monthly updates can still have a use, because updated valuations from the underlying funds’ managers are disclosed more quickly, and they can account for other factors such as foreign exchange movements.

A helpful aspect of all this is that the valuation lag in private equity absorbs some of the volatility of public markets. For example, when share prices shot up in 2021, private equity managers did not typically increase valuations to the same degree. Arguably, therefore, their NAVs did not need to come down quite as steeply when the public markets’ downturn hit the following year.

One metric that can help investors assess a private equity manager’s track record is the average exit uplift: the difference between the book valuation and the price at which a trust exits the investment when it is sold either to another party or via an initial public offering. If valuations are conservative, a private equity company should be able to be sold at a premium. This is particularly true for buyout funds, which often do deals as a way to realise value, because the acquiring company is typically able to cut costs, acquire new customers and improve its strategic position thanks to the transaction.

Despite worries over the impact of interest rate hikes, initial uplift data for 2023 suggests private equity trusts priced their assets reasonably, as the chart shows. 

There is a caveat: a manager’s track record on valuation uplifts is only telling over the long term. “A premium on a single company doesn't necessarily indicate that the rest of the portfolio is conservatively valued,” notes Rowland. “When investors are asking for their money back, managers sell what they can sell. [That] might mean that the rest of the portfolio cannot be sold at an attractive price, for example because it is too early.” For this reason, the volume of transactions can be a more telling metric to look at. In 2023 this was lower than in previous years, Rowland says.

Growing pains

James Carthew, head of investment company research at QuotedData, says that most of the companies in which private equity investment trusts invest are cash generative, which makes the valuation process easier. But growth capital and venture capital assets are harder to value. 

The fortunes of Chrysalis Investments (CHRY) are indicative of how things can sometimes go wrong. In the year to September 2022, the trust’s NAV dropped by 41 per cent, mostly because of buy-now-pay-later business Klarna, which at one point made up almost a quarter of the portfolio. A funding round in mid-2022 punctured the optimism that had swirled around Klarna at a time when base rates were at zero, and saw its valuation slashed by about 85 per cent. 

Earlier this year, Klarna’s chief executive said the company plans to list soon, creating the potential for an improvement in Chrysalis's position. Numis analysts say: “We understand that Klarna is being held in Chrysalis' portfolio at around the valuation of the 2022 fundraising ($6.7bn) meaning there could be significant upside if press reports of a valuation of $15bn-$20bn at IPO come to fruition, albeit there is no certainty about the process.” This goes to show how much valuations can swing in the world of growth capital. Trust share prices, of course, will often factor in some of these changes ahead of the fact.

It also shows that using funding rounds to evaluate a company exposes investors to some risks. Rowland explains: “In venture capital or late-stage venture capital, some managers value companies using the value of the last funding round or funding point. That shows what someone is willing to pay for some of the shares, but is not necessarily reflective of what the market is willing to pay for the whole company. If one investor was willing to buy a share of the company at a massive premium at a certain point in time, it doesn't mean you can sell the whole company at that same massive valuation.”

At the time of the 2022 Klarna round, Chrysalis also faced sharp criticism because the managers had just received a hefty performance fee. The trust reduced this fee the following year, but there has been no clawback of the initial amount. Understanding how performance fees work can help investors get an idea of how conservative valuations may be. Rowland says: “Investors should check whether performance fees are based on unrealised or realised gains. If they're based on unrealised gains, the manager is heavily incentivised to mark up the portfolio.”

Carthew argues that one area where valuations are particularly difficult to assess is early-stage biotech, because of the number of unknowns: whether the drug will work, what kind of market it could have if it does, what competitors are doing, and whether the company will be acquired by a bigger player. As a result, some degree of guesswork is necessary, Carthew argues.

These issues also concern the trusts investing chiefly in listed companies but which have an exposure to unquoted assets. Scottish Mortgage (SMT), which has close to a third of its assets in unlisted companies, has provided more in-depth information about this section of the portfolio in response to greater scrutiny since 2022, for example giving details of revenue growth and margins at its top 10 private companies.

The trust’s manager, Baillie Gifford, uses what Numis analysts label a “unique and active approach to valuations”, updating them more regularly than every three months, and reflecting the movement of public markets more closely, to account for the fact that investment trust shares are traded daily. “This is radically different to traditional private equity funds, where there are significant valuation lags,” the analysts say.

One-third of Scottish Mortgage’s portfolio is revalued each month, with additional revaluations made for trigger events such as share price moves in public comparables, changes in fundamentals, takeovers, IPOs and third-party transactions. In the 18 months to June 2023, the trust made a total of 871 revaluations across the 99 instruments in its unquoted portfolio. The unlisted portfolio as a whole dropped in value by 28 per cent in the year to March 2023.

Infrastructure: a cash flow problem

The infrastructure sector works a little differently because it typically relies on discounted cash flow models for its valuation processes. In many cases, those cash flows are quite safe and predictable, making infrastructure a less risky asset class than private equity.

But it isn’t always easy to predict what the cash flows will look like in a few years’ time, and what they will be worth. Ben Mackie, fund manager at Hawksmoor Investment Management, notes: “A discounted cash flow methodology relies on lots of assumptions about the future. Assumptions about revenue growth, about inflation, about power prices, about interest rates and discount rates.”

He argues that making these forecasts is particularly challenging for the battery storage sector, which is still a nascent one. While renewable energy trusts typically have long-term contracts that are often inflation-linked, battery storage revenues are partly uncontracted and depend on a range of factors, including power price volatility and the grid’s usage of batteries. “I think most people have been surprised by the volatility of the revenues in the battery storage space,” says Mackie. Earlier this year, Gresham House Energy Storage (GRID) and Harmony Energy Income (HEIT) suspended their dividends, although Gore Street Energy Storage (GSF) says it intends to stick to its dividend target. 

Infrastructure trusts disclose information about the assumptions they use in their valuations, so investors can compare how conservative they are. For example, among the renewable energy trusts, discount rates (the interest rates used to help calculate a portfolio's value) currently range from 7.4 per cent for Atrato Onsite Solar (ROOF) to 11 per cent for Greencoat UK Wind (UKW) when debt is included, according to Stifel analysis of company data. But these also depend on each trust’s exposure to different geographies and energy sources, so like-for-like comparisons can again be tricky. 

With some exceptions, infrastructure valuations have held up decently in a world of high interest rates, as the dividends paid by the trusts have broadly compensated for some modest NAV falls. But there might be more pain to come. Stifel expects power prices to have a negative impact on the renewable energy sector in 2024 and to reduce NAVs by up to 4 per cent, but dividends should once again be enough to offset this on a total return basis.