- With share price discounts still wide, private equity trusts have started putting their cash to work in different ways
- Is this a good sign or a red flag?
Higher interest rates and volatile markets only seem to have reinforced a notable trend in the private equity investment trust sector, whereby such funds are richly rewarding shareholders despite still being plagued by sizeable discounts.
Share price total returns over the past year for trusts not winding down range from a modest gain in the case of Apax Global Alpha (APAX) to the more than 70 per cent leap registered by the gravity-defying 3i Group (III).
And yet the discounts at which shares in such trusts trade versus stated portfolio net asset values (NAVs) are equally significant, with the largest for the mainstream trusts being HarbourVest Global Private Equity (HVPE) on around 40 per cent. That reflects an ongoing distrust in portfolio valuations, as well as reputational issues that have continued to hover over the sector since as far back as the financial crash.
Like many other trusts, some private equity vehicles have attempted to win shareholders over with a series of eyebrow-raising measures in recent months, as discussed in our latest Investment Trust newsletter. Princess Private Equity (PEY) was the latest to join the ranks late last month when the board said it would use 75 per cent of free cash flow to buy back shares whenever the discount was 30 per cent or higher. It will use 50 per cent of its free cash flow for buybacks when the discount is between 20 and 30 per cent.
As with major buyback programmes from the likes of Scottish Mortgage (SMT), such efforts might help narrow the discount and help protect a trust from activist investors and acquisition attempts. But much as that might please boards and professional investors, not all actions will play out in the same way.
The changes so far
At Princess Private Equity, free cash flow is defined as "gross cash plus distribution and secondary sales", once other outgoings such as the trust's dividend, fees and any debt have already been covered. Free cash will be recalculated at the start of each quarter, and the board reserves the right to carry out buybacks when the discount is less than 20 per cent, too.
It's worth noting that Princess is following in the footsteps of others. Pantheon International (PIN) unveiled a substantial buyback programme in August last year, committing up to £200mn, or roughly 15 per cent of the trust's market capitalisation at the time, to such purchases for the financial year to 31 May 2024. The board also set out a change to the trust's capital allocation policy that would see it dedicate a proportion of net portfolio cash flow to buybacks, with the exact amount to be determined "by reference to the prevailing discount to NAV at which the company's shares trade" and to be periodically reviewed.
HarbourVest, meanwhile, announced a new "distribution pool" in February to fund future share buybacks or special dividends. It will be funded by a proportion of the sales from the portfolio in future, with this amount initially set at 15 per cent.
The board's directors will decide when the cash is used, with them considering "the macroeconomic environment, the discount to NAV at which the shares are trading (both in absolute terms and relative to peers), market sentiment, and the relative merits of distributing capital against the potential benefit of committing to new investment opportunities."
This could involve opting for buybacks when the share price discount is especially wide, while the group might choose to retain the cash to "preserve capacity ahead of a future downturn, or allocate some for reinvestment". The board has also emphasised its focus on the impact such policies might have on the trust's balance sheet.
How effective are they?
A big debate about buybacks, for all manner of trusts, relates not just to whether they can help shift sentiment but also to whether such cash would be put to better use on new investments, especially in depressed markets. Our newsletter highlighted that buybacks across all sectors have had little obvious effect on discounts in 2023, albeit many other factors are at play here.
However, buybacks would appear to make sense in an era of especially wide discounts. As Mick Gilligan, head of managed portfolio services at Killik & Co, puts it: "I generally raise an eyebrow if a trust is sitting on a sizeable discount and then makes a new investment. A trust on a 30 per cent discount must find a new investment that is 30 per cent more attractive than the existing portfolio to justify investing in it, rather than buying the existing portfolio on a 30 per cent discount."
Discounts across the private equity sector remain extremely wide, amounting to 20 per cent or more for most trusts.
Investors should also take note of how a trust is managing its balance sheet more generally, especially in the case of private equity vehicles given they need to honour cash commitments and sometimes deploy more money to investments in follow-on funding rounds. The policies outlined above do allow some flexibility, however, with Pantheon International's buyback programme limited to one year for the time being and the other two trusts taking an approach that accounts for balance sheet strength and market conditions.
Some believe the sector should take up such policies more generally to shift sentiment. Investec analysts Alan Brierley and Ben Newell recently noted of Princess Private Equity's new policy: "The proposed allocations to buybacks are an impressive quantum at the headline level and although a 20 per cent discount entry level may not be regarded as overly ambitious, we note that the board reserves the right to undertake buybacks if the discount is less than 20 per cent.
"While the debate over capital allocation policies is still in its relative infancy, the listed private equity sector could, over time, perhaps show even greater ambition regarding the discount level at which a buyback allocation is formulaically triggered."
