Private equity investment trusts have seen extreme gaps emerge between the valuations that managers attach to the illiquid assets in these listed vehicles and the prices that investors are ready to pay.
The divergence has raised questions over whether trust managers are taking an overly optimistic view of their prospects amid a weak outlook for economic growth and high inflation, or investors are missing out on possible bargains if bad news is already priced in.
Private equity managers thus far have made only modest adjustments to the valuations of the illiquid assets which they own, even though the share prices of companies listed in broader public markets trade far below their peak levels.
Investors’ reluctance to pay the valuations reported by private equity managers is reflected in discounts on the trusts — the gap between the reported net value of their assets (NAV) and their share price — currently ranging between 18 per cent and 54 per cent, according to Investec.
It has calculated that the 14 largest private equity investment trusts (excluding 3i, which is a company rather than a fund) have reported a combined net asset value of £17.3bn but their aggregate market capitalisation was just £11.1bn, creating a gulf of £6.2bn on May 23.
The average discount across the 14 private equity trusts was 34 per cent, compared with a discount of 14 per cent for the investment trust sector as a whole.
Alan Brierley, an analyst at Investec, said large discounts have become “embedded” in private equity trusts, damaging the returns earned by investors. One obvious solution to address excessively large discounts would be for trust boards to approve share buybacks but most private equity managers appear unwilling or unable to pursue this option.
“A rethink is required as the current discount management strategy has failed. Buybacks can give some comfort at a time when there clearly are concerns about valuations. Buybacks also provide liquidity and can dampen the volatility in discounts,” said Brierley.
Nick Greenwood, manager of the £81mn Premier Miton Migo Opportunities trust which exploits mispricing across the entire investment trust sector, said that investors’ confidence has been damaged.
“Investors will take the view that if this widening in the discounts has happened once, it can happen again. Managers have shot themselves in the foot with their failure in the past to address discounts. It will be difficult for the private equity trusts collectively to achieve a meaningful narrowing of the discount across the sector,” warned Greenwood.
The Migo Opportunities trust owns stakes in the Neuberger Berman Private Equity trust which is trading on a 33.7 per cent discount and the Oakley Capital Investments trust which is on a discount of 29.5 per cent.
Neuberger Berman said the NBPE share price represented an “attractive entry point” and the trust discount “materially undervalues NBPE’s portfolio, balance sheet strength and prospects.” It gave permission to investment bank Jefferies in October to conduct a buyback programme but no NBPE shares have been repurchased to date.
High fees for private equity trusts with annual ongoing charges running up to 7 per cent are also forcing sales by wealth managers, who are concerned about passing these costs on to clients. This is driving a vicious circle of discounts.
“High fees for private equity trusts mean they have become uninvestable for some wealth managers and fund platforms. This has created structural selling pressure which is having a disproportionate impact on private equity trust discounts,” said Greenwood.
He acknowledged that investors were also concerned about trusts using inflated valuations that did not reflect the impact of higher interest rates on the earnings delivered by highly indebted private owned businesses.
“We are only now seeing the valuations for December 31 being disclosed for the portfolio companies owned by private equity trusts. These end of year valuations are audited by the big four accountants and that should provide some comfort to investors that the NAVs reported by the private equity trusts are increasingly realistic,” he said.
Brierley cautioned that further valuation adjustments were likely for private equity trusts with significant venture capital exposures, such as Augmentum, Schiehallion and HarbourVest Global PE.
“Venture capital delivered some spectacular gains in 2020 and 2021 when a tsunami of easy money from non-tradition investors pushed valuations to eye-watering levels,” said Brierly. He added that establishing a fair value for venture capital assets would be a “brutal” process.
Emma Bird, head of investment trusts research at Winterflood Securities, said investor scrutiny of private equity valuations was “entirely understandable” but some of the discounts were “excessive”.
However, private equity trust boards were reluctant to implement buyback programmes as any excess cash was often reserved to meet working capital requirements and possible future withdrawals by investors, said Bird.
“But the derating of listed private equity funds over the past 18 months has prompted more frequent buyback activity. This demonstrates confidence by trust boards in the value offered by their current share prices,” she said.
Brierley said he expected private equity strategies to continue to deliver superior returns and trusts would attract the attention of hostile activists if the issue of excessive discounts was not addressed.
“Listed private equity cannot say that it hasn’t been warned,” he said.
