Faith Glasgow explains why analysts are upbeat that private equity trusts are too cheap to ignore, despite investor concerns that the three-month lag in valuations may not reflect reality.
The turbulent environment of the past year has been a tough one for private equity-backed businesses and investment trusts that invest directly or indirectly in them.
Having started 2022 on an average 15% discount, according to Winterflood data, the private equity investment trust sector ended the year with share prices trading on a gaping discount to the portfolios' underlying assets of 36% on average.
An update from the analyst team at Numis is just the latest in a string of reports noting the extent of the sell-off. The fact that most listed private equity (LPE) funds are now trading on a discount of 30% or more, it says, implies “that investors have little faith in portfolio valuations and are expecting further falls given volatile equity markets”.
Discounts have widened across the sector due to concerns among investors that falls in listed markets are putting downward pressure on valuations for unlisted companies. The predicament that investors face is that the value of the underlying investments, the net asset values (NAVs), are reported quarterly by private equity trusts. This results in a timing lag on when the valuations are reported.
Therefore, those NAVs potentially do not reflect the reality of what those assets could be sold for today. At the moment, the latest valuations are for the end of September.
But like other brokers, Numis thinks investor pessimism is misplaced. “We believe the NAVs will be more resilient than most expect, due to the [trusts’] focus on defensive, non-cyclical companies, and based on the strong exits that several funds have delivered,” the note says.
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Winterflood’s team agrees that NAVs in the sector have been bearing up, pointing out that “most private equity funds (excluding the growth capital sub-sector) outperformed the FTSE All-Share Index total return of +0.3% over 2022 on a NAV total return basis”.
“Fears of outdated valuation assumptions delaying inevitable write-offs should be at least partially mitigated,” agrees Winterflood – yet the yawning sector discount persists.
The analyst adds: “We continue to view the depth of sector de-rating as overdone. This is supported by the continued deployment of share buybacks (whereby managers repurchase their own shares to reduce supply, narrow discounts and help improve investor sentiment).”
Of course, some private equity investment trusts were more painfully affected than others by the wider market disruption of last year.
Andrew McHattie, publisher of the Investment Trust Newsletter, makes the point that 2022 was indeed a very difficult one for growth capital, which enjoyed a valuation boom time during and after the pandemic.
Growth capital trusts suffered a dramatic reversal in fortune last year, with steep declines in NAV recorded by Chrysalis Investments (LSE:CHRY), Schiehallion Fund (LSE:MNTN) and Schroder UK Public Private Trust (LSE:SUPP).
However, McHattie thinks “the de-ratings across the board do suggest some element of throwing the baby out with the bathwater.” He points to the disconnect apparent in the position of trusts such as HarbourVest Global Private Equity (LSE:HVPE), which sits on a 44% discount despite having delivered a 15% NAV return over 2022 and 158% over five; and Seraphim Space Investment Trust (LSE:SSIT), which despite being housed in the growth capital sub-sector saw little change in its NAV over 12 months, yet is trading on a discount of 55%.
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Numis is also optimistic that the specific qualities of private equity-backed businesses held in the broader LPE sector mean they remain well placed to deliver strong earnings in 2023.
In particular, they tend to avoid traditionally cyclical parts of the market such as energy, high street retail or banks. They also tend to be quite defensive businesses with good pricing power and able to maintain performance across a range of economic conditions.
Importantly, the input of the private equity managers themselves has enabled management teams to make rapid adjustments as the economic environment has changed. “Operational improvement has been a key value driver for most managers in recent years,” adds Numis.
Finally, the proof of the private equity valuation pudding is in the sale of the asset. “There have been numerous exits during 2022 that have continued to support valuations and led to significant uplifts to historic valuations,” Numis says.
Overall, for investors prepared to take on some risk, the consensus is that good value is now broadly available in the LPE arena.
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