Are private equity investment trust prospects darkening?

Is Princess Private Equity’s dividend suspension a sign of things to come from other investment trusts in the sector?

The news last week that Princess Private Equity (LSE:PEY) investment trust has suspended its second interim dividend has not been well received by analysts - not least because it raises fears that perhaps this heralds similar moves from other private equity trusts.

Nor has it gone down well with the market. Shares had fallen over 18% since the announcement by the time Investec published its note on the subject on 4 November; as of 8 November they were trading on a 43% discount.

Princess’ board explains the decision as being due to a reduction in liquidity as a consequence of the strengthening of the US dollar against the euro. The trust hedges most of its currency exposure, and the strong dollar has resulted in more than €60 million (£52 million) being paid out to date in 2022 to settle hedging contracts.

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In addition, the board blames “challenging debt markets” for current industry-wide difficulties in seeing through asset sales. In effect, it has enough cash in the coffers to meet commitments, including €60 million of senior loans – but not enough to pay shareholders.

Dividend suspension ‘hugely disappointing’

Ewan Lovett-Turner of Numis believes the dividend suspension “will be hugely disappointing for investors”. Given that the trust has done the same thing before in other stressful situations, including during the 2008 financial crisis and the Covid pandemic, and that investors made their unhappiness known on those occasions too, he suggests that “a further suspension means it will be very hard for income investors to hold the trust”. 

Alan Brierley of Investec agrees. “Coming just weeks after Princess reiterated that its robust balance sheet position supports dividend payments, we believe it is a major blow to credibility,” he says.

Much of the problem is rooted in the currency hedge. As Lovett-Turner explains, hedging in this way means “asset values do not fluctuate with currency moves, but large cash requirements can be needed to settle the currency hedge on a periodic basis, often at times when it is hard to realise underlying assets to fund it”. 

But Brierley makes the point that companies making use of currency hedging strategies have an obligation to manage their balance sheet accordingly. “This is hardly an ‘unknown unknown’, with the decline in the euro versus the US dollar almost straight line since the beginning of 2021,” he observes.

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Yet during that time Princess’ management team has been on a spending spree, investing almost €480 million – more than half the value of its portfolio (as of the start of 2021) – including €72 million as recently as the third quarter of this year.

“Against this backdrop and given the importance of the dividend, investors are entitled to question why the company didn’t ease off the new investment programme, particularly given the maturity of the cycle and with valuations to match, and set aside €26.3 million for the dividend,” Brierley adds.

Canary in the coal mine?

So should alarm bells be sounding for investors in other private equity trusts? Certainly, over-stretched balance sheets led to forced asset sales and caused big problems for some listed private equity trusts in 2007-08.

Brierley recalls how a toxic mix of “poor balance sheet management, including high gearing, some with short-term debt facilities, aggressive over-commitment strategies, some portfolios tilted towards what proved to be materially higher-risk investments, and immature portfolios, contributed to a capitulation which led to many companies considering all strategic options”.

Moreover, the Princess board indicated in its announcement that difficulty in realising assets is an industry-wide issue. However, Lovett-Taylor points out that “several other listed private equity trusts have continued to see an active period for exits and transactions in their portfolios, which has generated cash flows so far this year”.

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Princess’ specific issue has been the currency hedge – and it is the only investment trust to hedge in this way. “In terms of forex hedging this appears to be an isolated problem,” Brierley says.

More generally, Lovett-Turner takes some comfort from the fact that other balance sheets are still in decent shape. “Boards are now much more focused on the strength of balance sheets, and we continue to believe that there will not be widespread issues,” he argues.

Indeed, several listed private equity trusts, including Pantheon International Ord (LSE:PIN), HarbourVest Global (LSE:HVPE) and Oakley (LSE:OCI), have increased their debt facilities in recent months, giving boards more flexibility.

Nonetheless, neither broker is complacent, and both say they will be monitoring activity in the listed private equity sector closely in the coming months, particularly with the prospect of recession or stagflation hanging over the economy.