How private equity is successfully navigating higher interest rates

Pantheon International manager Helen Steers sits downs with ii’s Sam Benstead to discuss private equity investing in today’s economic environment. She explains how the trust uses debt, how the portfolio companies are performing, and why sentiment towards the sector has soured.

Steers also goes into depth about how the trust is making more direct investments in companies, rather than using third-party funds, and why fees are typically higher than listed equity investment trusts.

• Invest with ii: Buy Investment Trusts | Top UK Shares | Open a Trading Account

Sam Benstead, deputy collectives editor, interactive investor:Hello and welcome to the latest Insider Interview. Our guest today is Helen Steers, manager of the Pantheon International (LSE:PIN) Investment Trust. Helen, thanks very much for coming in.

Helen Steers, manager of Pantheon International investment trust: It’s a pleasure, Sam. Thank you for inviting me.

Sam Benstead: Interest rates have risen a lot over the past three years, so the Bank of England rate is now 5.25%. How does this affect the private equity industry?

Helen Steers: Well, I think people get a little bit worried about rising interest rates because clearly when you’re doing a buyout, you are using debt to help [carry out] that transaction. However, what I would say is we are invested mostly in small mid-market buyouts and they tend to use much less leverage, so much less gearing than the very big buyouts that you might read about in the newspaper.

So, on average, we use about 5.2 times, earnings to debt. And on average, our companies have a holding value of about 18.5 times earnings to enterprise value. So, you can see that there’s a very large equity cushion as we call it.

So, with rising interest rates, it does add to the cost of doing the transactions, which means that the fund managers just have to work a lot harder to provide that growth and that value add.

The types of businesses that we’re investing in are high-growth businesses. So, they’re growing earnings at an average of 19% per annum. Therefore most of the value add is through this operational value add rather than through financial engineering. So, that’s a really important point to make in our portfolio.

• Watch our Pantheon International video: the secrets behind 12% annualised growth from private equity
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

Sam Benstead: And these higher rates are one of the reasons the discount has widened on the trust, but rates appear to be plateauing or potentially could fall towards the end of this year. Could that therefore be a tailwind for the shares?

Helen Steers: I think that this worry about interest rates has affected sentiment in private equity, and that probably is one of the reasons why the discounts have widened right across the sector. I think it’s important, though, to stress that the private equity managers are still underwriting the deals to the same rates of return that they were before.

So, even though interest rates have gone up, they are looking for other sources of operational value add. And as we see these exits coming through from our portfolio, even now in more difficult times at uplifts to the holding value, we can really see the proof of the pudding.

So, yes, if we start to see interest rate cuts that could affect the sentiment. But I also think as we keep on reporting these great exits, big uplifts and nice exit valuations that will also help bolster confidence in the trust and in other private equity trusts.

Sam Benstead: We had you in the studio about two years ago. What has changed in the portfolio since then?

Helen Steers: We’ve continued to lean more into direct investments. The trust started out 36 years ago just investing in funds. In fact, until 10 years ago, it was still just investing in funds. But now the weight of the portfolio has really shifted towards direct investments. About 56% of the portfolio is now directly invested in companies, and 46% in funds, and that direction of travel is ongoing.

So, we continue to do more direct investments, either through investments going directly into the equity alongside our managers or through these single-asset secondaries where we’re buying single assets from other private equity funds.

Sam Benstead: And why is that beneficial for shareholders?

Helen Steers: It’s beneficial because we’re essentially using a kind of a double-quality filter when we’re going into these companies.

The first quality filter is only working with the very best private equity managers. In private equity, there’s a huge dispersion of performance between the best managers and the least good managers. In fact, between the first-quartile and the third-quartile managers, it’s about 2,000 basis points. So, first, we need to work with best managers, that’s essential.

Second, we get to choose the assets that we’re investing in. So, we’ve got the top quality filter with the manager, and the second quality filter with the company. So, we’re able to really rifle shot the types of companies, sectors, and geographies that we invest in.

So, that’s a lot of value add for investors in the trust. You can start to see that coming through with this higher NAV performance. I mentioned that it’s close to 14% over the last 10 years versus 12% over the long term, net of all fees.

Sam Benstead: In terms of the sectors and types of companies you own, [we’re] seeing a lot of change over the past two years in the economy. Has that affected what you like to own, or you still sticking to your long-established process?

• The global stock market looks expensive: what should investors do?
• Ian Cowie: this investment trust sector has plenty of bargains

Helen Steers: We continue to lean into what we see as the most resilient, robust areas of the economy. That really started probably more than five years ago. But we’re now able to be even more selective about the micro sectors we invest in.

Around 53% of the trust is invested in information technology, but what I would call boring information technology. It’s these software packages I spoke about earlier, and healthcare.

So, those resilient areas of the economy continue to be what we like to see in terms of consumer. We do very little consumer. I think over the last two or three years we’ve shown that's been quite a good decision. So, consumer staples, consumer services, but not consumer discretionary.

Sam Benstead: And lots of inflation recently, and perhaps some cost-cutting from companies to try and manage that. Have your portfolio companies weathered this economic storm well?

Helen Steers: They’ve weathered it very well. That’s a testament to the real hands-on active management that you get in private equity. The private equity managers control their businesses, they have majority control. That means they can change management and they can direct the companies in different places. They can make acquisitions. So, they’re really able to control those businesses.

Over the last two years with higher inflation, we have seen both cost-cutting, which they’re able to do, and that line of command is very short. But also, interestingly, we’ve seen the managers lean into some of the areas where you can pass on price increases. Almost because of inflation, you’re able to increase prices and pass those prices on to the end consumer. If you’re investing in things such as accounting software, prices are quite easy to implement. You just pay a higher subscription at the end of the day.

Sam Benstead: Fees is an area that private equity is often associated with, high fees. But how expensive is the trust and is there a performance fee on it as well?

Helen Steers: Private equity is a very hands-on active style of management. The types of managers that we work with not only have investment professionals, but operating partners. They have people that go into the portfolio companies to help do that value add. So, it is very hands-on and it does take expensive people to do that. It does tend to be more expensive.

But then what you get at the end of the day, and why investors should consider it, is increased performance over the long term. So, you should be getting 2% or 3% net over public markets over the long term. So, on a net basis, you should be much further ahead, so there is a performance fee on the trust. But it only kicks in after the NAV per share reaches a certain value. That high watermark is £5.61.

We’re out of the money at the moment, and there's considerable headroom there. So, there is no performance fee being paid at the moment at all.

The ongoing charge for the trust, the Association of Investment Companies (AIC) ongoing charge, is 1.31%. If you look at the factsheet and click on the term sheet and the Key Information Document (KID) costs, you’ll see a higher number there. I think it's around 3.6%. Now that’s on the look through basis. When we make an investment in the fund, and 46% of the portfolio is in funds, we have to pay a management fee to the manager, but also a carried interest or performance fee and, rather ironically, the better the manager does, the higher the performance fee.

In some senses, it’s a little bit strange because the higher the performance fee, the higher the performance you’re getting, and therefore the higher the look through cost.

What I should explain is that the 12% net since inception and then 13.8% net over the last 10 years is net not only of our fees, but all the look through fees that you’ll see in that kit.

• Merryn Somerset Webb: investing doesn’t have to be all about America
• How to invest ahead of the general election

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in your trust?

Helen Steers: Yes, I do, and I’ve been investing in the trust for the last 20 years. It’s gone into my ISA and it’s gone into my pension plan as well. What I tend to do is invest regularly every month. So, I use pound cost averaging.

It’s probably worth saying here that right across Pantheon, the trust is very widely held. A lot of people at Pantheon hold shares in the trust. We can’t report on all of the holdings for compliance reasons, but I can say that 18 partners at Pantheon hold around 1.6 million shares in the trust.

I should also mention that our board, which is a very high-powered board, and completely independent of Pantheon, nobody from Pantheon sits on the board, holds 3.8 million shares in the trust. So, they’ve also got a lot of skin in the game, which is nice to see.

Sam Benstead: Yeah, good to see. There’s lots of alignment between the shareholders and the management team.

Helen Steers: Absolutely.

Sam Benstead: Helen, that’s been very interesting. Thank you very much for coming in.

Helen Steers: Sam, thank you very much. Pleasure to be here.

Sam Benstead: And that’s all we've got time for. You can check out more Insider Interviews on our YouTube channelwhere you can like, comment, and subscribe. See you next time.