Ceri Jones names investment trusts that invest in unlisted growth companies that operate in exploding growth markets.
While private equity is often seen as too high risk for most private investors, in recent years there has been burgeoning interest in so-called growth capital, namely established businesses that have not yet raised money from the public markets. These companies are often in areas of secular growth particularly tech, for example, digital payment services that are disrupting traditional banking.
This is a very different proposition from the kind of private equity that focuses on the acquisition of underperforming divisions of large companies and businesses that haven’t been aggressively managed, such as Morrisons (LSE:MRW).
Companies are choosing to stay private for longer
Growth companies are particularly attractive because not only do they tend to operate in exploding new markets, but the average time that a private business now takes from its first funding round to its initial public offering (IPO) is double the five or six years it was in 2012.
There is less demand for capital as these companies are not looking to buy plant and machinery, but instead can use modern tools and infrastructure that come under operating rather than capital costs. This means they can become sizeable before they are floated. The Spotify (NYSE:SPOT) and Uber (NYSE:UBER) floats raised £27 billion and £8.1 billion respectively, for example, while interesting companies such as Space Exploration Technologies, Bytedance and Klarna remain private despite valuations in the tens of billions.
“Companies are choosing to stay private for longer, meaning that if they do decide to go public, it is at a later stage in their development,” says Peter Singlehurst, head of the private companies team at Baillie Gifford. “The average age of a tech company at initial public offering is now 11 years. Earlier-stage venture capital funds, with lives of seven to 10 years, often exit just as the companies are hitting the steepest part of their growth curve, while investors in public markets miss out on the earlier gains.”
“The opportunity is huge. At the end of 2020, 923 private companies were valued at over $500 million, with an aggregate value of $2.2 trillion — a similar size to the listed American small-cap and mid-cap market.”
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These companies mostly focus on tech, biotech and wider healthcare, and consumer companies, with traditional businesses such as chemicals, textiles and building areas scarcely represented. However, there are other niches. Princess Private Equity (LSE:PEY), for example, has investments in education and private schools, which are stable businesses with attractive prospects. Success can also be found in surprising areas, such as the printing company Raksul that uses online tools to simplify the order and delivery process and quadrupled in value for Fidelity Japan Trust (LSE:FJV) when it listed in 2018.
Investment trusts are best route for unlisted firms
For the retail investor, investment trusts are a good way to access companies at this high-growth stage in their development. The investment trust structure is also particularly well suited to investing in illiquid assets because it is closed-ended, so managers do not have to worry about redemptions, and trusts will typically hold 30 to 40 holdings, which provides a buffer should a business fail.
“These companies can be attractively priced versus listed peers so if you select the right ones they can be very lucrative,” says David Lewis, co-head of strategy on the Jupiter Merlin team, which holds a position in Chrysalis Investments (LSE:CHRY), an investment trust that takes stakes in privately owned businesses potentially headed for an IPO.
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“Historically, this space was primarily accessed via private equity funds, which tend to be limited life in nature, often around five to 10 years. Here, investors would have to be willing to lock up their assets for that period with the hope of attractive returns at maturity. However, new options have arisen using investment trusts.
“Investors do face the risk of the trust share price swinging around the underlying net asset value, driven by supply and demand for the shares in the secondary market, but if the manager is able to identify successful companies at the right prices then it can be a source of attractive returns.”
Private equity trusts can be picked up on a discount
Currently, many private equity trusts trade on a discount. This is partly because the underlying unlisted businesses have little liquidity: for the trust to sell them, they must find another buyer. Moreover, the key market - private wealth management - remains sceptical because in the 2008-09 crash, some trusts were highly geared. Many investors may also be wary of unlisted securities after the Woodford Equity Income fund was forced to sell fledgling companies prematurely when faced with mass redemptions.
Some investors are also deterred by the high fees, which are typically 4-5%. The Schiehallion Fund (LSE:MNTN), run by Bailie Gifford, is an exception, charging a flat fee of 0.9%. Launched for the firm’s institutional clients in 2019, it is best known for finding buy-now-pay-later business Affirm (NASDAQ:AFRM), and Airbnb (NASDAQ:ABNB).
Among the trusts on appealing discounts are HarbourVest Global Private Equity (LSE:HVPE) on a discount (as at 28 October) of 21%, Standard Life Private Equity (LSE:SLPE) and ICG Enterprise Trust (LSE:ICGT) on 20% and 19%, respectively.
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Peter Hewitt, who manages the BMO Managed Portfolio Trust and has big private equity trust holdings in both his growth and income portfolios, particularly likes HgCapital Trust (LSE:HGT), which invests in business-to-business software. Bear in mind, however, that it trades at a premium of 3%. He also owns ICG Enterprise Trust. which is heavily owned by the retail market.
In the BMO income portfolio, NB Private Equity Partners (LSE:NBPE) is the second-largest holding, and Hewitt also holds Princess Private Equity (PEY), which does not naturally pay an income but is committed to paying out 3% of its NAV each year as dividends.
“Private equity trusts are not only appropriate for SIPPs, but also for a Junior ISA where the time frame is a decade or more, as a way to lock into secular growth areas,” adds Hewitt.
“Trusts such as Schiehallion are good to tuck away for several years as the businesses become mature.”
22 equity trusts have exposure to unlisted firms
Then there are the broader investment trusts you might not immediately think of when considering private equity. A paper by Peel Hunt looking at 22 equity trusts with unlisted exposure highlighted further uplift potential for RIT Capital Partners (LSE:RCP), Fidelity China Special Situations (LSE:FCSS) and Schroder British Opportunities (LSE:SBO, as well as almost the entire stable of Baillie Gifford trusts.
The most obvious is Scottish Mortgage (LSE:SMT), the FTSE 100 member with assets over £20 billion, has 15% in private equity. Edinburgh Worldwide (LSE:EWI) has the next highest weighting in private equity of the Ballie Gifford stablemates at 5%. Baillie Gifford China Growth (LSE:BGCG) and Fidelity China Special Situations have 3.4% and 1%, respectively, in TikTok-owner Bytedance, which plans to launch a music streaming app in China later this year.
Analysts also have high hopes for Swedish battery maker Nothvolt and Chinese payments company Ant International, which are both owned by Scottish Mortgage. Baillie Gifford has unique access to Silicon Valley: in a business where founders are often mission-driven, and looking for a trusted partner, a manager’s reputation helps generate early access to the most promising deals.
A number of trusts have recently upped their ability to hold unlisted positions. Fidelity China Special Situations can now invest up to 15% of its assets in unlisted companies, while Fidelity Japan Trust doubled its allowable allocation from 5% to 10% in 2018.
“In recent years, the unlisted space in China has expanded quite markedly and offers some excellent opportunities for patient, long-term investors,” says Alex Denny, head of investment trusts, Fidelity International.
“Today, ByteDance, whose core domestic Chinese products are its content platform Toutiao and its video-sharing service Douyin, as well as the globally popular social media app, TikTok, is held in the portfolio,” says Denny.
“From a market capitalisation perspective, the company has the potential to become one of the largest companies in China. Other positions initiated over the last year include Chime Biologics, a pharmaceutical biologics contract research and manufacturing company, and Venturous Holdings, a ‘deep technology’ conglomerate focused on digital transformation.”
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Denny believes the regulatory crackdowns in China are unlikely to damage the success, number or size of these IPOs. “Instead, it seems to be part of a greater focus on the rapidly developing domestic capital markets with China,” he says. “These policies are simply likely to drive more companies to listing on the mainland and Hong Kong rather than the US.”
“Similarly in Japan, we are seeing more entrepreneurial activity and a lot of growth companies are coming through, which is creating opportunities in the pre-IPO market.”
However, it may also be challenging for private firms to develop market share in the post-pandemic recovery phase where big will probably be beautiful. William Barlow, chief executive of Majedie Investments, warns that “the current market is one where smaller players can get squeezed out”.
A trust manager’s ability to pick the best underlying companies will therefore be critical. “Now we are seeing supply issues and inflation concerns, this should play to the style of stock pickers,” Barlow adds. “But given the scale of the shock last year, it will take some time to unravel.”
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