Interest rate rises since the end of 2021 have caused a re-pricing of all risk assets, which has resulted in many investors taking risk off the table.
With income of around 4.5% and 5% available on low-risk assets, such as cash and short-dated UK government bonds, for the first time in more than a decade investors have less incentive to look further up the risk curve for potentially higher returns.
In turn, those UK rate rises, moving from 0.1% two years ago to 5.25% today, have caused discount pain across the investment trust universe. The Association of Investment Companies (AIC) calculates that the average investment trust discount is now at 16.9%, the widest discount for a month-end since December 2008 when the world was in the depths of the global financial crisis.
According to Nick Greenwood, who specialises in buying out-of-favour investment trusts on sizeable discounts and who manages MIGO Opportunities Trust (LSE:MIGO), across the whole sector value opportunities are “patchy” as “some areas aren’t affected” by interest rate rises – mainly the dividend-paying UK equity trusts, which typically yield between 4% to 5.5%.
While there’s the risk of catching the proverbial falling knife, seeking out undervalued investments can potentially pay off over the long term. As Greenwood points out, with investment trusts “a combination of a rising net asset value (NAV) and a narrowing discount can generate quite explosive returns”.
One area that Greenwood is viewing as an opportunity is private equity. He is not alone, with other analysts in agreement that continued pessimism over valuations are misplaced. The sector has been out of favour with some investors due to concerns over whether the valuations attached to the underlying holdings have re-priced accordingly to factor in the higher interest-rate environment. Unlike in public markets, the valuations of private equity companies are set behind closed doors. In addition, there’s a time lag of a couple of months before those valuations are published to shareholders.
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Scepticism towards private equity valuations has caused discounts to widen, with the typical discount ranging between 15% and 40%. Bucking the trend, however, is 3i Group (LSE:III), which is trading on a premium of 8%. This is on the back of very strong recent performance, driven by a notable valuation uplift for its biggest private equity holding Action, the Dutch non-food discount retailer. 3i also has impressive long-term returns, but its 67.7% gain over one year has not gone unnoticed by investors, which is why it is one of only a small number of investment trusts trading on a premium.
Greenwood holds both Oakley Capital Investments (LSE:OCI) and NB Private Equity (LSE:NBPE), which is managed by Paul Daggett. In a recent interview with interactive investor, Daggett said he hopes the catalyst for sentiment towards private equity improving will be when investors acknowledge the evidence that valuations are being priced conservatively.
Daggett said: “There’s been a lot of questions around private equity valuations. I think it will take time for investors to see that the valuations are reflective of the operating performance and growth of the businesses. The realisations (when holdings are fully or partially sold) that we’ve had this year have validated the valuations. And as there are more realisations that prove the valuations, I think that will lead to discounts narrowing.”
In the first half of 2023, its valuations of private companies increased by 3.8% in constant currencies - which remove currency fluctuations. Daggett said: “This was largely driven by strong organic growth at a number of companies as well as accretive M&A – with several companies completing meaningful M&A transactions in the portfolio to support further growth.”
NB Private Equity is trading on a discount of 30.5%. The FTSE 250-listed private equity investment company managed by Neuberger Berman adopts a co-investment focus, which sees it invest alongside other private equity managers and have direct investments in private equity-owned companies. Its current dividend yield is 4.8%.
Scottish Mortgage (LSE:SMT), which owns around 30% in private equity, has also been negatively impacted by valuation doubts. At a recent investment conference, its deputy fund manager Lawrence Burns sought to reassure investors that the unlisted assets are regularly and fairly valued, but admitted that it was impossible to please everybody.
Burns said: “It is always difficult to dissect exactly why a discount exists. There has been a degree of scepticism about private assets in general and how they are valued. Different people have different valuation processes and update times, which can make people wary of whether falls in public equity markets are reflected in private assets.
“We have spent a lot of time in the last 18 months trying to show people the data points and show that we are trying to reflect markets, but at the same time you can’t convince everyone always.”
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Scottish Mortgage also recently released more data about the financial performance of its unlisted stock portfolio. It calculated that its 10 largest private companies had gross profit margins of 38% in the 12 months to June 2023, while revenue growth among this group was 38% on average.
While out of favour in the short term, private equity-focused investment trusts have proved rewarding over the long term.
In our recent analysis of the top-performing investment trusts since the collapse of Lehman Brothers 15 years ago, there were three private equity trusts among the top 10 overall performers: Oakley Capital Investments, HarbourVest Global Private Equity (LSE:HVPE) and HgCapital Trust (LSE:HGT). The respective annualised returns over that 15-year period are 14.1%, 13.6% and 13.3%.
David Johnson, an analyst at QuotedData, said that “this long-term outperformance gives some credibility to the commonly espoused notion that holding on to good businesses for a long period of time is key to generating capital growth”.
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