Jennifer Hill pits private equity trusts against growth capital trusts.
Listing on the stock market used to be seen as a mark of success for companies, but with many choosing to stay private for longer, opportunities to invest in unquoted businesses have grown.
With their closed-end structure and stable base of assets, investment trusts are an ideal vehicle for investing in unquoted companies. Growing demand for investing in later-stage private companies led the Association of Investment Companies (AIC) to introduce the growth capital sector in May 2019.
“The strategy has become more popular as asset managers have realised the growth opportunities in the unlisted space with companies staying private for longer,” says Jayna Rana, an investment companies analyst at QuotedData.
Investment in unquoted shares is the common denominator between the growth capital and traditional private equity sectors. Thereafter, there are several key differences.
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One key factor for investors to consider is where they want their investment to sit in terms of maturity – at the early stage of a company’s evolution, where there is arguably more risk but greater reward, or at a later stage when the business model is more established but still to reach its full potential.
Venture capital investing sits at the lower end of the maturity scale, whereby investors take minority positions in early stage companies, typically in the technology and healthcare sectors. At the higher end, private equity or buyout investors tend to take majority control in cash-generative, profitable and more mature businesses.
Growth capital typically sits somewhere in between. It can take various forms but Peel Hunt considers it an investment made by a minority investor in a private company to fund its next phase of expansion.
“We think of these companies as being more mature than venture capital funded businesses,” says Anthony Leatham, its head of investment companies research. “Typically, they are generating revenues and profits but perhaps lack the cashflow to fund the next transformational step in that company’s lifecycle. There is an overlap with private equity, which makes it hard to draw a clear distinction between the two sectors.”
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However, Oliver Gardey, manager of ICG Enterprise Trust (LSE:ICGT), regards the more mature buyout space in which he operates to be a more attractive investment proposition.
“For a business to get to that position, it has already established itself to an extent in its niche; it has demonstrated it has as ‘reason to exist’ and has an economic model that works,” he says.
“Buyouts focus on resilient companies with strong growth prospects. This results in substantially lower downside risk compared to early-stage investing.”
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However, for Alex Moore, head of collectives research at Rathbones, the distinction is not always clear-cut.
“Many private equity offerings have minority interests in private companies, either as co-investments with other investors or buying equity in the same manner as a growth capital fund,” he says.
Moore adds: “Growth capital ideas can also have a focus on ‘unicorns’ or companies that are a few years away from being publicly listed, something which private equity funds tend not to shy away from either.
“So, from a risk perspective, there are options within both classifications that are riskier than each other and it wouldn’t be appropriate to say one style of investing is riskier than the other.”
Ownership of underlying companies is another key difference. Private equity managers have traditionally taken controlling stakes in their holding companies, so are far more influential with regards to the hiring of management, having board representation and the ability to determine whether and when to exit via an IPO.
“The likes of HgCapital and Apax have large operational teams and will buy a business knowing the 100-day plan to implement operational improvements that they have learnt from buying and owning businesses in the same or similar industries,” says Ewan Lovett-Turner, head of investment companies research at Numis Securities.
“The control gives the private equity house the ability to make change if things aren’t going to plan or be rapidly reactive in difficult times, such as Covid.”
Growth capital funds, meanwhile, take non-controlling or minority interests in private companies. Like holding publicly listed equities, their managers have little or no bearing on the day-to-day operations of their investee companies.
“They may have voting privileges and priority in future funding rounds but are not directly influential with how a company is operated,” says Moore.
Growth capital funds are characteristically concentrated in fewer holdings, some targeting 30 to 60 positions, whereas private equity fund of funds (which partner with private equity fund managers) have a much larger number of holdings.
“Although there are private equity funds which buy direct holdings in underlying companies, fund-of-funds can spread this risk across many names, so on a look-through basis can hold well over 1,000 names,” says Moore.
At a sector level, they tend to offer greater exposure to non-cyclical sectors. Technology (especially software), healthcare and education are large exposures.
“The type of exposure investors get is quite different to listed markets, which have more cyclicality,” says Lovett-Turner.
“The best example is HgCapital (LSE:HGT), which is focused on software and tech-enabled services firms that seek to automate dull tasks, freeing up people to focus on more complex decision-making.
“Hg’s sweet spot is business critical software, for example tax, accounting, payroll and compliance, which generates high levels of recurring revenue.”
There is a noticeable difference in cost, too. Growth capital funds that have launched in recent years have higher charges than public equity offerings but tend to be notably cheaper than private equity funds.
“This is because traditional private equity funds have tended to utilise more resource in terms of personnel and committees to carry out research and make investment decisions,” says Moore.
Having considered several criteria for fund selection – the quality and experience of management teams, track records, key holdings and performance drivers – analysts see merit in funds across both sectors.
Many trusts in the private equity space are trading on wide discounts. Share buybacks at ICG Enterprise and Oakley Capital (LSE:OCI) may act as a catalyst for discount narrowing, according to Lovett-Turner at Numis.
He regards ICG Enterprise, currently trading on a 19.7% discount, as ‘an attractive way to gain diversified exposure to the private equity market’, with its technology and tech-enabled businesses performing particularly well.
He says another “high quality” manager is Apax, which runs Apax Global Alpha (LSE:APAX), one of the bigger trusts in the private equity sector, with more than £1 billion in assets. Rana at QuotedData highlights it for its “healthy and regular dividend of around 5% of net asset value per annum”, which it pays in March and August.
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In the growth capital space, Lovett-Turner and Leatham at Peel Hunt both favour Chrysalis (LSE:CHRY).
“It’s had success with the IPOs of THG (LSE:THG) and Wise (LSE:WISE), and we look forward to the potential performance contribution from holdings in Klarna, the Swedish fintech company, and Graphcore, a British semiconductor company,” says Leatham.
He also sees “plenty of upside potential” in the newly launched Schroder British Opportunities (LSE:SBO) trust, which aims to provide fresh equity for British businesses, both public and private.
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