Private Equity: Where are the real bargains?
Table: Private Equity
Investment Companies
Tapping private equity markets to invest in companies before they join public stock markets has become a big trend in recent years, particularly as more companies have delayed their debuts on recognised stock exchanges.
In the UK there is an established sector of around a dozen private equity investment trusts which invest either directly in unquoted companies or through other private equity funds, although some do a bit of both. Apart from two exceptions, their shares are cheap, trading on wide discounts to asset value. Nevertheless, their performance has been largely good, in part because they invest more in technology-powered companies than many investors realise.
More recently, a new breed of growth capital funds has captured investors’ imagination by investing in fast-growing internet disrupters. The shares of these younger funds have shot to high premiums over net asset value, leaving investors with a dilemma. Do they go for value and buy the discounted older trusts, or pay up for the shiny, new expensive growth funds?
London’s private equity investment companies may not have received the hammering during the coronavirus pandemic that many expected, but as we start to emerge from the coronavirus pandemic they are facing another challenge.
A new breed of growth capital names has sprung up in recent years, delivering eye-catching returns and stealing investors’ attention.
The likes of Chrysalis Investments (CHRY) and Schiehallion (MNTN) – run by managers with comparatively little private equity experience – invest in a concentrated stable of early-stage companies, whose valuations can soar when they list on the stock market.
Draper Esprit (GROW), a £1.1bn fund launched in 2016, is elder statesman of this young band, which tend to trade at chunky premium valuations 20-30% above their underlying net asset values (NAV). Although, it may soon be leapfrogged by Chrysalis – known as Merian Chrysalis before Jupiter Asset Management swooped on the smaller manager last year – which has announced a share placing programme, aiming to raise nearly £1.4bn.
The contrast with the traditional buyout-focused private equity trusts and fund and funds is ‘chalk and cheese’, in the words of analysts at stockbroker Jefferies.
Their shares almost all trade well adrift of the latest published net asset values, although £11.1bn sector giant 3i (III) and the technology-focused HgCapital (HGT) are exceptions with investor demand pushing them to premiums above NAV (although the latter has recently de-rated and stands close to asset value – check link to fact sheet in the table for the latest premium/discount).
Analysts have flagged buying opportunities, particularly in names like HarbourVest Global Private Equity (HVPE) with significant exposure to strongly performing sectors. Then there are the those on wide discounts, often with a bounce from performance in the latter half of the year yet to be factored in.
But while these trusts have avoided financial crisis-style chaos, investors are still struggling to get excited and discern whether there are actually bargain opportunities beneath stale valuations.
‘There is no doubt that the newer breed of growth capital portfolios offer a very exciting prospect with numerous near-term catalysts,’ said Anthony Leatham, head of investment companies research at broker Peel Hunt.
The team like Chrysalis and Augmentum Fintech (AUGM), a £210m fund focusing on disruptive companies within financial services. After a spell in the wilderness following a setback a year ago at its biggest holding, peer-to-peer lender Zopa, its shares rerated sharply in the second half of 2020 to reach a 26% premium rating in late February.
Leatham acknowledged high premiums on the newer private equity funds can ‘seem off-putting’, but need to be read in the context of good news in the underlying portfolios and companies floating on the London Stock Exchange in a buoyant initial public offering (IPO) market.
Chrysalis is one example, apparently trading on a nearly 30% premium to its latest NAV, which corresponds to the end of September. ‘Our sum-of-the-parts valuation estimate suggests that this is more like a 10% discount to a 12-month forward NAV,’ said Leatham.
Jefferies spoke to the same dynamic in recent notes, with promise in the portfolios justifying the ratings.
‘Rather than the circa 30% exit uplifts we typically see in buyout focused funds, we’ve seen evidence of late-stage venture IPOs generating 100%-200% uplifts to the prior carrying values. In this context the current premiums can be justified,’ said analyst Matt Hose.
Schiehallion is managed by Baillie Gifford, which only started investing in private companies in 2012, but has had a string of successes so far. The £617m investment company launched in 2019 holds stakes in Airbnb and Affirm, which enjoyed massive ‘pops’ in recent stock market listings, both doubling in price on their first day of trading.
Chrysalis is managed by Richard Watts and Nick Williamson, now at Jupiter, who both have strong records in listed small and mid-cap stocks rather than private companies. The concentrated £834m fund benefited from the flotation of top online retailer THG at a significant uplift last year. This month large holding Klarna, a Swedish buy-now-pay-later company similar to Affirm, added 32p to Chrysalis’ net asset value per share when it raised money at a $31bn (£22bn) valuation, three times more than the company was valued at only last September.
Liberum analyst Conor Finn estimated that could increase Chrysalis’ NAV by around 19% or 31p per share. There could be more gains to come if the rapidly growing business pursues a stock market flotation next year.
Jefferies rated both Chrysalis and Schiehallion as a ‘hold’ in late January, at the time saying it was unclear what the next catalysts would be in the portfolio.
In the year to 31 January, shareholders in the former enjoyed a 53% return and the latter a 42% gain. Draper Esprit and Augmentum delivered shareholder returns of 34% and 38% respectively, according to Morningstar.
Hose added that this new breed of funds had also managed to attract a new breed of buyers. ‘The reason they've been so successful is because they've attracted investors who don't traditionally invest in the listed private equity space,’ he said.
Those buyers include wealth managers, a pillar of demand across the investment trust universe, who in some cases were left reeling by the difficulties which firms like Candover and SVG Capital fell into during the financial crisis.
Private equity trusts entered 2008 overly loaded up with debt and proved unable to meet their commitments when they could no longer find buyers for their stakes in companies, with major writedowns in asset values as companies struggled through lack of support in incredibly testing conditions.
While most agree that balance sheets look in stronger shape today, some simply question whether the established names are good enough, including Mick Gilligan, head of managed portfolio services at Killik & Co.
‘I have never been a huge fan of the traditional established trusts. Yes, there are some fantastic track records and [chief executive] Simon Burrows has done an amazing job at 3i,’ he said.
Aside from 3i – which is a different proposition, given the portfolio is dominated by Dutch discount retailer Action and it also manages a £2.7bn infrastructure trust – Gilligan pointed out the sector’s long-term performance did not look so hot compared to global markets.
The Private Equity sector defined by the Association of Investment Companies (AIC) delivered a shareholder total return of 256% in the decade to 29 January. However, that is somewhat flattered by shares moving in from even wider discounts after their crash during the financial crisis.
NAV total return, which reflects a trust’s underlying performance with dividends reinvested, was 174% over the same period. The MSCI World index, representative of performance in developed markets, was 188%.
High charges are also unpalatable to many. Ongoing charges average 1.51% across the sector, according to the AIC.
‘I think most investors expect returns that are greater than quoted equities given the high fees and lower transparency,’ said Gilligan.
For these reasons, Killik prefers quoted equities and the firm does not currently allocate to private equity names in managed portfolios. Gilligan said they had backed Augmentum and Draper Esprit when they launched, although he ‘wouldn’t be inclined to add too aggressively at current levels’. They also own Syncona (SYNC), which backs early-stage companies in the life sciences sector.
Peel Hunt defended the older players, arguing share price total return was more relevant for investors, while noting the wide range of returns in the sector. Aside from 3i’s 333% NAV return, HgCapital has been the top performer over the 10 years to the end of January, posting a 269% gain over 10 years as self-managed minnow LMS Capital (LMS) lost 30%.
‘Manager selection is particularly important in private equity, given the illiquidity of the underlying holdings and the persistence of manager out/underperformance that tends to occur in this sector,’ said Leatham.
The broker thinks the right way to play the sector is blending ‘the excitement of the newer breed with the consistently strong total returns generated by a fund of fund portfolio’.
HarbourVest, a £1.6bn fund of funds run by US firm HarbourVest Partners, is Peel Hunt’s preferred pick. It offers a highly-diversified portfolio with broad exposure to the asset class and thousands of underlying companies, delivering a 401% share price total returns in the 10 years to January.
Leatham particularly likes the 35% of the underlying portfolio in ‘hard-to-access’ areas of venture capital. ‘We see this as a significant competitive edge as demand for pre-IPO access to “unicorns” is growing,’ he said.
The broker estimates the sterling shares are trading on a 14% discount, despite exposure to that area.
In a recent note, Stifel analyst Iain Scouller argued that the established listed funds ‘may surprise on the upside’ in the first half of this year.
NAVs are typically published with a three-month lag, which means updated valuations for the fourth quarter and end of December 2020 will start to appear in March. Even for funds publishing monthly NAVs like HarbourVest, much of the January valuation still corresponds to the end of September.
According to the analysis, there is a good chance the rally in listed markets will boost comparable private equity valuations, leading to hikes in NAV. While Scouller acknowledged that discounts had come in a bit since the start of this year, with shares still trading well wide of those stale valuations, that creates a buying opportunity.
At the end of January, the average discount in the AIC sector was just under 14%, ignoring 3i.
Scouller said we would have to wait till late March for more meaningful signs, but pointed to ICG Enterprise (ICGT) as the latest signal of latent value in portfolios. It reported a 2.4% uplift to NAV from the sale of Telos, its fourth largest holding.
Scouller recently upgraded both HarbourVest and Princess Private Equity (PEY) to ‘buy’, following the publication of strong NAVs with the prospect of further growth.
Underlying sector exposure is an important theme. Scouller noted that the growth capital funds have benefited from their focus on tech, an area many incumbents also have significant and overlooked exposure.
'The existing funds have got quite high tech and healthcare weightings as well, probably more than people quite realise,’ he said.
HarbourVest, for example, has about 44% of its portfolio split across those two sectors according to the January factsheet. After listed companies in those sectors’ strong 2020, that bolsters the chances of a jump in valuations.
The analyst also contrasted the diversified approach with the growth capital funds, which have concentrated portfolios and face the risk of the IPO market slowing down. He pointed out that while it had been relatively smooth sailing for these funds so far, issues with early-stage companies’ business models often take a couple of years to emerge.
At that point, the funds could face tough decisions about whether to put in more money. ‘I think there is a bit of a risk of that with some of the newer funds and some of their newer investments,’ said Scouller.
While its portfolio is now back to growth, Augmentum has already provided an instance of that dynamic with Zopa.
Oakley Capital Investments (OCI) is one name Jefferies has warmed to recently, with analysts slapping on a ‘buy’ recommendation in late January.
The £527m fund has historically had governance issues, for example issuing shares at discount to NAV and a lack of disclosure.
‘These issues have now been resolved though, with, on the former, the board making repeated announcements that it will no longer issue shares at a discount, and also now reflecting this in the fund's by-laws,’ said Hose.
There are challenges at some large legacy holdings, especially in the consumer sector, such as the listed TimeOut (TMO). The shares have overperformed global markets in the last decade, returning 129% to the end of January.
Those factors have combined to push the shares to the biggest discount of any large trusts in the sectors, around 28% in late February.
But more favourably, close to half of investments were in the well-positioned tech and educations as of June last year. Despite a high-growth portfolio, valuations are also ‘relatively modest’, at just under 12 times enterprise value to earnings.
Jefferies argue there is ‘clear scope’ for the discount narrow as the fund keeps making progress addressing its legacy issues and strong performance comes through.
