Private equity investment trusts have not been left behind by this year’s stock market rally with their shares up an average 18%.
One fund often overlooked in this still neglected sector is EPE Special Opportunities (ESO), an £86 million, AIM-listed, Isle of Man based investment company managed by Giles Brand of EPIC Private Equity. Its shares are up 13% this year on a portfolio gain of 33%.
I first came across ESO in early 2009. This was not a good time for the private equity sector, which was suffering a massive hangover following the financial crisis. A lot of new money had poured into the space during the boom times of 2006/07 (ESO was established well before this) with many funds being heavily geared, having purchased assets at the top of the market when the music stopped.
They suffered heavily when asset values collapsed while the value of their debt held firm. Some funds disappeared altogether, some were unable to fund their commitments, many investors lost money as a result, and the sector’s reputation was heavily tarnished (something that the sector has only shaken off more recently).
Not all funds were guilty of these excesses but ESO, like many of the survivors today, was nonetheless caught up in the aftermath. Data from Morningstar shows that its share price plunged 53% in the four months after Lehman’s collapse in September 2008, followed by a fall of 73% during the first half of 2009, making it a shadow of its former self.
At the time, you could have questioned ESO’s ability to survive. It had, and still has, a highly concentrated portfolio, and so was vulnerable to stock specific risk. Liquidity in the market was scarce and the shares traded at a huge 64% discount to net asset value, an NAV that was down 71% as a result of the financial crisis.
With hindsight, however, it made a good investment with Morningstar data showing the shares generated a total return of 1,084% in the last eight years, or 136.2% per annum.
How has ESO achieved this? ESO focuses on smaller and medium-sized enterprises (SMEs) in the UK, investing between £2 and £20 million in transactions. It has an all-sector mandate although it tends to invest in consumer retail, financial services, manufacturing, media and support services.
The transaction types it tends to favour are growth capital in established businesses, management buyouts, distressed situations and private investment in public equity (PIPE) fund raisings by companies. It is very selective, currently investing in just four companies with whom it works closely on their long-term development.
There are pros and cons to having such a concentrated approach. If the managers get the individual investments right, performance will benefit, although the reverse can also be true. One reassuring factor is the high level of alignment between the investment manager and shareholders. EPIC describes ESO as the cornerstone of its business and its employees own over 25% of the investment company’s shares. This incentivises the team to make good choices and explains the fund’s low turnover, buy-and-develop, approach.
A good example of its long-term approach is its investment in Luceco (LUCEL), which listed on the London Stock Exchange in October 2016. EPIC had undertaken a management buyout of the LED lighting products company over a decade prior, for £4.3 million, and received more than £50 million from the flotation. It also retained a 24% stake in the shares, and benefited from their subsequent 63% advance from the initial public offer (IPO) price. As a result ESO was one of last year’s best performers with its shares delivering a stunning total return of 133%, as the Investment Trust Insider e-zine highlighted in its review of 2016.
Interestingly, the Luceco flotation came after a nervous few weeks for new issues, with PureGym and Krispy Kreme cancelling their respective IPOs, while Biffa and Misys both had to trim their prices. The manager considers that this highlights the quality of their companies.
A further consideration is that, with such a concentrated portfolio, the return profile is likely to be ‘lumpier’. ESO’s closed-ended structure means that it can take long-term decisions but investors need to be comfortable with this and accept returns may be volatile.
As a relatively small fund with a performance fee, its expenses can be high. In its last financial year ongoing charges were 3.27%.
Nevertheless, the 444% total shareholder return over the past five years suggests that, for those able to be patient, there is the potential to make good gains. One beneficiary has been Miton Global Opportunities (MIGO) which is a top 10 investor with 4.6% of its investors’ assets in ESO.
ESO is not for everyone, particularly those looking for a smooth ride, but given its record its 29% discount looks higher compared to other private equity trusts, which stand at an average discount of 15% to their NAVs.
Matthew Read is investment company analyst at Marten & Co. James Carthew is on holiday. The views expressed in this article are his and do not constitute investment advice.