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James Carthew: the perverse discounts on private equity

James Carthew: the perverse discounts on private equity

Some of the discounts in private equity investment trusts look perverse given the high prices they are achieving on the sale of mature portfolios.

The listed private equity market has become cluttered with trusts suffering a slow death. Some of these can make interesting investments. For example, when I wrote about the decision of Dunedin Enterprise (DNE) to wind itself up in February 2016 it had a market value of £74 million. Since then, it has returned £30.9 million in two capital distributions and has paid some sizeable dividends, yet it still is valued at £79 million and the shares trade on a 15% discount to their net asset value (NAV) at the end of March.

This shows how the gains realised as private equity funds harvest their mature investments can be substantial, although the process of liquidating these portfolios can take some time.

The asset strippers in charge of Electra Private Equity (ELTA) have decided to try to accelerate matters by looking for a buyer for the whole company. I think this is not a big ask. A long run of good returns, aided by the realisation of investments made in the wake of the bursting of the credit bubble, has allowed private equity firms to raise record amounts of money for their new funds.

There is considerable ‘dry powder’ available for new private equity investments of around $553 billion in the US and Europe at the end of 2017 according to Prequin. Electra’s £415 million of net assets would be a bite-size chunk for many of these funds. No doubt though, even a deal at a price equal to Electra’s asset value would leave material upside on the table for the acquirer.

Given this backdrop, it seems strange to me that most of those listed private equity funds that aren’t in realisation mode are trading at discounts.

I think we ought to be in a phase where the best of these trade at asset value and are raising fresh capital. This applies in particular to those investing in limited partnerships who can use the secondary market to buy stakes in relatively mature portfolios.

I still meet many investors who have an aversion to ‘funds of funds’ and refuse to contemplate buying them. The reason given is usually the double layer of fees. My retort is always that the only thing that matters is the prospective returns after fees. I think a decision to dismiss a fund purely on its ongoing charges ratio is a lazy and, in terms of opportunity cost, potentially an expensive one.

Though I hasten to add that I'm not suggesting investors shouldn’t hold managers to account when fees are excessive!

ICG Enterprise (ICG) is one of these funds of funds. It is a decent size with a market value of about £575 million, trades on a low-teens discount and pays a modest yield of about 2.5%. Around 60% of its portfolio is invested in funds run by third party managers (including funds managed by Graphite Capital, the former manager) and the balance is invested in a mixture of funds and direct co-investments managed by ICG (Intermediate Capital Group).

A £100 investment in ICG Enterprise in December 1997 would have been worth £634 in January 2018. An equivalent investment in the FTSE All-Share index would be worth £330; amply demonstrating, I hope, the attractions of a long-term investment in an ‘expensive’ private equity fund relative to a low-cost index-tracker.

Over five years ICG Enterprise has grown its NAV by an average of 10.9% a year, behind rivals such as Standard Life Private Equity (SLPE) and Pantheon (PIN), which I hold, but just ahead of F&C Private Equity (FPEO) which has traded at or above asset value for two months.

Its recent results for the year to 31 January 2018 contained some interesting insights:

Uplifts on exits: It was making 40% uplifts over carrying value, on average, on the disposals in its portfolio. NAV valuations of private equity funds are conservative by nature and so uplifts of this magnitude are not that rare. I think this makes the discounts that investors apply to listed private equity funds look perverse.

Growth: the 30 largest underlying companies in ICG Enterprise’s portfolio seem quite healthy; they were delivering average revenue growth of 11% and ebitda (earnings before interest, tax, depreciation and amortisation) growth of 12% at the end of December 2017.

Cheap secondaries: the ICG Strategic Secondaries Fund that ICG Enterprise committed $35 million to in 2017 was making investments in funds containing companies valued on average multiples of 6-7 times ebitda. This compares to an average 10.6 times valuation multiple for the 30 largest companies in ICG Enterprise’s portfolio. This underscores the opportunity available in the secondaries markets.

Mature: ICG Enterprise’s portfolio is well diversified by maturity. Well over half of the portfolio was in investments made in 2015 or earlier. These will, most likely, drive returns over the next couple of years.

I know that some readers have entrenched views on the attractions of private equity and the merits of funds of funds but the evidence suggests that, over the long term, they can make you decent money. If we see a meaningful correction in valuations, the underlying funds will be in the market picking up bargains and laying the foundations for future performance. In the meantime, the listed private equity funds should continue to profit from disposals.

James Carthew is a director at Marten & Co, operator of the QuotedData website. The views expressed in this article are his and do not constitute investment advice.


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