During 2012 we have seen a rehabilitation of the private equity sector. While net asset values (NAVs) have drifted sideways to down over the past 12 months and underperformed quoted equities, discounts have tightened. Most private equity funds seem to be trading on discounts around 30%.
One outlier, on the cheap side, is JZ Capital Partners, which has been around since 1986, starting life as Mezzanine Capital Investment Trust. John Jordan and David Zalaznick have managed the fund since inception and have substantial personal investments in it. They are opportunistic value investors and try to work with the portfolio company’s management to build and streamline their business.
The main focus has always been on small or micro cap US companies but the initial emphasis was on mezzanine lending. It switched to standard private equity investment but mezzanine still features in the portfolio with traded bank debt.
The fund has a complex corporate history and, at first glance, disappointing long-term returns but with £400 million of assets, it is worth a closer look.
It is not worth dwelling on the corporate history, apart from 2009 and May 2012. The fund had geared itself with zero dividend preference shares, which had to be repaid or refinanced in June 2009. The credit crunch severely hit the NAV and portfolio realisations slowed to a trickle.
Needing to find $186 million to finance the deal and with just $103 million in the bank, the board decided on an equity fund raising and a new issue of zeros, priced to offer an 8% return. The new shares were issued on the basis of seven for every three held at a 75.7% discount to the last published NAV. The enormous dilution this entailed pretty much destroyed the company’s long-term record.
The 2009 issue compounded an existing problem. The fund was in danger of being controlled by US investors, which would have caused problems with the US regulators. The solution at the time was for US investors to be shepherded into holding separate class of limited voting shares.
To avoid them getting control of the ordinary voting shares, the company took powers to be able to force US investors to sell these shares. This proved inadequate however. In May 2012, it shifted the listing to the Specialist Funds Market and the Channel Islands Stock Exchange and converted all the equity into ordinary shares.
The new ordinary shares restrict the voting rights of US investors (not possible on the main market). The downside was the fund is no longer a constituent of the UK indices, which generated some selling by index funds.
In May there were other changes. JZ Capital Partners now owns 50% of an asset management company; it changed the investment policy to permit up to 30% of the portfolio to be held in non-US assets; and invested in a real estate joint venture that has acquired land in Wiliamsburg, New York. It also bulked up its exposure to the secondary mortgage market.
I am concerned these initiatives make the story more complicated, which could put off investors but the performance since 2009 has been quite impressive. Over most time periods, the NAV returns are among the best of the peer group, let down only by the persistently wide discount.
To address this, the board has committed to paying a dividend of 3% of NAV (a yield just over 4% on the current share price). The portfolio can generate a lot of income but this is unpredictable – hence the adoption of a smoothed distribution. I think they should also look at buying back shares.
At the end of June more than 40% of the portfolio was in liquid resources (including 8% in equities). They are putting more of the money to work, taking advantage of the current environment. The zeros, due for repayment in 2016, are a much smaller part of their funding and the events of 2009 are unlikely to be repeated. Much, however, will depend on the success of the latest initiatives.
James Carthew is a director of Sapient Research