Email of the day on investment trusts that invest in private equity from Jonathan Davis:
Comment of the Day

September 10 2020

Commentary by Eoin Treacy

Email of the day on investment trusts that invest in private equity from Jonathan Davis:

Private equity investment trusts are listed companies whose shares can be held in an ISA or SIPP, which is about as tax-efficient as you can get, in the UK at least.

Attached is a list of some of the largest - prices from the Association of Investment Companies as of yesterday morning. 

All bar a couple are trading at discounts, but note that they only publish NAVs at quarterly or six-monthly intervals, and often 2-3 months after the period end, so the estimated NAVs and the associated discount/premium to market price are always out of date and will not necessarily reflect recent market movements. Because of the virus the current published NAVs may be even more unreliable than usual, though a number have now published their Q2 valuations. There are industry valuation guidelines, which are generally widely followed and conservative, but different trusts do adopt somewhat different methods. Some are fund of funds, others invest directly. The basic approach is to apply public market multiples and/or realisation comparables.

Returns have mostly been good however over the last 10 years; until the Covid crisis, discounts have generally been coming in from the very wide discounts experienced during the global financial crisis, when many private equity trusts were heavily geared and suffered disproportionately (they are less so today). The current disparity in discounts partly also reflects the sectors that PE funds happen to favour: ones that focus on tech (such as HG Capital, the only PE trust I have owned) have naturally done better than some others. 

While ten year returns have been higher because of the big initial discounts, returns over five years have been broadly in line with the MSCI World index, so you have to decide whether that kind of return profile is worth paying for, given the higher fees, liquidity issues, gearing, discount volatility and relative lack of transparency compared to listed equity funds. Sometimes yes, sometimes not.

However, they are a diverse bunch and difficult to analyse/compare, so you really need to do your homework or take some specialist advice on which ones might be worth investing in today. Note that currencies in which they are traded are not uniform.

Does this help? Can provide some more granular detail if it helps. I do see some of the best brokers' research, but for regulatory reasons cannot unfortunately share it, least of all to the US market! Will be writing something about PE trusts and other alternative asset sectors in the next edition of the Investment Trusts Handbook out in December. 

All the best - keep up the good work.

Eoin Treacy's view

Thanks very much to Jonathan Davis for sharing his expertise on this topic. Here is a link to the Investment Trust Handbook on Amazon but waiting for the 2021 version may be advisable if additional content will be included to reflect interest in private equity firms.

The point I find most interesting is how returns have come to mirror the MSCI World. That suggests the valuation discount has narrowed and, in some cases, has probably reversed. The big question for investors is whether the COVID-19 has resulted in some mispricing like what happened following the credit crisis.

My sense is it is still too early. The bankruptcy cycle has yet to really occur because of the moratoriums on evictions and massive supports supplied to consumers. As these emergency measures wind down the true health of the real estate and start up scene will be more realistic. There is still a great deal of enthusiasm being expressed by venture investors. For example, here is a portion of an email I received today from a fund organiser I met a year ago:

Our Fund II has raised $10M and invested $3.5M in six startups with artificial intelligence, blockchain, and digital wallet technology. Mendoza provides an actively managed approach to venture capital by investing in areas where they have deep industry expertise, companies with early revenue, a clear value proposition to a market, and targets for early acquisition.
LP’s coming into this fund from now until December will benefit from a first cash distribution, unrealized gains, and allocation into existing investments.

In January 2021, Mendoza Ventures will launch its $100M growth venture Fund III to invest in 12 AI, Fintech, and Cybersecurity opportunities that have been vetted and de-risked using existing portfolio companies and that are ready for a Series A or Series B venture funding round. It is no coincidence that the best investment returns in venture funds come from vintage years when the economy is in recession as it dampens down valuations while allowing the most creative companies with true innovation to rise to the top.

I can understand the rationale of buying when there is blood in the streets but a 10X increase in the size of a fund is substantial and would in no way be possible without continued massive monetary stimulus and absolute faith in the exponential growth of technological solutions to every problem.

The simple fact is this sector is incredibly interest rate sensitive. As long as we have zero rates, there is no limit on the quantity of money these kinds of funds can attract. As soon as interest rates rise, the valuations will come under considerable pressure. That’s generally how bubbles play out.

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