For listed private equity funds, discounts to net asset value (NAV) widened sharply when bond yields rose in 2022. Investors were anticipating that the valuations of private equity investments would follow share prices down after the customary lag.
Boards responded with share buyback programmes in an attempt to add value and close the discounts. Yet discounts remained stubbornly high as valuations stagnated.
When markets started to move higher two years ago, investors could reasonably have expected private equity fund valuations to follow. This should have led to a fall in discounts, regardless of buybacks. Yet the evidence for this is mixed.
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Diverging fortunes for private equity funds
Pantheon International (LSE: PIN) and HarbourVest Global Private Equity (LSE: HVPE) have returned almost 20% in one year, while Patria Private Equity (LSE: PPET) is up over 50% in three. All had significant help from narrowing discounts. However, 3i (LSE: III) has lost 25% and HgCapital Trust (LSE: HGT) almost 15%, as their discounts have headed in the wrong direction.
What is going on? The answer is that 3i and HGT are special cases. 3i traded on a large premium thanks to the phenomenal performance of discount retailer Action, which had come to account for over three quarters of its NAV. When Action’s growth appeared to falter, that led to a slump in 3i’s share price. The £28 billion trust now trades on a 7% discount, up from 30% a few months ago.
3i’s update at its annual general meeting in June showed that pessimism about Action had been overdone. Performance in the rest of the portfolio is steady, but accounts for less than a quarter of the total. So despite 3i’s shares being much better value than they were a year ago, they are still very much a bet on one company.
HGT specialises in the software sector and so it has suffered from fear that its holdings will be disrupted by AI. This fear may prove exaggerated, but has led to a justifiable fall in the share price even though underlying performance has been good. In its June update, it reported growth in revenue and cash generation of 16% and 19%, respectively, as well as £134 million of realisation proceeds in the first half at an average uplift to carrying value of 31%.
However, it has continued to reduce valuations and its portfolio is now valued at a weighted average multiple of 23 times cash generation. This still looks rich, especially as the portfolio carries plenty of debt, but is more than offset by the shares trading at a 23% discount. The shares have recovered from their May low, but the rally should go further.
The price of Oakley Capital (LSE: OCI) has also recovered, but it still sits on a discount of 33%, despite reporting a gain of 6% in NAV in the first half. Literacy Capital (LSE: BOOK) was a sector darling until two years ago, since when its shares have slid 40% to a 37% discount. The NAV has fallen 7% over the last year and is up just 3% over three, but an upturn is surely imminent. Both shares look a bargain.
Time to boost demand for private equity funds
Meanwhile, the funds of funds such as HarbourVest, Pantheon, Patria, ICG Enterprise (LSE: ICGT) and CT Private Equity (LSE: CTPE) – which invest in the funds of other managers or co-invest in companies alongside them – all trade on discounts of 25%-30%. Their boards continue to be obsessed with share buybacks to reduce the discount, but they need to focus more on increasing the demand for their shares than reducing the supply.
Investors are hungry to see evidence of hidden gems in private equity fund portfolios that can grow much larger over time. Action was once just a modest holding for 3i. Boards need to move onto the front foot in extolling their holdings. Yet investors shouldn’t wait for them to do so, or they will end up paying much higher prices.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.