Private equity investment trusts have suffered over the past year as market liquidity has dried up and highly leveraged deals have been punished by the economic downturn. The reporting season is underway for those investment trusts with calendar year ends and almost without exception the news has not been good. Many trusts in the sector are now on very wide discounts – the sector average on February 28 was 48% according to the Association of Investment Companies (AIC). However, some, such as Candover, F&C Private Equity B, Pantheon International Participations and Standard Life European Private Equity, are at discounts of more than 80%.
Only one trust of the 16 in the AIC’s private equity sector managed to deliver positive performance over one year to March 16, 2009. HarbourVest Global Private Equity rose by 46.4% in a period where the average private equity investment trust fell by nearly 50%. The fund is also the only one in the sector on a premium to net asset value (NAV).
Candover Investments in particular has declined sharply of late – its NAV fell 50% in the second half of 2008. This fall was largely because of a decline in multiples accentuated by the effect of gearing both at fund and underlying level. For some this issue has called into question whether the private equity business model is sustainable, particularly for large leveraged buyouts. Candover, in the meantime, has announced that it is examining a range of strategic options which may include a temporary suspension of the investment period. A review is being conducted with regard to the outstanding commitment to the 2008 fund, and with gearing at 29% of net assets discussions are underway with lenders in order to restore financial flexibility for the long term.
Despite all this gloom and the potential for further headwinds to come, some funds in the sector could be positioned to benefit from more benign investment conditions over the next few years, in the view of James Brown, research analyst at Wins Investment Trusts, a subsidiary of Winterflood Securities. He highlights Dunedin Enterprise, Electra Private Equity and HgCapital. Wins says that even those funds that are out of favour and languishing on significant discounts still retain the potential for substantial upside, despite risks in the short-term which are reflected in share price volatility.
The primary reason for singling out these three funds, says Brown, is that they have cash on their balance sheets. “Private equity investors have been suggesting the 2009 and 2010 vintages, for those able to invest, could be very lucrative as there will be some distressed opportunities available. There will be upside from earnings growth and multiple expansion.” In particular, says Brown, Dunedin and HgCapital have nearly half of their assets in cash, and have not borne the brunt of the downturn. Crucially, neither has any gearing. On the other hand those trusts with stretched balance sheets, such as Candover, will struggle to invest, he adds.
Dunedin Enterprise is managed by Dunedin Capital Partners, which specialises in providing private equity finance for mid-market buyouts with a transaction size of £10m to £75m. The trust has benefited from investing in the lower end of the private equity market, which did not see the same levels of gearing that characterised the “mega-buyout” end. Wins says its investments are therefore better placed to withstand the economic downturn.
HgCapital Trust focuses primarily on buyouts across Europe. At the end of September 2008, 24% of the portfolio was in technology, media and telecoms (TMT), with 20% in industrials, 18% in healthcare and 17% respectively in both services and consumer & leisure. HgCapital, which manages the trust, restructured its sector teams in February. It closed its leisure and consumer teams in order to focus on four buy-out sector groups: TMT, healthcare, services and industrials. According to AIC figures, the fund is up 137% over five years to March 16, 2009 with lower than average volatility, although over one year it is down and is on a discount of 36.8%.
Ian Armitage is chief executive of HgCapital and manager of the HgCapital Trust, as well as chairman of listed private equity body LPEQ. He says there are two key aspects to look at – the existing portfolio and the opportunity of new investments. “At the moment the prospects for existing investments are poor because the outlook for corporate earnings is very weak. The effect of the downturn in profitability on equity valuations in buyouts is magnified by the debt. It’s exceedingly difficult to speak with certainty about the earnings outlook for many businesses. In respect of existing investments you have to be fairly bearish and run them with a very sharp eye to cashflow and balance sheet strength.”
To the extent that a trust’s companies may be so badly affected they struggle to service debt, Armitage highlights the fact that putting new cash into an existing deal gives the investor huge negotiating power.
Regarding new investments, Armitage is much more upbeat. “We’re seeing falling earnings, falling ratings and declining competition. We’re probably going into the best buying opportunity for 20 years. History has shown that there’s usually an inverse relationship between the level of the stock market and returns from investments. Our 50% cash includes a very prudent reserve for existing investments and will be deployed in new opportunities over the next three to four years.” Armitage says that with the lack of availability and increased cost of leverage, most deals done will be unleveraged and that volumes will decline. “At the moment we don’t see any reason to invest this side of the half year,” he adds.
One trust which has undergone a significant restructuring is SVG Capital, which refinanced its business and its balance sheet and now appears better positioned to meet outstanding commitments over the next few years. “SVG Capital has taken its medicine,” says Brown. “It’s really strengthened its balance sheet, and the NAV has taken a hammering as a result.” The key consideration, though, is not so much where the NAV is but the ability of the underlying companies to avoid breaching their banking covenants and continue to service their existing debt levels, in the view of Wins.