Quiet confidence of the long player

Private equity trusts weather stormy conditions because managers have a longer horizon - an approach that has paid off for the F&C Private Equity Trust, which returned 77% over five years.

Private equity investment trusts are well positioned relative to quoted equities to withstand the difficult economic and earnings environment, according to research from UBS. The comment follows UBS’ forecast that America and Britain will slide into a recession next year.

Iain Scouller, an analyst at UBS, says the advantages of the asset class are that managers are more long term in their investment horizon so they are less hit by short-term volatility. In addition, he says private equity-backed companies tend to avoid the daily scrutiny of the market. This is unlike listed companies, which can see severe falls in their share prices on the back of a profits warning or disappointing results.

So how does the theory translate into performance? According to the Association of Investment Companies (AIC) over 12 months to September 30, on a share price basis, £100 invested into the average private equity investment trust would have fallen to £83.10. This compares with the average conventional investment trusts, which would have turned a £100 investment into £77.10.

The only asset class that has made investors money over the past year is the sector specialist, endowment policy sector. It has made a £4.10 gain on £100. Of the 17 available private equity investment trusts to choose from, Scouller says he prefers those funds with diversified portfolios and low company-specific risk. Its buy ratings include 3i Group, Standard Life European Private Equity, while HG Capital has just been upgraded to buy status.

“Given the expected rise in writedowns and provisions later in 2008 and into 2009, we have a preference for diversified portfolios in terms of the number of companies in the portfolio,” says Scouller. “It makes sense for
investors to focus on funds with concentrated portfolios, where the sale of one investment at a good price can add a material amount to NAV (net asset value).

“However, in a more difficult environment for private equity and company earnings generally, which we believe we are now in, the concern is that if one of a fund’s larger investments has to be written down the damage to the NAV can potentially be quite significant.”

Nick Greenwood, a fund manager at Midas Capital, says that it is difficult to generalise that private equity investment trusts will do better than the market as a whole in current market conditions. He says his fund of investment trusts holds a “smattering” of private equity trusts in its portfolio, including the F&C Private Equity and Private Equity Investor funds.

“These are not generalist trusts and none of them invested during 2007,” says Greenwood. This, he explains, was because last year was a very “frothy” market meaning all investments struggled to generate a return.

The £182m F&C Private Equity Trust, managed by Hamish Mair, has returned 77% over five years to October 17, according to Morningstar. This ranks it third out of 15 trusts in the AIC Private Equity sector, in which the mean return over the same period was 34.32%. The reason behind this strong performance, says Greenwood, is stock specific. Neil Sneddon, a director in the F&C private equity team, explains that 70% of the portfolio is invested in unlisted private equity funds, with the remaining 30% in private equity companies.

Despite the trust’s performance Sneddon says that indiscriminate selling of private equity means the F&C Private Equity trust is trading at a 50% discount to NAV. He says other trusts in the sector are in the same position, with discounts as wide as 60-70%.

Scouller says that while many private equity funds saw little change in their NAVs over the first half of 2008, he expects some significant falls in the second half of the year.

Given its outlook for a recession in Britain and America next year, Scouller says a significant increase in defaults is also likely in 2009 to at least the 10% level.

Sneddon explains that performance on the F&C fund has held on the basis that the fund focuses on mid market companies. That is, those companies with an enterprise value of between €50m(£39.5m) to €500m. He says while these companies are not immune to writedowns, their conservative structure means they provide more downside protection than the large buyout market.