For more than a decade, investors who operate private equity trusts enjoyed a very fair wind.
An outcome of the quantitative easing policies that emerged after the global financial crisis was that both listed equity and bond prices rose sharply, prompting a cohort of investors to seek diversification in unquoted, or private, equity.
This made raising money from investors relatively easy, while low interest rates made the cost of debt cheap, potentially boosting the returns from investments as private equity trusts both raise equity from clients and borrow.
The extent of that performance is illustrated by the returns achieved, with those private equity investment funds that have a 10-year track record delivering an average of 301 per cent over the period, compared with a return of 187 per cent for the MSCI World index and 87 per cent for the FTSE 100, according to data supplied by Investec.
But an examination of the share price performance of the private equity trusts available to UK advisers and their clients indicates a sharp drop in sentiment towards the sector.
Investment trust discounts
This share price decline means many of the largest funds trade at steep discounts to their net asset value.
Part of the more cyclical factor reflects the economic and market conditions described above — 2022 saw bond markets sell off, thus enabling the traditional inverse correlation between bonds and listed equities to be restored, reducing the appeal for some investors of owning private equity trusts for diversification.
Additionally, given the extent to which interest rates have risen, private equity trusts are faced with higher debt-servicing costs at a time when the companies they bought — and which are supposed to generate the cash to service the debt — may be struggling to grow profits given the wider economic climate.
The potential for these trusts to suffer as they refinance the cheap debt built up during the pandemic has been described as a “cliff edge” by some market participants, but Stifel managing director for investment funds research Iain Scouller says there is “no sign” of the higher debt costs eroding returns yet.
He thinks that fears around the impact of higher rates are misplaced because many of the trusts took the opportunity to lock in low borrowing costs in the years when rates were very low.
For Peter Walls, who runs a fund designed to invest in investment trusts, the Unicorn Mastertrust, much of the bear case cited above is overblown.
He says it is a “good time” to invest in private equity trusts, because many of the negatives such as the potential impact of higher interest rates are dissipating, with it being likely that we are near the peak of the interest rate cycle.
On your marks?
Walls adds that there is “little evidence” that the net asset values of the listed investment trusts in the UK are “too optimistic” at present, and that there is no real incentive for the fund managers to do this because their bonuses are linked to the prices the investments are sold at, rather than the price they are valued at in the accounts.
