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How to invest in private equity

Retail investors have shown little interest in private equity as an asset class. Although it can be more expensive and somewhat opaque it offers diversification and, over the longer term, strong return potential.

| 10 min read

Stock markets don’t have the monopoly on investment opportunities. Some of the most innovative and appealing companies are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies.

Advantages and disadvantages of private equity investing

The world of private investments is potentially a source of diversification and decent returns for investors, although it can be higher risk. The growth a company enjoys can be strongest in its pre-stock market life, if it ever lists on a market all. Yet most private investments are impossible for individual investors to access.

It’s not just earlier stage businesses. The stock market has been getting progressively narrower for some time. Research from fund manager Pantheon highlighted that over a decade the number of US and European listed companies has fallen 23%, while the number of private companies had increased by 74%.

Private equity holdings come in all shapes and sizes. There is just as much variety in the unquoted universe as the quoted one, if not more. Mature private businesses can also provide differentiation to what is available in the public arena. There is a big difference between an unproven blue-sky start up and a mature, privately-owned business such as LV or the AA.

Investment Trusts can provide a gateway into the world of private investments, which is otherwise hard to access. It’s also an area where they can put their ‘permanent capital’ structures to good use.

Investment Trusts are companies listed on the stock market that invest in a specified area on behalf of shareholders. They can offer some important advantages over the main alternative, funds such as unit trusts and OEICs, because of their structure – a fixed number of shares that investors can buy and sell in the market.

It is inappropriate to include non-listed, private investments in open ended funds, i.e. where the size of the fund is variable, for anything other than exceptional and minor circumstances. This is because of their lack of ‘liquidity’ – the ease at which assets can be bought and sold – and the mismatch between this and the constantly changing size of assets under management.

With open-ended funds, a fund manager creates units for new investors and cancels them when money is taken out. Therefore, the fund grows larger as more people invest, and shrinks as they cash in. But when investors buy or sell the shares in an investment trust the trust’s assets don’t change.

This can offer several advantages. Having a fixed number of shares means there isn’t normally a need to buy or sell underlying assets to keep up with changing demand. This can allow a fund manager to be more fully invested as there is no need to keep some cash in reserve to meet redemptions. It also means investment trusts can be more appropriate vehicles to access more esoteric, illiquid assets that cannot be traded easily, such as commercial property, infrastructure projects, or shares in private companies. Having a fixed pool of assets means there is no need to engage in lengthy or expensive buying and selling to meet investor flows.

Why aren’t private equity investment trusts popular with retail investors?

It’s good for investment trusts to be differentiated from open-ended funds and make the most of their structure. It unlocks a much wider tool kit for investors. Yet there can be disadvantages of specialising in, or diversifying into, private equity. The area is notoriously sensitive to the economic cycle, interest rates and sentiment.

As growth slows so does the opportunity for companies looking to expand. Meanwhile, higher interest rates have resulted in a rise in the cost of borrowing, which can be an important factor in the fortunes and valuations of businesses. These things aren’t unique to private companies, but generally it affects them to a greater extent because there is a tendency for them to be more economically sensitive, indebted and less proven. This can make them more vulnerable than large, listed businesses. The interest rate trend, and to some degree investor perceptions around it, has therefore been a drain on sentiment within the area.

That’s perhaps why retail investors have shied away from many of the specialist private equity investment trusts. Having been a darling of investors in the post-Covid stock market boom, the area fell out of favour and has struggled to recover confidence. Although sentiment has improved somewhat over the past year, worries persist that the estimated values of private assets are not up with events, insufficiently taking account of the new environment of higher interest rates and slowing economic growth. For many trusts that’s led to wide discounts persisting in their share prices.

Retail investors account for only 10% of private equity trust ownership, with institutional buyers dominating the share register at 80%, according to AIC data.

As investment trust share prices are governed by supply and demand the market value of a trust’s assets doesn’t necessarily equate to its valuation – it can trade at less than the stated sum of its parts (a discount) or more (a premium). This can sometimes present opportunities to take advantage of depressed investor sentiment. However, there are no guarantees any discount will narrow, and investment performance is likely to be a more important factor in overall returns over the longer term.

An additional complication with private equity trusts is that underlying holdings may only be formally valued infrequently, sometimes as little as once a year. That means the stated Net Asset Value (NAV) is, to at some extent, backward looking – so investors need to factor in any movement, up or down, that might have occurred since.

Retail investors account for only 10% of private equity trust ownership, with institutional buyers dominating the share register at 80%, according to AIC data. This is very different to the ownership of investment trusts more broadly, which is split roughly evenly between the two. Private equity trusts are not as easy to understand as those investing in listed stocks, but there is no reason why over the longer term they can’t produce returns of a similar magnitude. Indeed, performance of the top trusts in the sector illustrates this – although past performance is not a reliable guide to the future.

Alongside complexity, the level of charges among specialist private equity trusts is typically off-putting. It’s more costly to run a private equity trust than it is to run one that invests in listed equities, so this is inevitable, but to some extent it can be mitigated by the trust’s share price. The average discount to NAV is 33% outside of 3i – a behemoth of the sector where the price is highly skewed by its very large position in the successful Dutch discount retailer Action.

Read more: Three investment trusts bucking the widening discount trend

How can you invest in private equity?

While traditional private equity funds require a significant minimum investment, there are opportunities available for investors making modest contributions to their portfolio. Anyone can invest in private equity through investment trusts or other collective investments, such as an Exchange-Traded Fund (ETF).

One example would be Pantheon International – a broad private equity-only trust offering a varied approach to the asset class. There’s a leaning towards more mature buyout and growth capital investments rather than early-stage venture capital, so Pantheon is likely to be a less volatile investment than others biased towards the latter.

The approach focuses on selecting experienced, well-resourced and strong performing private equity managers and maintaining a mature portfolio with exposure to different parts of the investment life cycle. Pantheon has a history of investing in private markets stretching back 35 years, which has fostered strong relationships with leading global private equity managers worldwide. Investors in the Trust therefore access a private equity portfolio diversified by manager, investment type, stage, geography, fund, vintage, and sector. Shares presently trade at a discount of 32% of stated NAV.

Meanwhile, there are broader trusts that invest in private equity companies, offering significant exposure to these assets as part of their portfolios. A standout here is Scottish Mortgage which presently has around 50 private company investments that account for about a quarter of assets. They include some large and well-known businesses including TikTok owner Bytedance and Elon Musk’s SpaceX.

The Trust remains an adventurous investment targeting the disruptive companies of the future, including some well-known private investments that would be otherwise be impossible to access. Clearly, there are very high risks involved with backing these types of companies and keeping to a sensible position size in a portfolio is of paramount importance.

Any investment capable of delivering outsized gains can deliver equally disappointing losses. However, as a modest part of a well-diversified portfolio we continue to believe it is a compelling proposition for the long term. I previously wrote on this topic in more detail: Is Scottish Mortgage a good investment?

Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How to invest in private equity

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