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 they have a permanent capital structure – a fixed number of shares which investors can buy and sell.
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. When investors buy or sell the shares in an investment trust the Trust’s assets don’t change.
This can offer a number of advantages. Having a fixed number of shares means there is rarely 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 that 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 undeveloped share markets. Having a fixed pool of assets means that there is no need to engage in lengthy or expensive buying and selling to meet ephemeral investor flows.
Is private equity the gateway to niche opportunities?
One illiquid area where a number of trusts have carved out a niche is private equity (PE) – investments that aren’t traded on public markets. Why invest in private equity? For starters, stock markets don’t have the monopoly on investment opportunities. Some of the most innovative and appealing companies and investments are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies.
It’s not just earlier-stage businesses, though. The stock market has been getting progressively narrower for some time. Fund manager Pantheon has 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%. More mature private businesses can provide differentiation to what is available in the public arena.
Although the area can be higher risk, it is potentially a source of decent returns. The growth a company enjoys can be strongest in its pre-stock market life – if it ever lists on a market all, the other common exit route being a sale to a trade buyer. Yet private equity investments are often impossible for individual investors to access.
Investment Trusts can provide a gateway into this world, and it is an important way they can use their permanent capital structures. In contrast, it is inappropriate to include private investments in open-ended funds, for anything other than exceptional and minor circumstances, owing to their ‘illiquidity’ – the ease at which assets can be bought and sold – and the mismatch between the constantly changing size of the assets under management.
Different strokes for different folks
It is generally a good thing 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 do the opportunities for companies looking to expand. Meanwhile, higher interest rates has resulted in a rise in the cost of borrowing, which can be an important determinant in the fortunes and valuations of businesses. These factors aren’t unique to private companies, but as a general rule it affects them to a greater extent because there is a tendency for them to be more economically sensitive, indebted and less proven, making them more vulnerable than large, listed businesses.
Having been a darling of investors in the post-Covid stock market boom, private equity has more recently become an anathema. Worries abound that 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. It is a narrative we believe has taken over with little regard to nuance.
Private equity holdings come in all shapes and sizes, and there is just as much variety in the unquoted universe as the quoted one.
There is a big difference between an unproven blue-sky start-up and a mature, privately-owned business such as Asda, LV or the AA. Similarly, there are significant differences in terms of valuation regularity, and we would argue that the processes applied within the highly scrutinised context of a publicly-listed investment trust are often among the most frequent and robust. In the cases we look at, we find this hard to square with assertions they are behind the curve.
In any case, investor sentiment has turned decisively negative and is showing little sign of respite. Trust share prices are being punished for investing in private assets of all kinds, as well as less liquid assets such as commercial property. As a result, significant discounts to net asset value (NAV) have opened up. As a reminder, investment trust share prices are governed by supply and demand, so the market value of the 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, but there are no guarantees any discount will narrow, and investment performance is likely to be a more important factor in overall returns.
Private equity: the eye of the storm
Private equity-only trusts such as Pantheon International have been most affected by the negative sentiment. Its discount has collapsed from less than 20% and the start of 2022 to around 50% today, almost touching the depths to which it plunged at the hight of the Covid-related market volatility when the world was in the grips of a potentially deadly pandemic with a highly uncertain outcome.
The more recent price action strikes us as overly dramatic. The economic outlook has deteriorated for sure, and we would not wish to underplay the challenges higher interest rates and inflation bring to corporates, but the level of discount, which is typical of the sector as a whole, looks unwarranted. Pantheon’s assets are varied with a leaning towards investments on more mature buyout and growth capital investments rather than early stage venture capital. The nuances of the make-up of the portfolio are, we suspect, lost on most investors who are minded to jettison private equity from portfolios, regardless of valuation, based on memories of the Great Financial Crisis when values cratered, or the high charges associated with investing in specialist vehicles with layers of management fees.
Although things can always worsen before they improve, we think this could be an opportunity in the making. NAVs have been robust thus far, even allowing for the inevitable lag associated with valuing private assets on a regular but not constant basis, and we see no evidence of a more aggressive valuation methodologies being applied. More costly borrowing is undoubtedly an issue, but the sector on the whole has much less leverage at a fund and company level than the during the financial crisis. In short, we think investors able to look to the long term, beyond the barrage of negative commentary, are now being well compensated for the risks.
Scottish Mortgage Investment Trust: from love to hate
Scottish Mortgage is a higher profile trust that dedicates a portion of its portfolio to unlisted companies. At the end of 2022, the Trust had 52 private company investments that accounted for around 30% of assets. Our Collectives Research Team recently met with met with lead manager Tom Slater with much of the discussion revolving around this exposure, which has been the subject of many column inches of late.
Five companies account for almost half of the private company exposure, and they are significant enterprises:
Tik Tok owner Bytedance is valued at $220bn, Ant Financial at $200bn, Elon Musk’s SpaceX at $127bn and Stripe at $50bn. As these holding illustrate, private exposure tends to be weighted to businesses scaling up and becoming profitable. Just 1.1% of the portfolio (or 7 holdings) have total values of less than $300m.
The processes of revaluation of these assets is regular. In 2022, they were revalued downwards on average by more than the NASDAQ fell in the year (34.4% vs 33.1%), and we find that the team at Baillie Gifford conducting this process in association with independent valuers has been proactive in marking them to public market equivalents. In total, 585 re-valuations were conducted in 2022 with 30% of the companies re-valued 8 times or more.
Chart: Scottish Mortgage private holdings as a percentage of overall portfolio
Source: Baillie Gifford, 31st December 2022
Looking back to 2021 when all things growth (and Baillie Gifford) were riding on the crest of a euphoric post-Covid wave, investors clamoured to own exposure to the mix of privately owned companies in the Scottish Mortgage portfolio, alongside the well-known listed businesses such as Moderna, ASML and Tesla. At one point in November 2021, shares traded on a 6% premium to NAV. Just as this was overdone, we think the level of pessimism prevailing at the moment is excessive.
To us it is striking what has not changed since this time. The types of companies Baillie Gifford look for hasn’t altered. The fund management process for identifying them and valuing the unlisted holdings is the same. The portfolio largely has the same constituents, though there has been a noticeable dialling back on Chinese exposure, an admission that their perception of risk in this market has, in our view rightfully, evolved. The Trust remains, as it has long been, a very high-risk investment targeting the disruptive companies of the future, including some well-known private investments that would otherwise be impossible to access.
Weighing up investment risks of private equity
Clearly, there are very high risks involved with backing these types of companies and keeping to the right position size in a holding like Scottish Mortgage is of paramount importance. Anything capable of delivering outsized gains can deliver an equally disappointing loss. It is also right to acknowledge that things may not improve in the short term. We see no immediate catalyst for sentiment improving in regard to private equity valuations. Investors want to see the proof in the pudding in the form of flotations and sales crystallising values of individual companies and make the read across to relevant industry peers. With sentiment low, interest rates at an elevated level, and no near-term prospect of them falling, this corporate activity has dried up. This implies the discount to NAV could deteriorate further.
Yet just as we have kept faith with high-quality ‘value’ managers through fallow periods, we remain patient with this growth manager looking to identify the winners of the future. The Trust has been part of the Preferred List since 2013, and while investors frequently change their spots we don’t believe the manager has. Investment trust managers must show their differentiation from passive investments such as ETFs that provide simplicity and minimise costs. Trusts are best used as to gain access to differentiated and dynamic assets as part of a diversified portfolio, and we continue to believe Scottish Mortgage remains a good example.
Looking for investment opportunities? Explore our Preferred List of collective investments today.
The value of investments can fall as well as rise. Investors may get back less than invested. Past performance is not a reliable guide to the future.
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.
Why private equity in investment trusts is a double edged sword
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