Industry veteran Jon Moulton was back in the headlines last week, after his publicly listed Better Capital reported interim results for the six months to September 30. News that it plans to pay out a £10.4 million (€12.8 million; $16.7 million) dividend provided another boost for its share price, now up more than 30 percent this year. And significantly, it's the only UK-listed private equity group to be trading at a premium to NAV.
The stock market has not been kind to listed private equity post-Lehman: in the UK, share prices have tumbled by nearly a third, while discounts to NAV have widened to around the 30 percent mark, on average. There are some obvious reasons for a discount to exist (illiquidity, blind pool risk and so on). But the managers of these listed trusts will tell you there's no reason whatsoever why it should be this big (it's well above the long-run average, which is somewhere in the mid-teens) at a time when net asset values have actually been rising.
“The discounts that are priced in at the moment can’t be right,” Stuart Howard, chief operating officer of listed private equity at HarbourVest, told us earlier this year. Managers have been employing various methods to try and narrow the discount – from share buybacks to realisation or even wind-down strategies – but without much success.
Moulton told us this week that there were three key reasons for this premium: “We are distributing, rather than reinvesting proceeds as a permanent capital vehicle would do. We have no fees based on net assets. And we're a market leader in a very popular area [i.e. turnaround investing].”
His last point is undeniable: Better's strategy is very much of its time.
The second is more debatable. Moulton's argument is that charging fees based on NAV creates an inherent conflict, because it incentivises managers to buff up their valuations. Perhaps that's true in theory – but in practice it doesn't seem to be happening. Analyst Louisa Symington Mills (then of RBS, now at Jefferies) recently completed a study of 17 of the biggest realisations affecting listed PE over the preceding 12 months: she found that, on average, managers had achieved a premium of 69 percent over book value on exit. So if anything, managers are actually erring on the side of conservatism with their valuations – partly because of accounting strictures, and partly because nobody wants to be booking a loss when they sell an asset.
But his first point is perhaps the most interesting one. It's certainly true that at the moment, investors are searching
The discounts that are priced in at the moment can't be right.
So should every listed trust be looking for ways to boost their cash generation in the short term? Not necessarily.
The first point is that it's a difficult thing to do, in practical terms. As HarbourVest’s Howard put it: “The private equity asset class doesn’t really support a long term progressive dividend policy – it’s a lumpy business so you can’t really predict the timing of cash returns.”
But the more significant point is that investors don't necessarily want it. This is the first year that investment trusts have been allowed to pay dividends – but some have decided not to bother. Another listed trust manager in this category told us that when they asked their investors, there was just no appetite for it. That's partly because there can be negative tax implications (if investors receive an ordinary dividend, they're effectively converting a capital gain into income – although Better has side-stepped that by structuring its payout as a return-of-capital rather than a dividend). But it's also because that's not why most of them are investing in listed private equity: they're doing it for the long-term capital appreciation, not the short-term dividends.
Share price is clearly one indicator of the health of these trusts (or at least how the market perceives the health of these trusts). But it's not the only one: long-term net asset value growth is surely just as significant. So if this goal is better served by reinvesting cash rather than distributing it to shareholders, then that's what these trusts should do.
However, that probably means accepting a lower share price in the short term. In the current climate, as Better Capital is proving, a vehicle with a clearly defined, timely strategy and an explicit distribution policy – not to mention a high-profile and well-regarded advocate – is going to look more attractive to a lot of public market investors.