Friday Letter Turbulent times for listed private equity

There’s trouble brewing in the listed private equity sector. Discounts to net asset value are resolutely failing to narrow, investors are beginning to agitate for change and even the industry’s former poster child in Europe, 3i Group, faces fresh speculation about a takeover or break-up.  

Europe’s listed private equity (LPE) sector has had a difficult time of it in recent years, with two major issues keeping managers awake at night: the wide discount to NAV (the average currently hovers in the 30s), and a lack of liquidity.

The first is correlated with public markets. In a bull market, the discount tends to narrow significantly, but in a bear one, the widening is often disproportionate – the sector suffered massive discounts in the wake of Lehman, for example. Virtually all managers are grappling with substantial discounts to net asset values, from HgCapital at one extreme (just a 9.5 percent discount) to Candover at the other (upwards of 40 percent).

Ian Armitage, chairman of trade body LPEQ, believes the discount will narrow to its historic average (in the mid-teens) once the economy begins to show signs of recovery. 

Providing greater liquidity to investors is the second major problem. Most investment trusts or listed funds are relatively small, and suffer from low volumes. The only way to address that is to build scale. That means raising more capital – unlikely given the current environment and wide discounts – or mergers. The latter is more probable –  so expect further consolidation this year after deals like HarbourVest’s acquisition of Absolute Private Equity in 2011. 

But for 3i, scale isn’t the solution – it’s arguably part of the problem.

The £2.7 billion group’s share price had plummeted by more than 40 percent since the start of last year until a rally following bid rumours began last week. Its discount is currently hovering around the 30 percent mark. It has made cuts to its staff and refocused its efforts on its core private equity practice, selling off its venture capital portfolio and merging the buyout and growth capital units.

What happens at 3i affects the whole sector, as many investors view it as a proxy for LPE generally. If 3i does badly, it colours perceptions of the whole asset class. Other listed private equity fund managers have expressed a range of sentiments about the group, from regret that its share price has fallen so low, to downright anger that its poor performance has “scarred” investors and damaged the reputation of the asset class.

But just how feasible is a Candover-esque separation of listed entity and management team – what one source termed “the nuclear option”?

Not very, it would seem. “I just don’t know how they’d do it. 3i’s particular problem is that it’s very, very big – it’s morphed into a goliath. It would be very difficult for the management team to disentangle themselves – it would be just a fantastically complicated and expensive deal,” commented one rival manager.

That’s not to say it would be impossible of course. With support from a big secondaries player perhaps – a possibility a number of sources have suggested –  the management team could attempt a buyout and then divest non-core divisions.

As for an outright takeover by a third party, potential acquirers – including, ironically, Electra (once the subject of a hostile bid from 3i) – have been queuing up to quash speculation.

According to 3i, the group remains committed to its policy of focusing on the portfolio to drive performance, keeping investors sweet with an increased dividend.

The most likely course of action therefore is probably a further evolution in strategy, driven by shareholder unrest. Ultimately, any listed group is beholden to its shareholders, and there’s only so much underperformance they can stomach. But that’s a problem for the whole sector, not just 3i. The year ahead is likely to be a difficult one unless the economy improves markedly. Expect consolidation, and increasingly vocal investors shaping the way funds are managed.

For more in-depth analysis of the listed private equity sector, see the April edition of Private Equity International.