Listed private equity: Narrowing the gap

It’s a tough time to be a listed private equity manager. Discounts to net asset value are stubbornly refusing to narrow (not helped by volatile public markets), and a lack of liquidity means investors – even if they’re sold on the value proposition – find it hard to gain access to many funds.

According to European trade body LPEQ, private equity investment trusts (excluding 3i Group) have suffered a 31.3 percent decline in their average share price over the last five years – after precipitous falls post-Lehman, they’ve never really recovered. Over the same period, the MSCI World Index grew by 14.2 percent, and the FTSE All Share rose by 9.3 percent. 

At the same time, discounts to net asset value have widened considerably.

The discount essentially measures the level of trust the market has in a manager’s valuation of its portfolio.
Unsurprisingly, in a downturn, mistrust increases. In the immediate aftermath of Lehman, the average discount increased massively, pushing into the 60s. Today, it stands around the 30 percent mark. That’s still substantial, and remains a source of unease for many investors. 

Andrew Lebus, a partner at Pantheon International Participations in London, explains: “The levels of discount experienced in the immediate aftermath of Lehman’s collapse were a kneejerk reaction that turned out to be wrong.

Private equity has in fact fared relatively well in the downturn – we’ve proven the pessimists wrong.
“But the problem was that a number of investors sold out during the trough and were badly burned as a result. Demand has therefore been slow to come back,” Lebus said. 

Stuart Howard, chief operating officer of listed private equity at HarbourVest and a veteran of 10 years at 3i, believes the market has got it wrong in terms of valuing listed private equity funds. “The discounts that are priced in at the moment can’t be right. Do I think we’ll trade at a premium? No, because there’s a liquidity discount that has to be factored in. But a narrower discount would be more appropriate to the value of the underlying assets.”

Dunedin managing partner Shaun Middleton argues that the sector as a whole needs to work to address the problem, not just single managers. “Performance is always a major issue. If you perform well as a manager, and the sector as a whole does, the discount will narrow. There haven’t been too many exits though recently, which hasn’t helped,” he says. 

But what can managers actually do, in practical terms?

BEWARE SHORT-TERMISM

Peter McKellar, chief investment officer and co-ordinating partner at SL Capital Partners, says: “It’s incumbent on all boards and managers to look at the discount and consider ways to manage it. Some have used share buybacks, and some realisation strategies. Unfortunately, to date most of these strategies have had limited effect.”

Buybacks might seem an attractive option – a manager can increase its holding at a knock-down price – but one fund manager likened them to heroin: “Once you’re hooked on a buyback strategy, it’s very hard to give up,” he said.

At best, they’re a short-term sticking plaster solution that seldom moves the needle much in terms of the discount, sources said. 

Increasing dividends – the policy currently being adopted by 3i – can help to placate shareholders, particularly in a low-interest rate economy. But again, it’s arguably a short-term solution. “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,” says HarbourVest’s Howard. “If you attract investors based on a promise of an attractive dividend policy, they’re likely to be disappointed in the long term. This is a capital appreciation play.” 

Far better to re-invest capital in the underlying portfolio, in the hope of paying out much greater returns at a later date, argues one listed manager. Having cash available for new deals is also important, the manager said. “There will be fantastic opportunities over the next 12 to 18 months as banks delever in response to Volcker and Basel III. The key is to marry that opportunity with the need to return cash to shareholders. If you look at 3i, they handed back a lot of money to sharheolders in early 2009, and had no money to do deals as a result,” the manager says. 

A focusing on returning cash seems to have worked for SVG Capital in the short-term: its share price has risen 33 percent since the start of the year, driven by a forthcoming tender offer and promise of a £120 million return of capital to investors.  But whether it’s the long term answer remains to be seen. 

The third option in terms of narrowing discounts is more radical: freezing new investments and adopting a realisation strategy. In its most extreme case, that means putting a fund into wind-down mode. 

“Wind-down is the most extreme step a group can take to try to realise value for investors and allow them to recoup their investment,” says David Hersh, a partner at investor Mantra Investissement, which last year lobbied hard for such a change at listed group Private Equity Holding. 

In October, LMS Capital’s board accepted proposals made by activist shareholders to break up the company and pursue a realisation strategy. Two months later, Switzerland-listed  Castle Private Equity said it was considering proposals from one of its key shareholders, Abrams Capital, to radically re-shape the fund’s structure. 

A fourth alternative is for firms to employ a combination of these three approaches via discount control mechanisms, whereby the strategy is altered automatically in response to the discount at the time. 

Still, the fact that boards are thinking harder about ways to realise greater value for investors is a significant step forward, Hersh argues. “The positive aspect of the recent troubles in the asset class is that discussions are now happening about how to address investors’ needs and concerns. Two years ago, boards would probably just have ignored the issue,” he says. 

Even now, a big discount isn’t necessarily bad for everyone, of course.  

Ian Armitage, chairman of both trade body LPEQ and HgCapital (which manages a listed trust as well as traditional buyout funds), says: “A discount might be a problem to a manager, but it’s an opportunity from an investor’s perspective. The sector looks very good value at the moment. The long-term average discount is in the teens, so what we’re seeing now – with discounts in the 30s or more – is much wider than normal. That means a massive buying opportunity. However, a buyer will have to accumulate shares patiently.”

SCALING UP

That last point illustrates LPE’s second big problem: liquidity, or rather the lack of it. 

One of the supposed advantages of listed private equity is that it provides liquid access to a traditionally illiquid asset class. But with a few notable exceptions – like the large US alternatives managers KKR, Apollo and Blackstone, and 3i Group in the UK – trading volumes are generally low.

“Liquidity is certainly an issue,” admits Monique Dumas, investor relations partner at Electra Partners. “You can talk a good game to a potential investor, but if they then say, ‘Ok, I’d like half a million shares tomorrow’, they won’t be able to get them [in one transaction] because there aren’t enough sellers.”

The only real solution, according to Armitage, is scale. Most funds at present are simply too small to attract large institutional investors or a sufficiently broad shareholder base to allow for higher volumes. 

The measured approach to building scale involves delivering strong returns, and raising more capital when conditions are favourable. A quicker solution is simply to acquire rivals. HarbourVest, for example, snapped up Absolute Private Equity in August last year. 

“There is likely to be further consolidation – the pricing of the shares are telling us that,” Howard observes. “That should unlock some investor capacity to deploy money in the remaining players. But given current discounts, it would be foolhardy for people not to be looking over their shoulders.”

In some respects, the long-term argument for listed private equity remains compelling. For some large LPs – notably big pension plans – regulatory changes are going to make it much harder for them to leave their capital tied up in an illiquid closed-end fund. But listed vehicles should allow them to invest in the asset class in a way that offers daily pricing and ongoing liquidity.

Clearly, a degree of education still needs to take place. “We need to get out and tell people about the asset class,” Howard says. “You have to come into this space with a long-term view. Most investors still think hedge funds, real estate, and gold are less risky than private equity – but as an asset class we’ve been able to reliably deliver outperformance.”

Analysts seem to agree. “Given 3.8 percent annualised outperformance of quoted equities over the past 15 years, we cannot understand why listed private equity trades on such wide discounts,” wrote Collins Stewart analyst Alan Brierley in February. “Most balance sheet issues (excess gearing or over-commitments) that impacted so many during the crisis have long since been addressed, while portfolios are generally in good health and maturing well. Barring a global economic collapse, we expect another year of healthy NAV gains.”

So perhaps there is light at the end of the tunnel after a bruising couple of years for LPE. But in order to attract additional capital into this space, managers will need to raise their game – delivering better value to investors and greater transparency.