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How to Diversify Your Portfolio with Private Equity

Unquoted investments can difficult to access for retail investors and carry liquidity risk. But private equity trusts package up these high growth investment opportunities

David Brenchley 9 November, 2017 | 9:42AM

Facebook and Airbnb are two examples of private equity and venture capital success stories

Looking for investment growth? Investing in smaller companies has historically been a successful way for investors to secure large capital gains. Smaller firms tend to have much more room for growth than larger firms. The Alternative Investment Market (AIM), launched in 1995, gave retail investors the chance to do this directly.

But although AIM listed stocks are small-fry compared to the FTSE 100 companies, they tend to be established firms rather than start-ups. Investors looking to profit from the next big thing, backing an entrepreneur or niche industry may want to consider unquoted companies. 

Unquoted investments can difficult to access for retail investors and carry liquidity risk. Certain fund managers invest in small start-up companies, including investment trusts Woodford Patient Capital (WPCT), run by Neil Woodford, and Scottish Mortgage (SMT), run by Baillie Gifford’s James Anderson.

For a purer play on this sector investors can consider private equity - investments which can be risky but also offer tax incentives and the chance for high rewards.

What is Private Equity?

Private equity companies run funds, usually based in the US, that commit large amounts of capital to take a controlling interest in firms that are not listed on public exchanges. The private equity managers will work to improve the company structure and efficiency with the aim of making an exit – through an IPO or sale – at a much higher return than originally invested.

The funds tend to be 10 years in duration and the managers typically use the first five years to identify and make investments before realising gains and returning them to investors. This creates a ‘J Curve’, meaning initially funds will show losses before recouping those and more throughout the life of the term.

As the minimum investment requirements are so large, private equity funds are difficult to access for ordinary retail investors, unless they are high net worth individuals. This is where private equity investment trusts come into the equation.

How are Private Equity Trusts Run?

These trusts, which include Harbourvest Global Private Equity (HVPE), a FTSE 250 constituent, and Pantheon International (PIN), allow retail investors to access the private equity arena.

Traditionally, they are run as fund of funds, investing in private equity funds, paying them management fees and allowing the expert managers to make the investment decisions.

“The managers that we work with are completely critical to this investment success that we’re creating,” says Andrew Lebus, manager of Pantheon. “The opportunity to create significant outperformance through good manager selection is better in private equity than it is in other asset classes.”

They will purchase these funds on both the primary and secondary markets, but will also make co-investments alongside private equity funds, which helps enhance their returns due to the fact they do not have to pay extra fees charged by those funds they co-invest with.

HVPE, which has an extra layer in that it initially invests in other Harbourvest funds that in turn invest in the private equity funds, also backs venture capital funds.

Facebook (FB) headlines the success stories from the private equity and venture capital world, with Snapchat a more recent example. The likes of Uber, Spotify and Airbnb are others and set to IPO in the coming months and years.

“The key point about private equity funds is that we’re providing access to these companies well before they make the headlines,” explains Richard Hickman, director of investment and operations at HVPE. Hickman says HVPE has exposure to over 7,000 companies.

What are the Risks?

The risks are abundant, which is reflected in the large discounts to net asset value (NAV) these trusts tend to trade on. They fared poorly during the financial crisis due to the high leverage of deals.

They have recovered since, though, and managers believe leverage is now more modest and due diligence deeper. Hickman says the average private equity fund has returned 12.4% over the past 20 years, compared to 6.8% from the MSCI World Index.

However, Adrian Lowcock, investment director at Architas, says the asset class has always been considered risky and that its recent outperformance has been partly due to low interest rates. This has meant they can borrow money at cheap rates and snap up companies at discounted valuations or ones in distress.

They are also extremely long term in their nature, meaning investors must be willing to lock away their cash for timeframes of at least 10 years in order to reap the rewards. “The argument is over the long run private equity will outperform,” says Hickman. “It may not outperform every year or in the short term, but every period of more than 10 years private equity has a significant level of outperformance.”

Should I Invest in Them?

Lebus makes the point that private equity is part of the equity market and, therefore, investors should seriously consider the asset class. He adds that if you don’t need liquidity in the near to medium term, in your SIPP, for example, “you really ought to be trying to invest in illiquid assets because you’re paying a price for liquidity”.

On the discount front, Hickman says: “We’re trading today at 15%, with cash on the balance sheet as well. If you strip that cash out the discount on the actual portfolio is significantly greater. We think that’s an opportunity.”

But Lowcock says that taking discounts at face value may not be advisable. The Z Scores of these trusts, which show their value compared to historical averages, “suggest the private equity sector as a whole isn’t attractively valued”. “They are effectively trading at a premium of historical value,” he adds.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Facebook Inc A179.00 USD-0.33
HarbourVest Global Priv Equity Ord1,276.00 GBX-0.70
Pantheon International Ord PLC1,820.00 GBX-1.36
Scottish Mortgage Ord456.50 GBX-0.15
Woodford Patient Capital Trust88.00 GBX-1.12-
About Author David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk