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Investment Special: Bottom fishing

In a panicked market, private-equity funds can offer hidden value

10 September 2011

12:00 AM

10 September 2011

12:00 AM

Here’s the good news. Share prices are falling. Investors are panicking. Talk of crisis dominates the headlines. These are precisely the conditions in which bargains tend to become available on the stock market. Just as history is written by the victors, so the day-to-day stock-market narrative is written from the perspective of those with most to lose: those who already have wealth, not those who need it in the future.

Yet when it comes to investment, as all great investors know, what matters most is how cheaply you can buy, not whether the market is going up or down around the time you do so. The younger you are, the more of your working life that lies ahead, the better a good stock-market disaster is for the value of your savings when you will finally need them, which is typically many years ahead. 

Anyone who bought shares in the dark days of late 2008 or early 2009, when the banking crisis was at its height, will most likely have doubled their money since then. Because you bought them when they were cheap, those shares will remain a good purchase for the longer term, even if, as remains a distinct possibility, the world now plunges into a second banking crisis triggered by the collapse of the eurozone.

Shares acquired in the days when the market was booming — remember 2005 when, incredible as it now seems, voters gave Blair and Brown a third term because everything was going so well? — won’t make much money for years to come, since they were trading on expensive multiples at the time. The moral is clear: if you are not thinking about how cheap things are when you buy them, you are never going to prosper as an investor.

In the case of investment trusts — managed funds listed on the Stock Exchange — crisis and gloom from time to time throw up even more attractive bargains, when investments which have already become cheap become even cheaper because the trust that owns them is itself trading at a substantial discount to the value of its holdings. In really bad times, it is not uncommon for discounts in the worst affected investment-trust sectors to widen to 30 or even 50 per cent.


In such cases the weakest trusts tend to go out of business, but the good ones become a wonderful buying opportunity: as the underlying assets recover, the discount disappears, giving the investor who recognised a bargain a double helping of returns. In recent times this has happened to trusts that invest in commercial property, in hedge funds and in emerging markets, all of which have traded at substantial discounts to their asset value as market sentiment turned sour on those types of investment.  

To take an extreme example, what could have been more out of favour than mortgage debt a year ago? Yet one small investment trust specialising in this area has seen the value of its investments rise by 14 per cent in the last 12 months; and because sentiment has improved and the discount has disappeared, its share price has more than doubled over the same period. European property funds that traded on an average discount of nearly 50 per cent three years ago, when nobody would touch them with a bargepole, now trade on an average discount of around 14 per cent; their share prices have risen by more than half in the past 12 months.

One sector that currently justifies a careful look on value grounds is that of listed ­private-equity funds. It is only a few years since the big hitters of private equity, the likes of Henry Kravis and Stephen Schwarzman, were lording it over the investment world, lionised by admirers for their high returns but deplored by others for the extravagance with which they celebrated the fact. In the good times, when debt was cheap, private-equity funds produced impressive, sometimes spectacular, returns. But when the credit crisis hit, many turned out to have feet of clay, having borrowed too heavily and over-reached themselves in their search for glory and personal enrichment.

Most private-equity funds remain just that — privately owned. A small number of private-equity investment trusts are, however, listed on the London Stock Exchange, giving smaller investors a chance to share in the returns of an investment class which is typically only open to very wealthy families and large institutions. Since the crisis, the share prices of these trusts have taken a pasting, and some have had to resort to rescue financing.

Discounts have started to narrow of late, but of the 13 largest trusts, more than half are still trading at a discount of 30 per cent or more to their net asset value, which suggests considerable upside potential. In picking the likely best performers, investors need to consider how much debt the funds employ, how conservatively they value the unquoted companies in which they have invested, and how closely the fortunes of these businesses are tied to the economic cycle.

Are they attractive now? Ian Armitage, chief executive of HgCapital, generally regarded as a class act in the listed private-equity field, argues that private-equity returns are always cyclical. A further slowdown in the global economy or a eurozone collapse would hinder progress, but most of the companies in its portfolio are growing sales and profits at a healthy rate. There have been signs of an emerging ‘buyer’s market’, enabling well-capitalised private-equity firms to buy more companies at attractive prices.

Investment trust analysts agree that wide discounts are creating interesting opportunities. Simon Elliott of Winterflood Securities rates both the Electra and Dunedin private-equity trusts, though ‘not for widows and orphans’, as good value on 34 per cent and 40 per cent discounts respectively. Charles Cade at Numis has HgCapital (which I hold, and which is on only a 6 per cent discount because of its superior track record) as a core holding, and SVG, Pantheon and Princess Private Equity as trading opportunities. Paul Locke at Cannaccord also likes Electra and thinks F&C Private Equity (on a 30 per cent discount) also looks attractive.

Jonathan Davis is the founder of Independent Investor.


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