Whenever I speak to investors and advisers, it is only a matter of time before I am asked about the share price discounts to NAV that listed private equity companies trade at. “What are the causes of the stubbornly persistent discounts for many listed PE trusts?” “Will those discounts ever close?” and so on.
These are important questions but, sadly, there is little industry consensus on the answers.
One reason for this is that the prism through which many people look at the sector creates misconceptions that actually entrench discounts. Instead, investors should focus on the distinct advantages of investing in private equity and the real driver of shareholder returns in the sector – capital growth – as growth in NAV per share is by far the largest driver of share price performance.
Regrettably, a lot of commentary on the sector asserts that discounts are the primary method for evaluating whether to invest in listed private equity trusts. Investors are told they need to compare a trust’s current discount to its long-run average. A discount wider than the average indicates potential upside – or a buying opportunity.
Conversely, a discount narrower than its long-run average offers less value than previously and constitutes a sell signal. This creates, in effect, a self-perpetuating cycle: investors buy shares when discounts are wide and sell as they narrow. This, in turn, causes share prices to decline and discounts begin to widen again. Lather, rinse, repeat.
Another fundamental problem with this approach is that it ignores a crucial factor – NAV figures are not a current reflection of the net value of assets, but a historic KPI that is arguably out of date as soon as it is published – some trusts are still publishing valuations last estimated over six months ago.
If a trust’s manager has a record of delivering strong NAV growth, it is unlikely that its NAV will remain static or decline between reporting periods – it will likely have continued to grow.
If the share price rises in the intervening period, then the discount to NAV will be perceived to have ‘narrowed’ but only because the NAV is stale. The discount will likely widen once the company reports a new NAV figure. And so the cycle continues.
This is a structural market inefficiency which means the concept that investors should acquire a trust on the basis of its discount is flawed. What is more, this investment strategy is almost entirely reliant on market timing which, as any market participant knows, is incredibly difficult to get right every time.
This is not to say that discounts cannot close over time, and buying into a trust at a discount would, of course, provide investors with an extra lift to their returns should it close. But it is a mistake to think that it should be the primary reason for investing in listed private equity investment trusts.
I believe that greater transparency and regular updates can help. We are moving to quarterly reporting from April, which will mean we publish NAV figures more frequently, allowing for better informed investment decisions.
The board also continues to implement a share buyback programme.
However, our ability to control this issue is ultimately limited, and the reporting cycle will always result in somewhat imperfect information.
So if we believe that a discount is somewhat irrelevant, what information should investors base their decisions on? Quite simply: look at what the manager can control, and look at their long-term performance.
First, focus on deal origination.
It is the ‘holy grail’ in private equity, even more so now we are in a period of rising interest rates and with too much capital chasing too few deals. New investments lay the foundation for future NAV growth. Make sure your manager can find the best deals without paying too much.
Second, look at what they do when they buy companies. How do they create value, how can they accelerate earnings growth? Again, this becomes more critical and harder to achieve in an uncertain economy with rising inflation. But it is key to growing NAV, especially during periods of market volatility.
Last, do they have a long, established track-record finding deals, accelerating growth and creating value? You want to invest in a manager that has successfully navigated several economic cycles and upheavals, including the Covid pandemic. Indeed, the consistent premium to NAV that many private equity investors achieve when selling businesses further underlines how misplaced discounts can be.
It is these factors that fuel asset growth and that will ultimately prove to be the biggest driver of shareholder returns. The attraction of investing in listed private equity trusts, therefore, is not discounts to NAV, but capital growth. The sooner we can shift the debate in that direction, the better for the industry and investors alike.
