Following on from last week’s piece concerning accessing illiquid asset classes through investment trusts, it happened that I was fortunate enough to attend a lunch organised by a leading investment house for the managers of a private equity investment trust. Indeed, they decided to focus on this esoteric asset class, inviting a number of trust managers in over a period. I picked the lunch which included the managers of the one private equity fund I held.
Investing in private equity, rather like commercial property, has not been a happy experience for me. The credit-crunch-induced bear market hit this particular asset class – and commercial property too, for that matter – particularly hard. In some measure, this was because it was hard to believe in the valuations being placed upon some of the investments held.
There was also the added complication that many private equity houses used gearing to enhance returns. Not only were returns not there – and gearing has precisely the opposite effect when asset values are falling – but maintaining lines of credit also became particularly difficult.
The combination of liquidity fears and lack of transparency took its toll on this market.
It happened that this particular trust did not have any gearing. There was a healthy measure of cash in the balance sheet. Even so, this had not prevented the shares from being savaged, falling at one stage to a 70 per cent discount on underlying assets – a valuation that pretty much meant that the market capitalisation of the trust was covered by the cash held, with all the private equity investments in for nothing.
Although matters had improved with the better tone to markets in general, the reality was that the discount was still frighteningly high. Yet the trust managers were remarkably upbeat. In their assessment, it is emergence from recession that provides the best opportunities for making money in their brand of private equity. Moreover, they adopted a cautious approach, with much of their financing of private companies held through secured fixed-income notes. The real question was whether other investors had any faith in this sector at all.
Private equity, like hedge funds, was once the province of the very wealthy or the specialist investor. American pension funds, in particular, embraced this asset class widely. The returns achieved were consistently good.
However, as access broadened and the sector developed a higher profile, it seemed as though valuations got ahead of reality. As is so often the case, many private investors entered the sector at the top.
The other problem that private equity faces is that it has not had an altogether good press recently. The report into MG Rover hardly reflects well on an industry which claims to turn businesses around and benefit shareholders rather than just enriching the managers.
I have not lost my faith in the sector, which does include many success stories, but I am not sure that it is going to bounce back very swiftly.
It was not so long ago that it was the private equity investment trusts that headed the tables for investment performance. Today it is more likely to be emerging markets that feature at the top. Neither sector is exactly risk-free.
It all goes to show that while the highest rewards can be expected from the riskiest markets, the value of shares can and will fall as well as rise. Strong nerves are needed for these sectors.
Brian Tora (brian.tora@ centaur.co.uk) is principal of the Tora Partnership