The private equity market is often considered to be a vast, moneyed investment territory that is dominated by institutional investors; a space where the average Joe Bloggs is not welcome. In this rather secretive world, large investors give private equity managers money to buy companies outright. These companies are then taken private and managers use leverage and different techniques to improve the companies, all in an effort to sell the firms for significantly more money than the original price tag. This sector operates using different rules than the public markets and it is far less liquid, but it is also known to offer superior returns.
A recent study by UK and US researchers found that American private equity funds have generally outperformed public markets for years. The researchers found the average private equity fund outperformed the S&P 500 by 20% to 27% over the life of the fund, which works out to roughly 3% outperformance per year.
While private equity is dominated by institutional investors, individual investors can also access this market through a number of different publicly accessible investment vehicles. Investment trusts are the most established way for individuals to access private equity. Currently, there are roughly 80 listed private equity investment trusts on the UK and European stock exchanges, which allow investors to buy a stake in a private equity portfolio.
The following well-known UK-traded investment trusts operate in the private equity space:
- Dunedin Enterprise Investment Trust (DNE)
- Electra Private Equity (ELTA)
- F&C Private Equity (FPEO)
- Graphite Enterprise Trust (GPE)
These investment trusts and many others offer individual investors a way to access growing, private companies.
Direct Investment vs. Fund of Funds
Amongst these investment trusts, some make direct investments in companies while others invest in a variety of private equity funds, providing diversification benefits.
“A ‘direct’ listed private equity company will typically have exposure to a dozen or more privately-held businesses, while listed private equity ‘funds of funds’ invest in a selection of other private equity funds and so have diversification across hundreds of companies, invested in at different points in the [investment] cycle,” explains the organisation LPEQ, a not-for-profit group representing listed private equity investment companies.
“A fund of funds makes a lot of sense for retail investors [because of diversification benefits] but then you have to be careful because then there are fees on top of fees,” explains professor Tim Jenkinson, a private equity specialist at the University of Oxford’s Saïd Business School. While his research has shown that private equity generally outperforms public markets, he admits that the fees “could easily eat up the extra returns that you’d get above public markets.”
There are other risks investors must understand before buying into private equity investment trusts. Various risks can stem from liquidity issues, transparency issues and discount issues, which will be discussed in more detail below:
Liquidity
Since private equity managers invest in private firms, the investments are generally illiquid assets. Furthermore, shares in private equity investment trusts are usually rather illiquid as well, with very little trading happening from one day to the next. “This is a double whammy of illiquidity,” says Morningstar’s director of investment trust research, Jackie Beard. "Investing in private equity needs very careful consideration. Investors who want to buy into this sector should take a very long term view," she said.
Discounts
Due, in part, to the highly illiquid nature of private equity, the investment trusts operating in this space tend to trade at large discounts to the net asset value (NAV) of their underlying holdings. For example, the four investment trusts listed above are all trading at more than a 30% discount to their NAVs.
While a discount could be seen as a threat to investors who are concerned about realising gains on their investments, private equity fund manager Tim Spence from Graphite Enterprise believes the current wide discounts in the industry present an opportunity for investors. Speaking at an event held by the Association for Investment Companies (AIC), Spence explained that discounts are the widest they have been in years across most private equity investment trusts, and if investors expect those discounts to shrink, investing into the industry now would be a prudent move.
Transparency
The private equity industry is inherently more private and opaque than public markets. There is less information available in this space, and oftentimes managers are given free reign to invest in whatever private companies they want, says Beard. This means investors must do additional due diligence to try to understand where their money will be invested, and then decide whether this is a suitable investment option for their portfolio.
