1st July 2022
An important aspect of fund management is the constant reappraisal of assets through time as we don’t think asset classes should always be regarded as low or high risk. Instead we believe that valuation is the best determinant of whether an asset should be regarded as low or high risk, and therefore whether or not it will cause a permanent loss of capital. Regular readers will know our views on bonds and how it has been (and still is!) nonsensical for them to be badged as low risk when they offer such pitiful yields. So, let’s look at the other end of the lazy risk spectrum and consider private equity. Listed Private Equity Investment Trusts (LPEITs) are certainly volatile with some sharp falls in the share prices of our LPEITs within our Hawksmoor Funds in recent weeks, but that does not mean they are necessarily high risk – volatility is not the same as risk despite what most of the industry says.
Although we are long term investors intent on owning assets for a long time when there are periods of poor performance from what we had hitherto thought were attractive investments, it is natural to doubt your original investment thesis. LPEITs’ discounts have widened in recent weeks as share prices have fallen despite evidence of stable net asset values (NAVs). LPEITs have been a constant, albeit varied, allocation to our funds ever since our Vanbrugh fund launched in 2009, as we see them as a strong source of growth with numerous examples of superior returns relative to listed equity markets. The main reason for this outperformance, in my view, is the ability for the owners of private companies to manage their underlying businesses away from the constant scrutiny of public markets where quarterly earnings and guidance are poured over by dozens of analysts and investors who have become obsessed with companies hitting short term targets, which then leads to businesses being run for the short term in order to please the market. It is commonly thought that private equity owners rely heavily on financial engineering to make returns, but that has become much less of a factor in recent years with operational improvements being the key driver of returns. Picking out ICG Enterprise as an example of superior performance because it offers diversified exposure to the asset class rather than relying on one sector or style, it’s share price has delivered a total return of 550% over the past 20 years compared to a total return of about 240% from UK equities. This record of consistent superior returns is why large institutions such as pension funds, family offices and endowments have been increasing exposure, as their much longer term horizons suit an allocation and mean they can worry less about short term bouts of volatility. Yet the sector is largely shunned by UK retail and wealth managers, perhaps due to misplaced fears of over-leverage and high fees, leading to discounts to NAVs becoming entrenched and annoyingly widen further at ‘risk-off’ times like recently given the lack of marginal buyer. ICG Enterprise’s discount has widened from 20% at the start of the year to around 40% now, a similar experience to a number of other LPEITs, and is now, in our minds, a ridiculously cheap entry point to a high quality portfolio. We appreciate that there is some justification for a modest widening of discounts at the moment as it is the market’s way of anticipating a lower future NAV, given publicly listed comparisons are falling in value and there are fears that the more immature, high growth private companies may not find it so easy for private investors to support capital raises unless priced lower. But concentrating only on snapshot valuation multiples misses the earnings growth achieved via improvement in operational performance that can offset multiple contraction. There are also concerns that the ability for private equity owners to sell their stakes in businesses are diminished now that IPOs or M&A activity are more muted than last year, but the owners of assets do not have to sell if the exit price isn’t high enough! In fact there is more pressure on the buyers to spend the cash they are sitting on having raised billions of dollars in the last couple of years, which gives some support for current valuations.
As always, there are nuances to general statements like that. We don’t own the sector and have specifically chosen the best quality LPEITs with best-in-class management. Rather than use our favourite example in the sector again, Oakley Capital, I’ll raise the profile of Augmentum Fintech, which, as the name suggests, focusses on a new breed of financial companies, such as, but not only, online challenger banks. At the time of writing this, its share price trades on a 38% discount. The highly experienced management team has been very prudent with their cash with no investments made for over 6 months, and holding back the proceeds of the sale of its most recent holding, Interactive Investor, to Abrdn. The recent sell-off in its shares, from about 160p per share to as low as 88p this week, has been so extreme that cash now represents 50% of the market cap! The majority of its underlying businesses are still valued at cost with no valuation uplifts last year when the tech sector was buoyant, so there should be limited downside pressure following the weakness in markets this year. Further, the Board is buying back shares regularly sending a very clear message to the market that the NAV is robust and the share price is too cheap. We want to see more LPEIT boards buying back shares at these extreme discounts as it surely makes economic sense to be buying your own portfolio that you know very well at a significant discount. You might remember from our previous Crescendos that we view buybacks as a tool to allocate capital efficiently rather than a tool to narrow discounts (which might be a happy by-product).
Seeking to establish whether the market is wrong and we are right is ultimately where all active fund managers try to gain an advantage. As the famous value investor Ben Graham said “In the short run, the market is a voting machine but in the long run, it is a weighing machine”, and our interpretation of that quote is that sentiment can often override fundamentals in the short term, but over the long term, valuation and fundamentals should win out. We will stick with our allocation to LPEITs and wait for the market to swap the ballot boxes for the scales.
Daniel Lockyer – Senior Fund Manager
For professional advisers only. This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC370.