Private equity funds look set to bounce back

Private equity investing is making a comeback this year – leading analysts to suggest that now could be a good time for investors
to snap up listed private equity funds.

This week, three separate private equity deals totalling nearly £1bn were announced, while 3i, the UK’s oldest private equity group, said it was ready to buy companies again.

The resurgence follows a two-year period of bad news for private equity funds. Deals dried up during the credit crunch as banks stopped lending, while many funds were forced to write off assets they had already bought.

Listed private equity funds saw their share prices slump dramatically in 2009, with the average fund trading at a discount to its net asset value (NAV) of around 70 per cent. Now, the average discount is closer to 30 per cent.

But even though share prices have already risen to narrow this gap, research suggests they may have further to go.

Listed private-equity funds fall into two groups: direct private equity companies, such as 3i, Candover and KKR, and funds of funds, which are often run by fund management groups such as F&C, Henderson and JPMorgan. Now, analysis by LPX Group has found that when direct private equity companies trade at discounts to NAV at the end of the year, they are likely to outperform global equities over the next three years. At the end of December, the direct
private equity companies were trading on a 16 per cent discount.

However, analysts advise caution before leaping into the sector, as some private equity funds are looking more attractive than others.

Charles Cade, analyst at Numis Securities, says: “It’s always best to buy private equity towards the bottom of the cycle – but you do have to differentiate between the funds.”

He believes that for the sector to attract investors back, funds need to have clearer valuations, clarity over what they invest in and better balance sheet management. “A lot of them are in a mess. The sector has a legacy portfolio and no capacity to put funds to work,” he says.

Stephen Peters, an analyst at Charles Stanley, agrees. “You have to be very selective with what you buy,”
he says.

Some funds are still very illiquid and do not provide investors with information on what they invest in – as well as being highly in debt.

Funds can also over-commit to financing deals. The funds have promised money to private equity groups that can be called upon at any time – which means the money remains on the private equity fund’s balance sheet as a liability.

However, other funds are taking advantage of this. JPMorgan Private Equity has been buying commitments from other institutional investors and is active in the secondary market. These investors, desperate to clear their balance sheets, are selling off their private equity commitments at bargain levels.

Peters says: “JPMorgan can come in and buy private equity commitments off existing investors at
anywhere from 30p in the pound.”

Over-commitment issues also meant that many funds of funds were forced to resort to raising money themselves last year by issuing zero-dividend preference shares – Electra, NB Private Equity and F&C Private Equity all took advantage of the strong demand for zeros from private client brokers.

John Newlands, analyst at Brewin Dolphin, says it is a good time for private investors to consider putting some of their assets in private equity.

“This is how you get exposure to the Microsofts and Pret A Mangers of the future – they got where they are with private equity funding,” he points out.

“First-time investors should consider something cautiously run, not taking on huge amounts of risk, that has been around for a few years and has a known track record,” he advises. He thinks Dunedin Enterprise and Electra Private Equity both qualify on this basis.

Peters recommends HgCapital, which he says has a high level of net cash and is in a good position to make acquisitions. “It will start investing in the
market and, hopefully, in three to four years, realisations [sales of investments to take profits] will take place,” he says.

But Peters warns that it may be too simplistic to buy only those private equity funds that have cash on their balance sheets. Good management is also key, as is being at a discount and holding a good portfolio of existing assets.

Cade says the best performers have been “recovery plays”: those that traded on the largest discounts – such as SVG Capital, Electra and Pantheon – and have seen those discounts narrow.

But Iain Scouller, analyst at Oriel Securities, believes most of the discount narrowing has already played out – though he is also a fan of Electra Private Equity, which has “tiny” over-commitments. He is, therefore, more cautious on the outlook for private equity funds, arguing that the market needs to see more realisations, and higher company earnings, for NAVs to rise further.

NAV growth and narrowing discounts are key, as listed private equity funds provide no income, and are only suitable for investors looking for capital growth.

Private equity groups are scheduled to announce their results in the next few weeks. NAVs are gradually improving but Cade says the big issue will be refinancing debt and whether, or how soon, the banks will start to lend again.