When investors examine the recent fortunes of the private equity sector, they might assume that all private equity is alike. Investment trusts are trading at similar discounts, and have been treated with similar caution by investors, who see little difference between them.
This is evident in the broader narrative around private equity as well. It has become the norm to describe private equity as a single asset class and to ascribe it a series of common characteristics. More recently, those characteristics have generally been unfavourable, such as high debt or high risk.
Yet if investors defined public equity in a similar way, it would seem incongruous. Investors have no problem recognising that public equity can be heterogeneous: high risk or low risk, or run across multiple sectors.
Just as in public equity, private equity comes in a variety of flavours. There are speculative and high risk private equity options in early stage or overly indebted companies, but private equity is a far richer and more diverse asset class that this caricature suggests. Private equity can be a high-octane option, but it can also fulfil a range of other roles in a portfolio and be a source of strong, consistent returns.
Different options up and down the risk spectrum
Within private equity, an important distinction is between strategies focused on direct investment – involving high concentration to individual companies – and a partnership model investing alongside talented managers. The risk profile of each option is different, and the balance in which they are held in a fund is important for its overall risk/return characteristics. ICG Enterprise Trust offers a balanced exposure to funds and direct investments.
Equally, there is no such thing as a typical private equity company. Investors looking for higher risk private equity exposure can look at earlier-stage, venture capital-backed companies, but this is not where large swathes of the sector are invested.
With ICGT, our focus is on buyouts in North America and Europe. We invest in medium and large well-established private equity funds, with a balanced risk/return profile: we want a consistent approach and to minimise losses.
That means the underlying companies in which we invest tend to be market leaders, are profitable and cash generative, and have resilient business models. Most importantly, their growth will be driven not by the economic environment but by structural growth themes. This is a notably ‘lower octane’ approach and a far cry from the prevailing view on private equity.
In action
We also like companies that offer mission-critical services. One example would be Minimax, a company that provides sophisticated fire protection systems. These are mandated by regulation and need to be serviced and checked. This company provides those systems and meets their ongoing servicing requirements. Its revenues do not depend on economic activity, but the product they provide is vital. The scope of regulation keeps growing and is becoming more sophisticated.
Private equity has grown to accommodate different company sizes, different types of businesses and different sectors. There are many stable, sophisticated businesses with recurring revenues and cash flow which benefit from the private equity model.
Many investors still have a vision of private equity through some of the early and worst examples of the asset class. We believe this needs to be re-examined.
The valuation anomaly
The operational performance of the companies within our portfolio is influenced far more by idiosyncratic factors, unique to the companies themselves. Yet, in recent history, the market has focused on external factors – interest rates, the economic environment, regulation. The market has been worried about the reliability of valuations, with low M&A and public market activity giving poor visibility on pricing.
After a quiet period, realisations and new investment activity are showing signs of revival. Private equity realisations have come at a premium to carrying value.
The advantage of operating in our part of the market – $500m to $2bn – is that there are multiple ways to exit a company: selling to another private equity group, for example, or a strategic buyer, or – less often – an IPO.
Yet even with this improving backdrop, the valuations ascribed by the public market to private equity investment trusts have not recovered. This remains a significant anomaly.
A lack of differentiation in investor views on private equity is leading to a missed opportunity. Lower risk private equity has been treated in the same way as higher risk private equity and this has continued even as the environment has started to improve. This misses the reality that many private equity-backed companies are well-established businesses, creating skilled jobs.
There is an increasing trend for these companies to choose private ownership, reducing the opportunity set within public markets. These high-quality companies are available – now – to investors at attractive valuations relative to their public peers.
We believe that as activity levels recover and there are more proof points for valuations, investors will start to interrogate the sector in more detail and to differentiate. The market has not been as discriminating as it should have been, but this could be about to change.
Colm Walsh is the portfolio manager of the ICG Enterprise Trust plc. The views expressed above should not be taken as investment advice.