Investment Guide: Private Equity Sector
Both the fund universe and investment trusts have specialist areas, where investors can access niche or overlooked areas that might be ripe for growth.
If you're interested in, say, Japanese smaller companies, forestry & timber, Latin America or biotechnology, you can find a collective vehicle of some sort that will give you access.
For this month's briefing, we're going to focus on one of those specialist areas – the private equity sector, where there are 23 private equity investment companies vying for investors' attention - all with different investment methods and strategies.
How they work…
Private equity investment trusts invest in small, unlisted companies, often start-ups that have the potential to grow rapidly and even list on the stockmarket themselves. Clearly, these investments also have the potential to fail spectacularly, which is why - unless you are a high-net-worth individual who can afford to lose money - private equity is better accessed via a collective fund. Or not at all, if you are in any way risk-averse.
In the wake of the last financial crisis, for example, private equity investors suffered badly, while decent private equity investments were hard to find - in a low-growth environment, the number of successful business launches dwindles.
That said, the performance of some private equity investment trusts has been compelling. Of the 23 investment trusts listed in the private equity sector, only six have lost money over the past year. Over three years just two have lost money, while only two have failed to make a return over five years.
At the other end of the performance table, some of the gains have been exceptional. For example, over one year, 3i Group - perhaps the best- known private equity vehicle in the UK - returned 45.4% to investors, while over three years it returned an incredible 209.6%. Over five years, the runaway performer is Northern Investors Company (263.7%), followed closely by SVG Capital (218.5%) and Pantheon International Participations (165.2%).
Types of private equity company
There are two types of private equity investment company: those that invest in tiny companies directly, and those that invest in other private equity funds, although there are a small number of investment companies that will do both.
Investment trusts, in particular, are well-placed to invest in private equity, mainly due to their 'closed- ended' structure.
Unit trusts are open-ended, meaning they get bigger as more people invest and smaller as investors withdraw their money. However, if a large number of investors wish to sell up at the same time, the unit trust manager may have to sell some of his assets in order to provide the money to satisfy these 'redemptions'. But investment companies are closed-ended funds because there are a set number of shares and this number does not change regardless of the number of investors.
This means that investment trusts offer a better structure than unit trusts for investing in private equity because tiny companies can be illiquid assets, making them harder to sell or 'exit' from. With a unit trust, a manager is forced to sell holdings to return cash to investors whenever they wish to withdraw from the fund but an investment company manager does not have to do so.
However, that does not mean private equity is risk-free – far from it. Investment companies in this space are far higher risk than more straightforward vehicles, so they are only suitable for high-net-worth investors or someone who has the majority of their money in more traditional investments and puts 10% or less of their cash into the private equity arena.
When it comes to which investment company to choose, investors must ask themselves many of the same questions they would when investing in other sectors.
Look at past performance (though, of course, this is no guide to future returns), the track record of the managers, when the manager expects his portfolio of investments to reach maturity (ie, when some of his tiny company investments might grow to the point where they can be cashed in), what companies and regions the vehicle is invested in, and whether there is any borrowing.
Out of 23 investment companies in the private equity sector, only nine have borrowed cash to invest (known as gearing) - but some have borrowed heavily. For example, JPMorgan Private Equity has gearing of 27%, while JZ Capital Partners has gearing of 26% and NB Private Equity Partners has 23%.
Gearing can indicate that a manager has the courage of his convictions and, if successful, can amplify returns. But, if unsuccessful, heavy gearing can lead to losses mounting even further.
It's worth looking at the performance of the private equity sector against the average investment company, too. For example, over one year (to the end of June 2015) private equity vehicles have performed worse than average, but they have outperformed over three and five years. Then again, over 10 years they have seriously underperformed the average investment company – which perhaps sums up how private equity is something of a rollercoaster ride.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.