As fewer companies around the world choose to be listed on a stock exchange, asset managers are increasingly searching for investment opportunities in private equity. Entrepreneurs are often put off by the level of regulation and media scrutiny that comes with listing. In the US, the total number of listed companies has dropped by nearly 40% since 1997. The Wiltshire 5000 index, one of the broadest representations of the US market, named after the original number of constituent companies, when established in 1974 now only comprises 3660 companies.

Private equity companies can provide rich rewards for shareholders. They have different governance and incentive models to listed companies, which tend to result in stronger earnings growth. Private equity managers tend to be controlling shareholders and can therefore react more quickly to threats and opportunities.

Global private equity exposure can be accessed via listed investment companies quoted on the London Stock Exchange. These listed companies are the ideal structure for investment in illiquid assets such as private equity. The closed-end structure of an investment company is perfectly suited to investing in illiquid assets which owned directly may not be as easily tradeable as the shares of an investment company. This is one of the greatest advantages of an investment company over a unit trust. There are several examples of unit trusts having to restrict redemptions due to liquidity mismatches, which render them unable to meet their promise of daily dealings. The greatest strength of investment companies comes at a price. Holding illiquid assets in a liquid tradeable share has a price in the form of discount risk.

Listed private equity companies are now trading at very wide discounts to net asset value. Their de-rating is blamed on the rapid rise in interest rates and the impact of sharply higher bond yields on long duration assets. Companies promising returns many years in advance are especially susceptible to higher discount rates. There is some suspicion that valuations reported by private equity managers are unrealistically high. Yet, private equity managers are not generally incentivised for keeping valuations unrealistically high. They are incentivised instead on their purchases and performance fees are based on the value of their realisations. In general, earnings growth across private equity companies has remained strong, gearing has been modest so rising interest rates have not posed a material risk, and private equity realisations have continued to validate valuations.

Private equity exposure comprises 12.4% of OAM’s global growth portfolios and 10.7% of its global balanced portfolios, via holdings in 3i Group, HG Capital Trust, Rothschild Capital Partners and Scottish Mortgage. These companies exhibit excellence in management, their business models and their performance track records.

3i Group grew its NAV in the first nine months of FY 2023 by 26.8%, boosted by strong performance from Action, a fast-growing European discount retailer that comprises around 60% of its NAV, plus its other value for money private label healthcare and infrastructure investments. These are not long duration assets looking at turning a profit way into the future. In the 12 months to 1st January 2023, Action delivered a 46% increase in provisional EBITDA. 3i Group is secured by a resilient investment portfolio, investments made from permanent capital, a strong balance sheet with gearing of just 3%, and running costs covered by cash income. A careful and consistent approach to valuation means realised values of its investments are consistently above reported values.

HG Capital has delivered annualised NAV growth of 17.8% over the past decade and 15.6% over the past 20 years. It is a highly profitable company with strong earnings growth and high levels of recurring revenues. Its business model is to provide business critical software services in the tax and accounting, legal and compliance, ERP and payroll, automation and engineering, insurance, SME technology, wealth management, and healthcare sectors. Businesses enjoy repeat subscription revenues and risk is mitigated by a fragmented customer base, years of accumulated intellectual property and high margins. Far from being speculative, management’s focus is on “dull” technology companies. HG Capital’s NAV increased in calendar 2022 by 5.4%. Its top 20 investments, comprising 77% of NAV, delivered average year-on-year sales growth of 30% and earnings growth of 25%. Exits in 2022 continued to validate reported valuations with an average uplift on the three full exits of 28% versus December 2021 valuations. At 31st December, HG Capital’s liquid resources amounted to 23% of NAV. Managers say that “Increasingly, we see this environment as one of opportunity, as valuation adjustments create the opportunity to acquire businesses with attractive long-term performance.”

Rothschild Capital Partners had a difficult year in calendar 2022 with an NAV decline of 13.3% versus a decline of 12.9% for the MSCI All Country World Index. However, since its inception in 1988 to June 2022, it has delivered a valuable return profile, participating in 76% of market upside but only 40% of market declines, resulting in impressive risk-adjusted returns. Private equity exposure comprises around 41% of NAV. For this reason, the shares have derated and now trade at an unusually wide discount to NAV of over 20%, but based on the company’s track record, ability to mitigate risk, and management’s connections in sourcing investment opportunities, this discount seems too good to ignore.

Scottish Mortgage, which has around 30% of its NAV in private equity investments, its largest being SpaceX, suffered a terrible year in 2022. NAV declined 41.3%. This has detracted from its superior long-term performance but not by much, with its returns over the past ten years more than double those of the MSCI All Country World Index, and over 3 years and 5 years its NAV is still up by a remarkable 44.5% and 75.0%. The share price has dropped nearly 50% from its late 2021 peak, the largest decline since the 2008/09 Global Financial Crisis, when the shares fell over 60%. Its managers are excited, believing that novel technologies can now be acquired “on the cheap”. Just as the managers highlight that “the biggest winners are built in bear markets”, buying a manager with the track record of Scottish Mortgage after a period of weakness is generally a successful investment strategy.

3i Group, HG Capital, Rothschild Capital Partners, and Scottish Mortgage are long-term holdings in OAM’s global portfolios, providing private clients with valuable private equity exposure. The shares are trading at historically cheap levels with discounts to NAV of 6.1%, 22.5%, 22.5% and 16.6%, respectively.