The private equity (PE) sector displays a similar risk-reward profile to major equity indices, US real estate investment trusts (REITS) as well as other equity classes over the longer term, according to Edison’s latest report on listed private equity (LPE).
LPE also continues to trade at a 14 per cent discount to NAV despite achieving double-digit annual returns over the last five years. Despite these findings, public market investors still tend to treat LPE with caution, citing leverage and investment commitments, lack of disclosure, high valuations and discount volatility as issues.
The view that LPE is considered more risky than other equity-like comparables, Edison believes, stems largely from the sector’s performance during the financial crisis which is still prominent in investors’ memories.
The perception appears at odds with the strong recent performance of the LPE sector which has generated strong average annual total share prices returns over the past five years of close to 19 per cent while NAV returns have been close to 10 per cent with very low volatility. In addition, the long term risk-reward profile which notably includes the financial crisis years and does not differ significantly from that for the major equity indices.
Analysis of more than 23 years of return and risk data however shows that LPE displays a similar risk-reward profile to major equity indices and US real estate investment trusts (REITs), and Edison notes that although NAV discount volatility during the financial crisis was acute, few portfolio companies failed.
The report also notes that the PE ownership model tends to mitigate risk as a result of portfolio diversification, extensive due-diligence, alignment of stakeholders and value creation through active management. Moreover, the drivers of problems during the crisis – aggressive leverage and commitment – are no longer a feature of the sector.
Analysts at Edison believe that there has been a structural reduction in the risk profile of LPE following the financial crisis with most major LPE companies currently running a net cash position while investment commitments are much more tightly managed, providing an optimistic outlook, suggesting that the risk: reward profile could improve further over time.
The sector continues to trade at a considerable discount to net asset value (NAV) of 14 per cent despite the strong recent investment performance of LPE, according to the Association of Investment Companies (AIC). Edison notes that the discount has narrowed in recent months, partly due to continued strong NAV returns and corporate activity such as the HarbourVest bid for SVG.
Rob Murphy (pictured), analyst at Edison Investment Research, says: “We have seen that LPE has delivered competitive returns compared to equity indices and closed-end structures like US REITs both recently as well as over very long time periods and there is good reason for optimism regarding the perception of LPE moving forward. The fact that the sector is trading at a meaningful discount reduces valuation risk compared to equity markets in general. The less flattering risk-return profile of the last 10 years will arithmetically fall out of the comparisons over the next couple of years or so, which should improve the sector’s relative attractiveness from an investment consultant’s point of view. We believe that the PE model mitigates risk and the resilience of the sector has been demonstrated during difficult times, as evidenced by the low incidence of failed investments during the financial crisis.
“The PE ownership model itself is relatively unchanged and has proved to be a highly effective and successful vehicle to create value in unlisted companies with tight control over risk and lessons have been learned from past mistakes at the LPE company level. The relatively aggressive leverage and commitment strategies at a few LPE companies are no longer a feature for the sector. This augurs well for the relative performance of LPE in future down cycles, which will inevitably occur, and suggests potential to further improve the average risk: reward profile.”
