Are investment trusts the answer to investing in private equity?

In a couple of recent posts, we took a look at some of the issues around private vs public equity, and the volatility thereof. But what if we could go a step further and combine listed equities and unlisted equities into one vehicle, which we then only valued on the same cycle as unlisted (ie. infrequently)?

Could we create a vehicle with the benefits of private-equity style (optically) lower volatility, but also the scale to charge low fees and the flexibility to overcome the drawbacks of a limited life structure?

 

Limited life partnerships are the conventional way of structuring a private equity fund. This makes perfect sense on the basis that it pools the assets of different investors and seeks to treat them equally. It therefore needs clarity of timing on both the investing and disinvesting side. Clients commit assets and they are deployed over time as private investment opportunities arise. They need to know there’s some planned mechanism to get their money back, so investments are then sold (say) 5-7 years later or where clients prefer, rolled over into a new vintage.

It’s the company that matters, not the listing status of its equity. 

Step back for a moment: why is investing in private equity different to publicly listed equity? It’s the company that matters, not the listing status of its equity. For us, it’s just about seeking long-term growth, and working with the companies in which we invest to help them realise that potential. Why should we sell an investment just because it lists? Why should we not buy an investment just because it isn’t listed? An obvious way to overcome these issues is to use a listed equity allocation as the flexible ‘treasury’ in a combined portfolio of private and public equity. The benefits of this are manifold: (1) No ‘out of market’ timing challenges. (2) Far more flexibility to await only the very best private investment opportunities. (3) The ability to quickly reinvest the proceeds of sales of private investments. (4) The ability to hold onto private investments once listed if they remain strong investment opportunities. (5) Flexibility to increase or reduce the listed equity investments to raise or deploy cash to / from private investments without having to change the overall shape of the portfolio. (6) The existence of liquidity to make further rounds of private investment into companies as they progress. (7) The combination of listed and private allocations into one pot, creating the scale for investment managers to charge vastly lower fees than in private equity-only pots.

 

The above combined public-private portfolio approach is a plausible route for large institutional investors to increase their exposure to private equity. At Baillie Gifford we have done this for a handful of clients (we’re looking into whether such an approach can be wrapped into a vehicle, which would make the various technicalities easier for clients, and which could benefit from the infrequent valuation of the private equity component). In the meantime, the British Business Bank and others are simultaneously working hard to find ways to ‘democratise’ access to unlisted growth opportunities for (amongst others) DC pension savers. This is very challenging to do within regulatory hurdles such as the DC default fund fee cap, and the challenges of accommodating regular cashflows to and from an illiquid asset class.

Whether it’s a large institutional portfolio investing through special purpose vehicles, or smaller scale cashflows through investment trusts, there is a strong case for overcoming the public-private divide. 

The really interesting conundrum (to me, anyway) is that there’s a solution to this which is staring us in the face yet seems to be on nobody’s radar screen: investment trusts (the mention of an investment vehicle takes me into financial promotion territory and this is an open blog so I should tell you that there is no guarantee in an investment trust and you may get back less than your original investment).

 

For the uninitiated, investment trusts are closed-end vehicles, usually listed on a stock exchange, in which investors buy and sell shares in the trust rather than the underlying assets. They are therefore ideally suited to private equity investments. A number of trusts are already going down the public-private route, prompted by our new world of ‘capital-lite’ growth companies in which many stay private for longer. Traditionally, investors’ main objection to investing in investment trusts is that they are subject to the balance of supply and demand for the shares, meaning that the price can trade at a discount or premium to the value of the underlying assets. Large investors worry that they won’t be able to find buyers if they want to sell their shares and so will end up offering them at a hefty discount. Both of these challenges can be mitigated; there are now several trusts which are large enough to have meaningful liquidity in the secondary market (how nice to see the secondary market being used for the maturity transformation purpose it was originally designed for); and many more trusts actively issue or buy back shares to balance market demand. DC investors typically have investments horizons which are measured in decades, and they don’t all retire at the same time. So, at least for large trusts there is probably enough liquidity to accommodate a decent allocation from the average DC scheme, providing built-in exposure to private equity.

 

The summary of all this is that whether it’s a large institutional portfolio investing through special purpose vehicles, or smaller scale cashflows through investment trusts, there is a strong case for overcoming the public-private divide. This would allow more investors to participate in the widest set of growth and innovation opportunities at a sensible price. I think this might be what our industry originally did, before we made it so very, very complicated.

Stuart Dunbar

Partner

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