Allocating that marginal pound of savings is unquestionably hard following an eight year rally in equities (let alone a 30-year bull market in bonds). It requires a firm view that the forces that have sustained that rally will remain in place for some time, or that new, beneficial, forces will replace those drivers. So, if we acknowledge that record low interest rates and quantitative easing are likely a thing of the past, then we must look to stronger growth in company revenues and earnings to drive markets ever higher.
However, while the wider economic picture looks relatively stable, corporate earnings forecasts appear over-optimistic with 18% growth estimated for the S&P 500 index over the next 12 months. Moreover, the starting valuation is more than 18x times those forecast earnings, well in excess of the long-term average. At these levels, we believe it makes sense to look off the beaten track for compelling investments at more attractive valuations.
The Henderson Alternative Strategies Trust currently has just under one third of its assets invested in private equity, given the asset class’s compelling value and fundamentals. Private equity (PE) is an asset class that is either not well owned, given its inherent inaccessibility, or often plainly misunderstood. PE generally requires often large commitments to private funds, usually for as long as 10 years. This is beyond the scope of most ordinary investors – but there is a large and diverse listed PE fund sector.
The misunderstanding of its nature comes from the oft-repeated claim that PE is simply about buying stakes in companies, injecting large amounts of debt and slashing costs, primarily through job cuts. In fact, the classic private equity model is based on investing alongside management and helping them take their already successful business to another level in terms of scale and profitability. It is about alignment of interests, not asset stripping. PE general partners take seats on the board, often have controlling positions, can make important decisions quickly, and are not hostages to the fortunes of the public markets and their slavish focus on quarterly earnings announcements. These factors all help boost long-term returns.
While investors in PE have made very handsome gains over several decades, we believe that the current environment still looks particularly attractive, especially for the listed PE market. PE investment trusts give investors access to those otherwise inaccessible funds. The universe is broad enough to encompass all areas of the PE market from venture capital (early stage financing) funds to large leveraged buyouts (using debt to fund acquisitions), and from fund-of-funds to direct investment strategies. Since the crisis in 2008 these trusts have fallen out of favour with investors based on what we believe are misplaced concerns over issues such as the levels of debt used to purchase assets or too infrequent pricing.
More recently however investors have woken up to the opportunities and acquired a better understanding of the actual risks. Entry prices seem attractive, trading at large discounts to the value of the underlying assets that the PE fund owns, while exiting has often realised gains at a much higher price than the value of the underlying assets – sometimes more than 40%. These attractive growth characteristics look particularly appealing to company executives who are sitting on piles of cash and are either struggling to grow organically or are too nervous/short-termist to invest in their businesses for growth further down the line. As such, we expect ongoing merger and acquisition activity to further boost PE returns.
Of course, high valuations in public markets mean that it is harder for private equity firms to put their capital to work without overpaying. The investments we have identified in the listed market tend to have fairly mature profiles – that is, they are now firmly in selling mode, harvesting the healthy valuation uplifts resulting from investments made several years ago and plenty of hard work improving those underlying businesses.
We have also invested in more specialist areas of the market where there is a particularly strong opportunity, theme and/or management team in place. Riverstone Energy is a fund focused on shale oil and gas assets in North America. It listed in late 2013 and the management team have a peerless, multi-decade track record in the space. Their timing was particularly good, as they had a sizeable war chest to deploy as the oil price tumbled in 2014/5, enabling them to buy very high quality assets at very attractive prices.
Another niche opportunity is Mantra Secondary Opportunities, a fund that invests in mature private equity funds, with only a few underlying holdings yet to be exited. Essentially Mantra acts as a liquidity provider to investors who have made a good return on their investment but would like to move on and free up their capital. Mantra buys these remaining holdings at a sizeable discount to NAV and then further benefits from any uplift that is realised upon exit of the remaining holdings.