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Is your portfolio an ‘80s throwback?

Private equity investment trusts could add valuable diversification to private investors portfolios, which often still resemble old fashioned 60/40 strategies…
Kepler Trust Intelligence
Last update 10 November 2021

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by NB Private Equity Partners. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

Theories on how to build a portfolio abound in the world of professional investing. As we wrote in an editorial earlier this year, in the 1980s investors adopted the 60/40 equity and bond split as shorthand for a well-diversified portfolio as fixed income became a less reliable beast.

Since then, professional investors have amalgamated a broadening range of asset classes into their portfolios as they looked to international equities, real estate and even hedge funds as new sources of diversified returns.

However, for individual investors, it can often be difficult to discern what presents a genuine, new frontier of opportunity. As a result, many portfolios are still dominated by the 60/40 model of allocating to domestic equities and fixed income.

While there is no harm in pursuing this approach, it does mean that individual investors could be missing out – on returns, on portfolio diversification and, potentially, on future growth.

Untapped potential

One area that is treated starkly differently by private and professional investors is private equity. After seeing the sector outperform public equity markets over multiple cycles, some active UK pension funds have up to 10-15% of their portfolios allocated to private equity (and in the US this sometimes climbs to over 20%). Meanwhile, the MSCI Private Investor Indices group private equity with other alternatives, such as infrastructure, hedge funds and renewables, which each have very different risk and reward profiles. This is reflective of the relative lack of attention paid to private equity by private investors.  

Typically, this is attributed to the challenges in accessing the asset class. Professional investors, such as pension funds, are able to invest through private equity limited partnership funds whose minimum investment puts them far out of reach of (most) individual investors. However, in the UK there is an accessible and relatively underappreciated route to investing in the sector.

Listed private equity trusts (LPE) offer investors exposure to a portfolio of institutional-level private equity companies through their publicly traded shares. Although the way these trusts invest varies, at their core they all provide investors with the same benefits: exposure to private, non-listed companies backed by private equity firms, a focus on fundamental value creation and a source of diversification.  

Added benefits

The diversification benefits of a private equity allocation are most evident when contrasted with a typical UK retail investor allocation. It is commonly understood that private investor portfolios are overweight the S&P 500 and FTSE 100 versus their professional peers, investing in these through a mix of country-specific funds, global funds and direct share ownership.

These indices are made up of very different sectors and subsector weightings to those of most private equity portfolios. For instance, the FTSE 100 is dominated by financial institutions, FMCG (fast moving consumer goods) conglomerates and traditional oil & gas operators. Meanwhile, the S&P 500 is significantly weighted towards the FAANGs, while also seeing a substantial presence from financial institutions and FMCGs.

Conversely, while LPE funds will invest in some of these sectors, they lean heavily towards specialist underlying private equity expertise in specific subsectors. For example, when investing in financial services, they may target growing and evolving subsectors, such as wealth management, which is seeing increasing private equity activity and consolidation. Private equity backed companies are also typically significantly smaller than those found on major public markets, especially the S&P 500.

Another benefit of private equity investing is that private equity funds own and therefore actively control their portfolio companies and their value creation. Private equity investors typically enter into an investment with a clear plan as to how they can help grow earnings over time and work closely with management, or even bring in new management, as part of this process.

Once the private equity manager has achieved its goals or believes they have maximized value in a reasonable time frame, they will seek to exit their investment, often at a premium to carrying value, through either selling it on or seeing it float on a public market.  

The bargain buy

While the appeal of private equity is clear, there is a further attraction for UK private investors. The listed private equity (LPE) sector has typically traded on a discount to NAV, meaning that investors can tap into this opportunity comparatively cheaply.

For example, NB Private Equity Partners (NBPE) currently sits on a discount of 21.5% (as at 3 November 2021), despite being the third-strongest performing trust in share price terms in the AIC’s Private Equity sector over both the short term, one year, and the long term, over ten years. The trust is unique in the sector as the only fund investing exclusively through co-investments alongside third-party managers which both extend its diversification benefits and benefit its total fee structure.

By focusing on public markets alone, private investors could be missing out on both the potential diversification and reward offered by private equity. While its diversification benefits and focus on value creation are compelling in themselves, the discount that many LPE funds currently sit on could add further appeal for those considering a private equity allocation as a core part of a broader portfolio.

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