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There is value to be found in private equity

Kathleen Brooks
AFTER two years in the investment wilderness listed private equity companies have emerged fresher, leaner, less debt-ridden and ripe to outperform the overall stock market, according to some analysts.

Traditionally private equity houses tend to be a good play on a cyclical economic recovery. Their share prices should rise when their portfolio companies start to grow, which for most firms is when the economy is doing well. However, the other side of the coin is that private equity stocks get badly hit during a downturn as the value of their portfolio companies tumble.

For example 3i, the only private equity house listed on the FTSE 100, had to write down more than £800m from the value of some of its top assets in January 2009 – the peak of the credit crunch. This hit caused its share price to fall more than 80 per cent.

IMPROVING PERFORMANCE
But the environment for 3i has been improving since the start of the year. It announced an increase in realisations from asset sales from £1.3bn to £1.39bn in the year ending 31 March and it drastically reduced its debt. The firm said that its net asset value (Nav), the measure of its underlying investments, was 321p at the end of the first quarter. However, its share price is still lingering around the 270p level, 70 per cent below where the stock was trading in the summer of 2008. 

PE HOUSES ARE GOOD VALUE
And 3i is not alone. Research published by LPX Group, the listed index provider, found that the sector – which included 17 listed European private equity houses – was trading at a 16 per cent discount to Nav at the end of last year. And this could point to strong performance in the future. LPX Group found that over a 16-year period, when the share prices of listed private equity companies traded at discounts to their Nav, they have typically produced superior returns in the following three years.

For example, listed private equity firms traded at a 16 per cent discount in 1998 and then went on to produce a return of 71 per cent between 1999 and 2001. So based on an historical basis, investors in listed private equity stocks could see bumper returns over the next three years.

Added to this, the fundamental backdrop is supportive for good performance this year, says Iain Macmillan, private equity partner at Deloitte. He says that the industry was more resilient during the downturn than most commentators gave it credit for, and he is now “cautiously optimistic” for 2010. “Private equity houses have had to look much harder at how they deliver value to their investors, by and large that has meant increasing focus on operation teams, which feels like a sensible repositioning,” he says.

There have been some widely reported disasterous investment decisions within the private equity sector, for example, Terra Firma’s 2007 acquisition of EMI. However, Macmillan believes that the high value acquisitions made by some private equity firms in the boom years are a thing of the past, and instead firms will concentrate on building value at the companies they already own and enhancing Nav.

Exchange traded funds (ETF) are an easy way for investors to get access to a wide range of private equity stocks. ETF provider db x-trackers offers an ETF that tracks the LPX private equity index. It is currently trading at €19 per share, this is a discount to Nav, which is currently €20.5.

The ETF tracks 25 of the largest private equity houses including 3i, Blackstone and Apollo Investment, and nearly 30 per cent of the fund is invested in the US. Its dividend yield is more than 6.5 per cent.

Investors should take advantage of this discrepancy between price and Nav as this is poised to narrow assuming the economic recovery stays on track.