Here at Inside Investor Club we focus on direct investing into private companies rather than going through a fund manager.

But it’s impossible to ignore some juicy discounts in the private equity fund market so it’s worth taking a look to see if there are bargains to be had.

By nature we tend to be suspicious if something seems cheap – what’s wrong with it? Why is it trading at a discount to the apparent value of its assets? With some funds available at up to 50% discount to their NAV our Too Good To Be True antennae are twitching nervously.

One fund that is trading counter to this trend is the UK’s biggest private equity firm, 3I. Formed way back in 1945 as the Industrial and Commercial Finance Corporation with £15m of capital to provide long term funding for SMEs, 3I is today trading at a 56% premium to its NAV and has returned a staggering 1070% over the last ten years.

The biggest allocation in the £32 billion fund is its 58% holding in supermarket group Action. Little known in the UK, Action has 2,725 stores in 12 European countries and has been successfully growing and generating cashflow and profits sufficient to enable some chunky dividends to be taken by 3I. But there are those who claim 3I is over-egging the Action pudding by valuing it at 18.5 times earnings against a sector average of 14.4.

It’s unlikely that 3I will lose too much sleep over these objections, given that their investment has grown by 120 times since 2011. However, it now forms such a large part of the fund that a partial sale would surely make sense so that new opportunities could be added.

There are two main drivers for the funds that are trading at a discount such as the second largest UK fund, HarbourVest Global Private Equity, which you can snap up at the time of writing for 43% less than the assets it holds. The first contributor to lower share prices has been higher interest rates.

Private equity’s main modus operandi is leveraged buy-outs, where a small amount of equity is matched with massive chunks of debt to acquire companies with reliable cashflows. The cash pays down the debt over a period of time, increasing the value of the equity portion. So, even with little or no growth in the underlying business, the PE fund can achieve an impressive rate of return through financial engineering. Higher interest rates have played havoc with this model, leading to reduced availability of debt and significantly fewer deals.

The second driver of reduced share prices has been doubt about the valuations PE funds are placing on their portfolio companies. Unlike shares on public stock markets, companies in a PE fund do not have their share price ‘marked to market’ on a daily, real time basis. It’s only when a capital event such as a new share issue, an IPO or a trade sale takes place that we can genuinely confirm how much that company is worth.

Yet the signs are that, if anything, PE funds tend to be conservative in their valuations. Companies which have been bought out by their management with the help of a PE fund have been shown to grow profits at a higher than average rate – a sign that they have addressed the Principal/Agent dilemma by having management adopt the same mindset as shareholders now that they co-own the business. Because of the prolonged gap between valuations, it is normal for the sale of a company to be at 20-30% above its last valuation with a positive impact on NAV.

So where else can PE funds be found at a sizeable discount? Oakley Capital Investments currently stands at 30% below the value of its underlying assets and has a portfolio of tech, digital and education companies. NB Private Equity offers a 25% discount on its US centric portfolio, while the aforementioned HarbourVest’s 43% discount looks like one of the best bargains in the current environment.

The reason we focus on individual companies is that it’s hard for a basket of companies to provide the 10-50X multiples that we scour the world for. We are looking for the one or two exits that will transform our net worth. But that shouldn’t preclude picking up some bargains when they are on sale.

It’s simply a matter of overcoming our suspicious human nature… 

Until next time

Graham