Private equity trusts have produced some of the best returns in years, but investors remain skeptical. The average decline in equities in the first quarter was 9% and the average discount to net asset value (NAV) rose from 15% to 21%.
The £2 billion HgCapital Trust (LSE: HGT) tops the performance chart with a five-year return of 233%. Net asset value growth has been 20% over the past ten years, but the stock is trading at a 7.5% discount.
Hg was one of the few trusts to come through the financial crisis unscathed. Its strong financial position then allowed it to buy businesses while its competitors were forced sellers. It sold underperforming peripheral investments to focus on its core specialty, software and services, investing primarily through the $30 billion in funds managed by Hg. Sales of the top 20 companies in its portfolio over the past five years have increased by 22% and cash flow by 28%.
However, these companies look highly valued at a multiple of 27.4 times cash flow, well above the 20.5 for the S&P 500 software and services sector. still very expensive, this valuation premium explains some of the skepticism. Investors fear it’s too good to last.
Greater focus on profits
David Toms, director of research at Hg, puts this into context. The value relative to sales of loss-making companies has halved over the past year, he says, but that of profitable companies is down only 4%. “Unprofitable companies were growing sales much faster, but growth for growth was hit hard.” A year ago, unprofitable companies were valued at very similar levels to profitable companies, but they are now back at their historical discount.
The software sector now trades at 18 times cash flow, compared to 14 for non-software, but the valuation to free cash flow is similar to 28 and 27. This reflects software’s low capital requirements.
Twenty years ago, software companies sold large packages, which made sales lumpy and vulnerable to delays and postponements. Now, sales are by annual subscription, which makes them more predictable. Software sales growth in 2022 was 11%, compared to 6% for non-software. Hg is focused on companies with “consistency and replicability of performance,” says Hg senior partner Nic Humphries. He expects “software sales to continue to grow at 2.5 times the rate of GDP.”
Hg focuses on business-to-business critical software. It does not invest in start-ups: “we follow companies on average five years before investing”. While this doesn’t rule out unprofitable businesses, a clear path to strong margins is essential. Portfolio companies are highly profitable, generating an average 35% cash flow margin on sales.
The manager’s continued ability to find new investments at attractive prices was demonstrated by two acquisitions in early April, which cost Hg £114m. This still leaves £318m of liquid resources available for future purchases, assuming no divestitures. The fact that divestments in 2021 were up an average of 40% from book value confirms that the valuation of the portfolio, far from extravagant, is modest.
Portfolio management is labor intensive and managers are well rewarded for success. As with all listed private equity trusts, the total expense ratio is high (1.4% in 2021). This makes most private wealth managers reluctant to invest in the sector and it therefore trades at generous discounts to net asset values which are both conservative and outdated. This is the opportunity for private investors solely concerned with performance.