Why investors should not ignore unlisted companies

What does the decline of public markets mean for investors? Tom Bailey considers Woodford and potential trust moves for cautious investors.

Stock markets connect the monetary savings of a society with companies in need of capital to invest and grow. At its best, this allows businesses to expand, powering economic growth and prosperity while providing savers with a return on their money.

Historically, the fund management industry has acted as a successful mediator of this process. Funds, being pools of investment, allow investors access to more diversified holdings, while managers do the research and stockpicking.

In recent years, however, a troubling trend has emerged: the decline of public markets. In the US, the number of initial public offerings (IPOs) has fallen from an average of 300 per year between 1980 and 2000 to just 100 between 2000 and 2017.

Peter von Lehe, manager of Neuberger Berman Private Equity fund, notes: “What you’ve seen in the US since 2000 is the number of public listed companies drop by around 40%.”

Time to market

Meanwhile, according to a report by management consultant McKinsey, in 2014 the average US technology company took 11 years to go public, compared to just four years in 1999. The average age of a company on the US market is now 20 years – double what it was in 1997.

Similar trends are afoot in the UK. The Alternative Investment Market (Aim) listed 760 companies at the start of December 2019, 15% fewer than 10 years ago. This are several reasons behind this. First, companies have many more options for financing themselves, including direct investment through private equity flows. Adam Coffey points out in The Private Equity Playbook: “At the end of 1990, there were 312 private equity firms in existence. By the end of 2017, that number had grown to 5,391 firms with current assets under management totalling $2.83 trillion.”

At the same time, many companies have less need to go to public markets in search of large capital injections. As Nick Greenwood, manager of Miton Global Opportunities (MIGO) investment trust, observes, “the world has now changed”.

Greenwood points out that businesses are increasingly reliant on intangible assets such as brand power or software, rather than capital-intensive machinery. The costs of creating intangible assets are often borne in the early years of a company’s life, so there is less need for capital investment to support expansion than with traditional manufacturing industries.

This clearly presents a challenge for private investors. With companies staying private for longer or not going public at all, there are fewer profitable places for the investing public to put its savings. James Anderson, manager of the Scottish Mortgage (SMT) investment trust, notes: “The majority of new capital and knowledge investment is in private markets. Just about all ability to build new companies will happen in private markets.” He continues: “It is really important to give investors access to these companies.”

Similarly, argues von Lehe: “If an investor wants to gain access to certain areas of the economy and growth, the only way is through exposure to unlisted companies.” As a consequence, there has been growing investor interest in retail investment funds focusing on unlisted companies.

Woodford woes

However, with the implosion in 2019 of Woodford Investment Management, investors could be forgiven for expressing some scepticism over such a prospect.

The failure of Neil Woodford’s open-ended Woodford Equity Income fund has been widely blamed on the inappropriateness of using an open-ended fund structure to hold illiquid unlisted assets. The elephant in the room, however, was Woodford Patient Capital (WPCT).

The trust aimed to provide growth capital to early-stage and potentially fast-growing companies. To do this, it used a closed-ended structure that is theoretically well-suited to provide access to unlisted companies. On the back of its losses, then, investors could conclude that investing in private equity-style funds is just too risky.

However, that would be overly simplistic. WPCT was largely invested in very early stage biomedical and technology companies. Providing growth capital to such companies is notoriously high-risk .

Additionally, there is an argument that such a trust was unworkable from the start. Innovative as Oxford Business Park (where Woodford IM was headquartered) may be, it is hardly Silicon Valley or Shenzhen. According to Anderson, the whole proposition of such an investment trust was flawed. Woodford, he says, “was fundamentally trying to do something useful but on a canvas that was limited. It is dubious whether British capitalism produces enough of such [early stage] companies.” In contrast, Scottish Mortgage is a global trust with extensive holdings in both the US and China.

Another issue was Woodford’s own expertise. His background was in large-cap value investing. While there are some transferable skills, he was not an expert in private equity or venture capital investing.

Lessons to be learned

Rather than proving that unlisted companies are inherently inappropriate for private investors, WPCT’s failure offers some key lessons for anyone considering such an investment.

The highly risky nature of the holdings in WPCT highlights the importance of distinguishing between different types of private equity-focused trust. As mentioned, Woodford’s trust aimed to provide growth capital for start-ups. For many investors, the inherent riskiness of such investing is too high, although Woodford’s reputation nonetheless helped WPCT raise £800 million when it launched on the stock market in April 2015.

Investors, therefore, must keep in mind that such exposure to unlisted firms via investment trusts should form only a small part of their portfolio. Importantly, also, unlisted companies and start-up companies are not synonymous – particularly now that companies are staying private for longer – and there are much less risky ways to access unlisted businesses.

As Richard Staveley, managing director of strategic public equity at Gresham House, notes: “There is a huge range in risk and reward between those with unproven technology and business models versus, for instance, mature family businesses looking for a partial exit, or profitable companies seeking acquisition capital to consolidate the sub-sector of an industry.”

One example of a trust focused on unlisted companies that doesn’t provide early-stage growth capital is Merian Chrysalis (MERI). Launched in 2018, it aims to invest in companies that are near IPO stage, including some already reasonably mature companies. This of course comes with its own risks: several high-profile IPOs in the US went sour in 2019, for instance. However, in theory, Merian Chrysalis invests in more mature companies with proven business models.

Other options also exist. As James Carthew, head of investment company research at QuotedData, points out: “The vast bulk of listed private equity funds are focused on buyouts. Some, such as HG Capital, make investments directly. Others, such as Standard Life Private Equity and HarbourVest, are funds of funds. These invest in limited partnership vehicles which, in turn, make direct private equity investments.”

Cautious investors

For more cautious investors, there also exist several trusts which invest only small amounts in private companies. Such trusts still focus primarily on public companies but also have the potential to buy a limited percentage of private holdings (see table).

For example, Fidelity China (FCSS) can invest 10%, Edinburgh Worldwide (EWIT) 15% and Scottish Mortgage 25%. This allows managers to adapt to the decline in public companies without going exclusively into the private equity space. Many of the companies they back would in previous times already have come to public markets looking for funding.

However, this brings us to the final lesson from Woodford: investors should be sure any manager purporting to run a trust that buys unlisted companies has plenty of experience under their belt. With unlisted holdings this is especially important, as valuations are often opaque. There is no daily quoted market price for unlisted holdings, so it is not clear how much the share price and actual net asset value of a trust are diverging.

This means putting your trust in the manager. While there is a lot of overlap, stockpicking and private equity investing are distinct disciplines. Any investment trust with a large remit for the latter should have a team that reflects that bias.

Trusts ranked by private company holdings

Investment company Sector Unlisted
holdings (%)
Lindsell Train Global 50.3
Tetragon Flexible Investment 44.0
Caledonia Flexible Investment 36.0
UIL Flexible Investment 35.3
Hansa Investment Company (Ord) Flexible Investment 31.2
RIT Capital Partners Flexible Investment 26.0
Majedie Global 22.3
Scottish Mortgage Global 19.4
Miton Global Opportunities Flexible Investment 15.8
Geiger Counter Commodities & Natural Resources 15.0
International Biotechnology Biotechnology & Healthcare 14.0
AVI Global Global 13.4
Baillie Gifford US Growth North America 13.2
Law Debenture Corporation UK Equity Income 12.5
Gresham House Strategic UK Smaller Companies 9.0
F&C Investment Trust Global 6.7
Aberdeen Emerging Markets Global Emerging Markets 5.0
Edinburgh Worldwide Global Smaller Companies 4.9
Athelney UK Smaller Companies 4.4
Fidelity China Special Situations Country Specialist: Asia Pacific - ex Japan 4.2

Note: Lindsell Train is 50% invested in its own unlisted fund management company. Source: AIC, as at 31 January 2020

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