Investment companies have recently been struggling with rampant levels of discounts and left with very blunt instruments to counter them.
Managers such as Richard Hickman, who is in charge of HarbourVest Global Private Equity, are having to deal with “pretty extreme” discounts to net asset value (NAV) and are facing “the million-dollar question” of how to control them.
Historically, boards have implemented share buyback programmes (whereby the trust buys its own discounted shares to balance supply and demand), but their effectiveness for narrowing the discount has increasingly been questioned.
Below, experts share their take on the efficacy of buybacks and the possible alternatives.
Founded in December 2007, HarbourVest Global Private Equity has traded at a discount for most of its history, with a long-run average of 15-25% pre-Covid. But today, the discount reached 47%.
“So, we have been buying back shares. Since September of 2022, we bought back $44m of shares, which is about 2% of the current market cap. That's material,” the manager said.
“But the discount is wider now than it was a year ago. We don't actually see any evidence that buying back shares narrows the discount.”
Despite this, the trust has allocated a further $25m to share repurchases, as it announced in its half-year report published at the end of last month. The expectation is that buying back shares at a wide discount mathematically increases the NAV per share. This always works, but not always as intended.
“Because you're effectively reducing your cash balance at the same time, the market may look through that and not ascribe the full value of the NAV per share increase,” Hickman explained. “That seems to be what we've seen in our own case.”
Performance of fund vs sector and index over 1yr
Source: FE Analytics
This might not be the case for every trust, however. Peel Hunt researchers have found evidence that for some of them, buyback programmes do have an impact on the discount but the sounder proof mostly relates to liquid vehicles.
Of the conventional equity trusts, those that have bought back at least 5% of shares in issue and £25m by value (not including those with zero- discount policies) have experienced a less severe discount widening (2 percentage points) than their respective peer groups.
“Within this subset, we note a meaningful correlation (circa 50%) between the proportion of shares bought back and how well the relative rating has held up year-to-date,” the report read.
Similarly, the discount of infrastructure funds has been an average of 4 percentage points better than their respective peer group’s weighted average discount.
The researchers also highlighted the “natural experiments” offered by Aquila European Renewables and SDCL Energy Efficiency, which have paused their buybacks since 11 October and 11 September respectively.
Since the date of their last buyback, the discounts have widened 8 and 5 percentage points more than their peer group respectively, the research showed.
But buybacks aren’t a panacea for every trust, according to Hawksmoor’s Ben Mackie.
“I don't think there is a silver bullet there to containing the discount. If the buybacks are of a sufficient size, they might narrow it – but when we're encouraging boards to consider buybacks, it’s less about narrowing the discount and more about a capital allocation decision,” he said.
“This is particularly relevant in less liquid spaces such as private equity and infrastructure. When your shares are trading on a really big discount, is it put to good use by buying a brand new investment, with all that diligence, research and underwriting needed, or is it a better risk-adjusted return and a more accretive use of capital to use it to buy the existing portfolio at a massive discount? That’s what buybacks are about.”
While there might not be a unique solution to narrowing the discount, boards can combine multiple strategies – and some investments companies are more equipped at this than others.
One mechanism is annual redemption facilities, which allows shareholders to redeem their shares once a year at net asset value less cost.
This means that investors can buy a trust trading on a 20% discount in January knowing that there will be a redemption facility in May where they can get out to, say, a 2% discount, corresponding to NAV less cost.
“With very liquid assets such as equities, it doesn't take a huge amount of time to meet those redemptions and investors have a fairly good handle on the value that will be realised,” said Mackie. “Redemption facilities have absolutely acted as very good discount controls.”
Tender offers, whereby one can tender 20% of their shares at NAV less cost, also work similarly – but neither of these instruments goes well with illiquid portfolios, because to meet the demand of the shareholders who have chosen to tender or to redeem, the manager needs to sell assets, which can be difficult to do.
For illiquid trusts, the only solution is to use continuation votes, which have become standard in the industry and allow shareholders to vote on whether they want the investment company to continue in its current form. A negative vote is a normally a prompt for a strategic review.
“It doesn't necessarily mean the vehicle winds up and it certainly doesn't mean a fire sale of assets, but it does mean a strategic review which, if governance is correct, should involve a very deep consultation with shareholders,” said Mackie.
Continuation votes can also be triggered if certain performance thresholds haven't been met.
But what if the discount persists?
“The simple answer is that it’s a question of time. How long have the shares traded on a discount? People usually look at Z-scores [a measure of the discount compared to its historical average], and the danger might be that they look at these scores, buy a trust when it’s trading wider and then as soon as the discount narrows, they sell it again, so the discount becomes self-perpetuating,” Mackie said.
“That’s what we mean by ‘entrenched’. The broader issue here is that in an ideal world, everyone should have the ambition of these vehicles trading on premiums, because if you can’t grow, you’re sub-scale and mimicking what could be done in an open-ended fund, then what's the point?”
The industry has reacted. In some cases this has been through mergers, such as in the case of Nippon Active Value, while in others it has resulted in closures (RM Infrastructure Income).
“You've got to shrink to win, which really means less supply. That has to be a good thing for the sector that remains,” concluded Mackie.