Sententia Articles October 2019

In this issue

The Private Equity Question: Can the client commit to the long term?

There’s been a great deal of discussion in the press over the last few months around Private Equity, or unlisted stocks, with a trigger being the Woodford fund suspension. There are many holdings that Neil Woodford has been unable to sell because they are not listed on a stock exchange. This has caused concern for some about the potential dangers of including such Private Equity within a portfolio. On the other side of the debate, however, is the argument that a certain portion of Private Equity could still prove to be a worthwhile part of an investment portfolio, with good potential for growth for both start-ups or more mature companies. The real question, according to this line of thinking...

Pension Freedoms (2015) and the Opportunity for Improved Succession Planning

‘Pension Freedoms’ introduced an expansion of the options available to the member nominated beneficiary(s) or ‘nominees’ of a pension scheme. Its introduction in April 2015 allowed for improved succession planning and a wider range of options for the nominees of death benefits. Allowing for nominees to select drawdown as an option meant that the money no longer needed to leave the SIPP as a lump sum payment (back into the nominees’ estate for IHT purposes), and allowed for better planning in a tax efficient vehicle...

 

 

The Private Equity Question: Can the client commit to the long term?

There’s been a great deal of discussion in the press over the last few months around Private Equity, or unlisted stocks, with a trigger being the Woodford fund suspension. There are many holdings that Neil Woodford has been unable to sell because they are not listed on a stock exchange. This has caused concern for some about the potential dangers of including such Private Equity within a portfolio. On the other side of the debate, however, is the argument that a certain portion of Private Equity could still prove to be a worthwhile part of an investment portfolio, with good potential for growth for both start-ups or more mature companies. The real question, according to this line of thinking, is not so much whether Private Equity itself is intrinsically a good or bad investment choice, but rather whether or not clients properly understand Private Equity’s relation to risk, liquidity and investment term, and that it is this that has made situations such as the Woodford fund suspension more difficult.

So what is Private Equity?

In the simplest terms, Private Equity is shares in a private company not listed on a stock exchange. So while shares in a publically traded company listed on the LSE, such as BT, say, can simply be purchased through a stockbroker or platform, if you want to buy shares in XYZ ltd - a private limited company set up by your friend in the local village – you’ll need to deal with your friend directly as well as the company secretary, lawyers, accountants and so on to make the investment.

There are a number of ways in which investors can gain exposure to Private Equity, such as Funds, Investment Trusts and Unit Trusts/ OEICs (to varying degrees and in different ways, see footnote),* Venture Capital Trusts (VCTs)** and Enterprise Investment Schemes (EIS).***

Private and Public Equity - what are the differences?

So one of the key differences, then, between Private and Public Equity is their degree of liquidity. Listed stock is easier for investors to buy and sell. Using the above examples, if you want to sell your shares in BT tomorrow, you could place a trade online any time between 08:00 and 16:30 GMT. But if you have shares in your friend’s hypothetical XYZ ltd and you wake up tomorrow morning deciding to sell, on the other hand, accessing your invested monies is unlikely to be so easy. In fact, you’ll need to go through a process with XYZ ltd where it could take months to find a new buyer.

Another key difference involves regulatory and stock exchange disclosures. Being a publically traded company, our example of BT is required to publish certain pieces of information such as Annual Reports & Accounts, Quarterly updates and notifications of large trades or trades by Directors or Board members. This makes a lot of the company’s dealings visible to the public. Your friend’s XYZ ltd, being a private company, is not subject to the same requirements. They may still be required to publish annual reports and accounts with Companies House, but might be able to apply for an exemption from such disclosures due to their size and capital.

How is private equity valued?

There are a number of methods and guidelines used for valuing private equity investments.

  1. Price of a recent investment – when a recent investment has been made in a company, the recent market value of that investment may be used for valuation.
  2. Earning multiple valuations –
    1. P/E ratios: equity value/ profit after tax
    2. EBIT multiples: enterprise value/ earnings before interest and tax
    3. EBITDA multiples: enterprise value/ earnings before interest, tax, depreciation and amortisation
  3. Net asset valuation (NAV) – When a company is not profitable or is involved in activity that involves real assets then they may be valued by reference to their net tangible assets.

Other methods used for valuation include Discounted Cash Flows (DCFs) and Industry Benchmarks.

Questions of performance

The recent problems encountered in the Woodford suspension have highlighted the potential for clients to be unaware of the presence of Private Equity in certain funds and to have an incomplete understanding of the different risks associated with it, with the Woodford Equity Income fund being an example. In the Woodford case, the percentage held in unlisted stocks exceeded what would generally be considered acceptable and manageable. But should other funds including more cautious levels of such assets in their portfolios automatically be tarred with the same brush?

There are in fact a number of funds with their Private Equity portion kept under the 10% limit that have done well. Proponents of Private Equity would argue that, with the right strategy and understanding, an investment with such a makeup has the potential to be beneficial both for portfolio returns and economic growth; the tendency for greater complexity and potential for higher risk, they would argue, simply necessitate extra care in ensuring any exposure to the asset class is measured and understood by clients, where they are not sophisticated or institutional investors who already appreciate and understand the complexities of the investment, and the long term nature.

As with every asset class, there are vehicles that have performed better over the last three years and others that have not done so well. Outlined below are three of the better performing Private Equity Investment Trusts, plus three that have not achieved the same kind of growth.

Pantheon International:

Fund

Total returns (%) – 3 years

Pantheon International Price

46.84%

Pantheon International NAV

40.75%

 

BMO Private Equity Trust:

Fund

Total returns (%) – 3 years

BMO Private Equity Trust Price

45.30%

BMO Private Equity Trust NAV

38.73%

 

Princess Private Equity:

Fund

Total returns (%) – 3 years

Princess Private Equity Price

42.80%

Princess Private Equity NAV

27.19%

 

NB Private Equity:

Fund

Total returns (%) – 3 years

NB Private Equity Price

9.22%

NB Private Equity NAV

12.29%

 

Electra Private Equity:

Fund

Total returns (%) – 3 years

Electra Private Equity Price

-3.64%

Electra Private Equity NAV

-8.34%

 

Symphony International:

Fund

Total returns (%) – 3 years

Symphony International Price

15.58%

Symphony International NAV

3.72%

 

Data as at 27 September 2019. Source: Citywire Investment Trust Insider

                                                                  

* Investment Trust Vs Unit Trust/ OEIC - The main difference between an Investment Trust and a Unit Trust or OEIC is their legal structure. An Investment Trust is a Public Limited Company, whereas a Unit Trust or OEIC is an investment company that holds shares of other companies for investment purposes. The Investment Trust is closed-ended whereas the OEIC is open-ended. Also, the Investment Trust is listed on the stock exchange, whereas the Unit Trust/ OEIC is not.

Both investment vehicles can offer access to private equity, but to varying degrees and in different ways. Investment Trusts are closed ended which means they have a fixed number of shares in issue. This means that the managers do not have to sell assets when investors sell their shares, giving them a longer-term view. Managers of Investment Trusts are also allowed to borrow money if they see opportunity in a growing market, which is known as “gearing”.

Unit Trusts/OEICS on the other hand are more restricted, and can only invest up to 10% of the fund in unlisted stocks/private equity. These funds are open ended and therefore when investors want to sell their shares the money needs to be readily available within the Unit Trust/OEIC. The restriction of 10% is important for such a vehicle because a proportion of retail investors expect a certain level of liquidity in their investments and the ability to withdraw money when required. Given the structure and liquidity requirements it makes good sense to have the limit in place.

** A VCT is a listed company that allows individuals to invest indirectly in a range of small, unquoted trading companies. A private individual investing in VCTs can receive relief on Capital Gains Tax (CGT) from the sale of shares, and tax free dividends (subject to limits)

*** An EIS allows individuals to invest in small companies directly, instead of through a VCT as above. However, an individual must not be involved with the company. The benefits are similar to those of a VCT.

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Pension Freedoms (2015) and the Opportunity for Improved Succession Planning

‘Pension Freedoms’ introduced an expansion of the options available to the member nominated beneficiary(s) or ‘nominees’ of a pension scheme. Its introduction in April 2015 allowed for improved succession planning and a wider range of options for the nominees of death benefits.

Allowing for nominees to select drawdown as an option meant that the money no longer needed to leave the SIPP as a lump sum payment (back into the nominees’ estate for IHT purposes), and allowed for better planning in a tax efficient vehicle.

The key benefits of keeping the money within a SIPP are that it is:

-        usually exempt for IHT purposes

-        tax-free for under 75s, subject to a lifetime allowance test

-        tax-free for investment growth

The subject of passing away can be a difficult one to broach with the client. However, it’s a conversation which should be had to ensure the right provisions are made for loved ones.

 

Importance of being a nominee or a ‘dependant’

It’s been over four years since the new freedoms ‘lifted the lid’ on pensions. A change in legislation removing the requirement that only a dependant could be offered a Drawdown or an Annuity as a death benefit option, together with the wider expansion on who could receive death benefits, has changed the scope of how succession planning is made. The differences between the options available to nominees and dependants before and after pensions freedoms are summarised in the following table:

 

Nominee

Dependant

Before Pension Freedoms

Lump Sum Payment

Lump Sum Payment

Drawdown

Annuity

Post Pension Freedoms

Lump Sum Payment

Lump Sum Payment

Drawdown

Drawdown

Annuity

Annuity

 

As you can see, the same options are available to dependants, but more have opened up for nominees. But how are these defined?

Dependant

A dependant is broadly classified as anyone who was:

  • married to or a civil partner of the member when they died
  • married to or a civil partner of the member when they first started drawing income from that pension scheme, where the scheme rules allow for this
  • a child of the member and less than 23 years old
  • a child of the member aged 23 or over and who, when the member died, was dependant on them because of a physical or mental impairment, or
  • was neither married to, nor a civil partner of, nor a child of the member but who, when the member died, was:
    • financially dependent on the member,
    • in a financial relationship with the member of mutual dependency, or
    • dependent on the member because of a physical or mental impairment

Nominee

As the name implies, a nominee is someone who has been specifically nominated. This may have been specified by the member themselves on an Expression of Wish. Alternatively, the individual could be nominated by the scheme administrator, as long as there is no surviving dependant nor an Expression of Wish on which that individual was not nominated. In other words, the scheme administrator cannot override an Expression of Wish or a dependant.

Only nominees fitting the above criteria may receive Nominee Flexible Access Drawdown. Failure to nominate the beneficiary could inadvertently restrict the options available to them, and in turn the opportunities for the pension to be held in a tax efficient manner.

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