Standard Life European Private Equity — Update 7 November 2016

Launched in May 2001, SEP is an LSE-listed investment trust aiming to achieve long-term capital gains from a diversified portfolio of private equity funds investing predominantly in Europe, with a focus on funds that invest in mid- to large buyouts. The investment strategy involves detailed and rigorous screening and due diligence by the manager to identify and evaluate private equity fund offerings. The private equity asset class has historically exhibited a wide dispersion of returns across funds and the manager believes that access to leading private equity houses, manager selection and appropriate portfolio construction are vital to optimise investment performance. In that regard, the objective is for SEP’s portfolio to comprise around 35 to 40 active private equity fund investments at any one time, with portfolio diversification being controlled through concentration limits applied at an individual fund (12.5% of NAV) and manager (20.0% of NAV) level.

SEP’s investment manager, SL Capital Partners is one of the largest investors in private equity funds and co-investments in Europe, managing €10.0bn of commitments. Headed by Peter McKellar, Roger Pim and Graeme Gunn, the investment team comprises 28 professionals and the senior executive team has on average more than 12 years of tenure. The manager believes that its scale and the investment team’s experience enables it to identify and invest in Europe’s premier private equity funds, where knowledge of and access to these funds may be limited.

SL Capital senior executive Graeme Gunn conveys the manager’s anticipation of slower UK economic growth following the UK’s vote to leave the European Union, as well as an increase in market volatility that will affect broader European markets. While increased market volatility has seen discounts widen across listed private equity trusts in general, Gunn observes that this market reaction ignores the countercyclical nature of private equity investing, which has seen the sector deliver its best performance during periods of economic downturn or market stress. He also points to recent corporate activity in the sector, with bids to acquire portfolios being made at or around NAV, while the sector as a whole trades on a discount of more than 20%.

Gunn expresses the view that, while returns from private equity investing have the capability to outperform listed markets over the long term in benign conditions, there is potential for an additional return to be generated by private equity fund managers who actively invest during a recessionary period and exit as economies recover. He observes that this positive correlation was evident during the dotcom bubble and the global financial crisis, noting that private equity returns also spiked in the recession that followed the Greek/euro issues in 2011-12. He sees this as particularly relevant today, in the belief that the aftermath of the UK’s EU referendum is likely to have a similar risk profile, and highlights that assets acquired during the 2011-12 recession were subsequently exited at highly attractive values, driving strong performance.

Gunn emphasises that during periods of dislocation, private equity strategies can employ a flexible approach and target companies that are under operational pressure. As the manager has previously observed, rapid change and uncertainty during tough market conditions drives deal flow towards private equity buyers: large corporates dispose of assets as they focus on core strategies, forced sellers emerge and the curtailment of the IPO market means that sources of liquidity are reduced. Gunn notes that the first element of additional return is achieved through buying well, as pricing and leverage reduce, while any downturn presents multiple strategic opportunities, enabling private equity managers to deploy their considerable resources to turn around underperforming companies or target M&A, seeking to generate top-line growth and profitability.

Gunn considers that SEP is well positioned to provide investors with access to this countercyclical strategy. At end-September 2016, the trust had £260m of undrawn capital committed to private equity funds (net of c £50m commitments considered by the manager as unlikely to be drawn), with £106m cash and an £80m credit facility. As a limited partner investor in the underlying funds, the manager has good near-term visibility over the expected timing of realisations and drawdowns, and Gunn indicates that the majority of SEP’s current cash position could be invested tactically in potentially high-performing investment opportunities without prejudicing the trust’s ability to meet existing commitments. He highlights the potential for SEP to increase UK exposure from its current relatively low level of 15% through secondary market transactions, as well as underlying private equity funds deploying SEP’s committed capital into attractive UK-orientated investments. While any recession raises concerns over current portfolio value, in the manager’s view, SEP’s euro-denominated asset base will benefit from both sterling weakness and the strong underlying assets in delivering returns to sterling-based investors.

SEP’s principal focus is to invest in what the manager views as the leading European private equity funds investing in mid- to large-sized buyouts (transactions with enterprise values between €100m and €2.0bn). The aim is for the portfolio to comprise around 35 to 40 active fund investments. SEP’s policy is to maintain a broadly diversified portfolio by country, industry sector, maturity and number of underlying investments. The investment team’s extensive fund and direct deal experience gives the manager a strong insight into the strategies, processes and disciplines of the funds considered for investment, which should lead to better qualitative judgements being made.

In recent years, SEP has increased its focus on the private equity secondary market, whereby original investors sell their fund interests, which may comprise an unfunded outstanding commitment as well as invested assets. This enables SEP to buy and sell selected secondary fund interests to fine-tune portfolio exposures as well as maintain capital efficiency. Secondary investments typically generate lower absolute returns, but shorter holding periods can lead to higher internal rates of return (IRRs) being achieved. The manager expects c 1.4x exit multiples, with IRRs of 20% to 25% for secondary investments compared with c 1.8x exit multiples and IRRs of 17% to 18% for primary investments. Fully invested secondary interests also have a lower risk profile than primary commitments as the underlying holdings can be evaluated prior to purchase.

To maximise the proportion of invested assets, the manager follows an over-commitment strategy by making fund commitments that exceed the trust’s uninvested capital, based on an assessment of available capital, and the amount and timing of expected and projected portfolio cash flows. SEP invests in private equity funds that invest principally in Europe, but has the flexibility to invest up to 20% of its gross assets in funds that invest principally outside Europe. SEP’s non-sterling currency exposure is primarily to the euro and US dollar. Foreign exchange exposure is not hedged due to the irregularity in size and timing of individual cash flows, but cash balances and bank debt are held broadly in proportion to the currency of SEP’s outstanding fund commitments.

The SL Capital Partners investment team follows a systematic, disciplined approach to investment selection, monitoring and realisation. The investment selection process broadly breaks down into three stages, resulting in the preparation of a deal qualification memorandum (DQM), preliminary investment recommendation (PIR) and final investment recommendation (FIR). DQMs are prepared each year on around 100 to 150 of the c 800 institutional-grade private equity funds in Europe that are monitored, with about 25 funds reaching the PIR stage. SL Capital as a whole typically commits to between 10 and 15 primary fund investments and completes at least 15 secondary transactions each year, while SEP makes around four primary and five secondary investments a year.

At 31 March 2016, SEP was invested in 46 private equity funds, which collectively had interests in 476 underlying companies (excluding four secondary fund investments made in 2001 and 2005/06, there are c 300-350 ‘core’ underlying companies). Highlighting its focused approach, SEP’s top 10 fund holdings at 31 March 2016 represented 44.2% of NAV, equal to 54.3% of the invested portfolio, with each fund holding 16 investments on average (see Exhibit 2). Exposure to individual managers shows greater concentration, with over 80% of NAV attributable to 10 private equity managers. The top 10 underlying company holdings represented 14.2% of NAV (see Exhibit 1), with five companies each representing more than 1.0%, a level enabling them to make a material contribution to portfolio returns, thus differentiating SEP from the broader private equity market.

Top-down allocations are not imposed and SEP’s portfolio diversification by geography and sector (Exhibit 3) is the outcome of the investment process. The manager observes that investing in a broad portfolio of fund interests leads to a natural diversification of the portfolio due to the variety of investments within each fund, as well as the distinct specialisations of individual managers. SEP’s 20% US exposure stands out given its European focus. This results from a number of the European managers investing part of their funds in stronger investment opportunities in non-European countries, principally the US.

SEP’s portfolio saw a 6pp decline in UK exposure over the year to 31 March 2016, continuing the trend since SEP’s listing in May 2001 when UK exposure stood at 64%, while there was a 2pp increase in US exposure. These moves saw the US become the trust’s largest exposure, accounting for 20% of the portfolio at 31 March 2016. Compared with a year earlier, the other most significant changes in exposure were 3pp and 2pp increases in Scandinavia and Benelux. The portfolio was well spread by sector at 31 March 2016, with the largest exposures in industrials and consumer services seeing 2pp and 4pp increases compared with a year earlier. Other notable changes were 2pp reductions in financials and basic materials and a 2pp increase in consumer goods. Secondary fund exposure declined 2pp over the year to 31 March 2016.

As shown in Exhibit 5, SEP’s NAV total return has outperformed European private equity (PE) peers, represented by the LPX Europe index, over one, three, five and 10 years. Compared with global PE peers, represented by the LPX 50 index, SEP’s NAV total return has outperformed over three and 10 years, while underperforming over one and five years. The strengthening of the US dollar against the euro over three, five and 10 years (+17.5%, +31.0% and +15.6%) is likely to account for a significant element of the stronger performance of the LPX 50 compared with LPX Europe over these time periods. Exhibit 4 illustrates SEP’s NAV total return outperformance of the FTSE All-Share index over one, three, five and 10 years, with the decline of sterling against the euro in June 2016 contributing a large part of the outperformance over one year.

As illustrated in Exhibit 6, over the last three years, SEP’s share price discount to NAV has ranged from 10% in June 2014 to 36% in March 2016. Having followed a broadly widening trend for much of the period, the discount has narrowed noticeably since March 2016 and has recently moved below its three-year average of 21.2%, currently standing at 20.0%.

SEP has 153.7m ordinary shares in issue, having repurchased 2.0m shares (1.3% of outstanding capital) in the year to 30 September 2016. The board views share repurchases in relation to capital efficiency, alongside new fund commitments, secondary fund purchases and dividend payments. At 30 September 2016, SEP’s £80m credit facility to December 2020 was undrawn and £105.9m was held in cash and money market funds, equating to a 20.3% net cash position. At 30 June 2016, £40.5m of SEP’s liquid resources had been invested in European and UK equity index tracker funds but these were sold in July, generating a realised gain of £2.3m.

SEP pays SL Capital a management fee of 0.8% pa of net assets. In addition, a 10% incentive fee is payable on NAV total return in excess of an 8% pa hurdle rate, measured over the five-year period to 30 September 2016. Based on estimated NAV of 338.9p per share at end-September 2016, NAV total return for the five-year period was 9.8% pa in sterling terms. While the decline of sterling against the euro following the Brexit vote appears to have contributed materially to the hurdle being exceeded, with NAV total return over one year of 21.0% in sterling terms and 3.1% in euro terms, we note that NAV total return for the five-year period was 9.7% pa in euro terms. For FY15, excluding indirect fund fees, the ongoing charge was 0.98% of net assets.

In FY14, the board modified its approach to dividends to reflect the importance many shareholders place on the reliability of income. Emphasising capital discipline, the board’s intention is to at least maintain the real value of the dividend from the 5.0p paid in FY14. At 31 March 2016, SEP had revenue reserves equating to 8.0p per share after payment of the interim dividend.

An interim dividend was paid for the first time in FY15, amounting to 1.75p, with a final dividend of 3.50p, bringing the total dividend for FY15 to 5.25p, representing a 5% increase from FY14. The interim dividend for FY16 was increased by 2.9% to 1.80p and the final dividend is due to be declared with SEP’s preliminary results on or around 2 December 2016.

Exhibit 7 shows a comparison of SEP with a selected peer group of listed private equity funds of funds and direct investment companies. SEP’s NAV total return in sterling terms to 30 June 2016 is ahead of the peer group average over one and three years, but modestly below the average over five and 10 years. Sterling weakness has helped SEP’s recent performance relative to UK peers, but over three and five years the euro declined by 3.5% and 9.1% against sterling and by 14.9% and 23.7% against the US dollar, weighing on SEP’s performance relative to UK and global peers. Similar to most peers, SEP’s share price total return has lagged NAV by a considerable margin, reflected in wider discounts across the sector at end-June 2016, suggesting that market sentiment towards listed private equity funds in general had weakened in spite of positive underlying performance. While wider than the peer group average, SEP’s current share price discount to NAV is in line with the 22% average excluding funds trading at a premium. SEP’s 1.9% yield ranks it at the lower end of the eight dividend-paying funds in the peer group of 13.

SEP’s board comprises five independent non-executive directors. Edmond Warner (appointed director November 2008, chairman January 2013) is chairman of Panmure Gordon & Co and a director of BlackRock Commodities Income Investment Trust. Senior independent director Christina McComb (appointed January 2013) spent 14 years with 3i Group. David Warnock (appointed January 2009) is chairman of Troy Income & Growth Trust and a director of Seneca Investment Managers. Alastair Barbour (appointed April 2011) is a director of Phoenix Group Holdings and Liontrust Asset Management. Alan Devine (appointed May 2014) is CEO of RBS Shipping Group.