Raise interest rates fast enough after 30 years of cutting them and stuff will break — and not just in the banks. Ask Fiona MacBain. She has just had to resign after 14 years as chair of the Scottish Mortgage Investment Trust (SMIT), one of the most popular investment trusts in the UK.
The fund managed by Baillie Gifford & Co was known for its extraordinary success under its one-time guiding light James Anderson as a growth fund willing to buy into any company with brilliant ideas —listed or unlisted. At its peak, it was worth about ￡20 billion (US$24.5 billion). Today the trust has assets of ￡9.4 billion — real money, but rather less real money.
Rising interest rates have degraded the value of long-duration assets, and there is little more long duration (in the sense that the cash returns from any actual profits) than speculative growth stocks. The likes of Northvolt AB, Tesla Inc, ByteDance Ltd and Spacex (all big names in the Scottish Mortgage portfolio) just are not worth what they once were. The shares are down 35 percent in the past 12 months and over five years have barely outperformed the FTSE All-World Index. They used to trade at a premium. Now they trade at a 20 percent discount.
It is not, however, the whopping losses alone that cost McBain her job. Turmoil on the board has focused attention on the trust’s large holdings in private companies. SMIT is allowed to invest up to 30 percent of its assets in unlisted businesses (up from 25 percent in 2016). It has been heading toward the limit for a while. Now, thanks in large part to the falling value of the listed portfolio, which has pushed up the unlisted part in percentage terms, it has reached the ceiling.
That matters for all sorts of reasons. The 30 percent cap is based on purchase values not current values so as to not force any selling of the private assets.
However, it means the trust, which has always been known as a supportive owner, cannot provide follow-up finance to its holdings. That makes them a price taker when other private equity backers do — and means their stakes could end up nastily diluted. It also means that they buy back shares to try and close their 20 percent discount to the net asset value (selling liquid assets to raise the cash for such buybacks would push the private holdings over 30 percent, something that is technically OK, but not a good look). That makes SMIT shareholders irritated — the trust issued an awful lot of shares in the good times and investment trust convention says that if you issue shares at a premium you should buy them back at a discount.
Finally, it makes people wonder if the unlisted companies are correctly valued. If the public and the private companies in the portfolio are all in similar sectors, why would the private not have fallen at least as much in value as the public? Or more. After all, if the privates are mostly smaller and further from creating sustainable dividend-creating profits (never forget that valuations are a function of predicted cash flows) than the public, and the disadvantages of their illiquidity is also more obvious now than it once was, surely their values should be falling faster than those of listed companies.
There is obvious incentive to dilly dally on marking down the value of private holdings: Doing so not only cuts net asset value (more), but also raises debt levels relative to asset value (most investment trusts have debt, and banks are more nervous than they were).
Baillie Gifford says its process is robust and, relative to most private equity investors, it very probably is.
Here are the analysts from Stifel on the matter: “Baillie Gifford values unlisted holdings on a three-month rolling cycle, with one-third of holdings reassessed each month... However, regularity does not guarantee accuracy.”
Ouch. Here then is the problem. Valuing listed companies is easy. The market does it for you — the prices are available any time, any day. You might not agree with the market, but you still have a price. Job done.
Valuing unlisted companies is hard. You can fiddle around with cash flows, revenue and earnings (should there be any); make comparisons with similar listed companies and watch the multiples of new initial public offerings.
However, you cannot really know the price until the company lists or you sell it. When there is lots of movement in the market (and lots of initial public offerings) it is easier to get it right — and evidence that you have that skill. Where there is not — it is not and it is very easy for trust to start to slip. As it is now.
If the market trusted SMIT’s valuations, it would not be at an 18 percent discount. If it believed those of the other private equity trusts they would not be at 40 percent discounts. SMIT is not the only trust finding that their private holdings are getting them into some trouble: Stifel has criticized other Baillie Gifford trusts for a “poor” level of disclosure over their processes; Alan Brierley of Investec had a go at another of the UK’s big investment trusts, RIT, for transparency issues around unlisted firms: and there is a new and constant clamor for the big private equity trusts to get on with the job of revaluing all their holdings (mostly down).
There is an obvious lesson here in the difference between doing clever things in bull markets and in bear markets. When everything is going up, exact valuation is not a big deal. “Up a lot” is just fine.
On the way down it is another matter altogether. Investors are less giving. “Down a bit” does not cut it. They want to know precisely how far down and how you figured it out. They want radical transparency more than they want radical innovation. Perhaps there is a reason why in the days before the everything bubble, private equity was mainly the preserve of pension funds.
There is also a lesson here on diversification. For the past 20 years we have been told that private equity is a great portfolio diversifier. That is not necessarily so: Overpriced assets fall just as hard in the listed and unlisted markets.
However, the biggest lesson of all is about bull market models. SMIT still holds great companies (that are rather cheaper than they were) and its cracks are not going to become a major crisis in themselves. However, its troubles should work as a reminder that what worked in a low-interest-rate-driven bull market just does not work anymore. Bear markets break bull market models.
Merryn Somerset Webb is a senior columnist for Bloomberg Opinion, covering personal finance and investment, and host of the Merryn Talks Money podcast. Previously, she was editor-in-chief of MoneyWeek and a contributing editor at the Financial Times.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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