abrdn Private Equity Opportunities Trust — Wider discount to NAV amid macro risks

APEO’s NAV TR in the first half of FY22 (ending March 2022) was driven by exits, which accounted for 87% of the private portfolio revaluation of 8.7%. The exits were realised at a robust 16% average uplift (to the valuation two quarters prior) and a 2.2x multiple on invested capital. APEO highlighted that the main exit route was by trade sale to a strategic investor, as well as by sale to financial buyers (ie transactions between financial institutions, including PE sponsor-to-sponsor deals) rather than IPOs. The five largest transactions, which were responsible for roughly half of the total distributions received by APEO (excluding secondary sales) were from the software (Vizrt, Autoform), healthcare (General Life, Atos Medical) and financial (Sbanken) sectors.

The above performance was attributable primarily to Q122 (to end-December 2021) when APEO’s NAV TR was 5.2% (valuations were marked up to end-2021). The Q222 total NAV return (91% of private valuations as at end-March 2022) stood at only 1.5%, which is still above the UK All-share (up 0.5%) and MSCI Europe (down 4.6% in sterling terms) indices. APEO’s unrealised private investments were revalued upwards on the back of strong operating results, as revenues and EBITDA increased across the portfolio by 17.8% and 25.7% on average respectively (over the 12 months to end-March 2022). Meanwhile, the listed stocks within APEO’s portfolio (the result of former IPOs) posted a 22% aggregate decline in H122 and consequently made up 8.5% of the portfolio at end-March 2022.

APEO’s latest NAV estimate as at end-June 2022 implies a 2.4% NAV TR in the first six months of 2022 and we understand the estimate still largely reflects end-March 2022 private valuations. Hence, it does not account for most of the sell-off in public equities this year, with the MSCI World and MSCI Europe indices down by 2% and 5% respectively (in sterling terms) between end-2021 and end-March 2022 compared to their H122 declines of 11% (although we note that equity markets have rebounded somewhat since end-June 2022). As a result, APEO’s investment manager expects the macro headwinds (elevated inflation, high interest rates and economic slowdown) to have an impact on corporate earnings (including some margin compression) and valuations across its portfolio in the second half of the year. This helps explain the current wide discount to NAV (c 39% versus a 10-year average of 21%), as investors likely price in some downward pressure on the valuations of APEO’s private holdings. Widening discounts to NAV have materialised across the listed PE space lately, with the average discount for APEO’s peers currently at c 37% versus 26% in our most recent note in February 2022 (Exhibit 3). This has also been a function of a varying degree of valuation lag.

Over the long term, APEO has delivered an NAV TR broadly in line with its listed peers, with a 10-year average annual return (to end-June 2022) of 14.9% versus the peer average of 15.5% (see Exhibit 3). Meanwhile, the whole sector outperformed public equities, as the MSCI Europe and UK All-share indices delivered annualised returns of 8.7% and 6.9% respectively. APEO’s dividend yield is the second highest in the peer group and dividends are distributed quarterly; the most recent payment (ex-dividend date of 23 June) of 3.6p per share implied a 3.3% annualised dividend yield. Importantly, APEO managed to continue its dividend distributions with no changes to the amount and frequency during the COVID-19 disruptions. The board is confident that further dividends of 3.6p will be paid in October 2022 and January 2023.

APEO’s long-term return profile is underpinned by its emphasis on funds managed by high-conviction GPs focused on European companies (78% of the portfolio) and mid-market opportunities (funds of €1.0–5.0bn in size). Recently, APEO has gradually increased its exposure to lower mid-market funds (€150m to €1.0bn in size). We believe that these PE market segments have accumulated proportionately less dry powder in recent years (according to PitchBook data, 41.2% of capital raised in 2021 was from four megafunds), hence these funds may face less pronounced competitive pressure, while at the same time being less dependent on an IPO as an exit route, as they can more easily sell their holdings to a strategic buyer or other financial investor. This could support distributions to APEO despite the worsening macroeconomic environment.

Moreover, APEO has expanded its direct co-investments portfolio to 17% of the portfolio at end-March 2022 (up from 11% at end-September 2021). The continuous flow of co-investment opportunities encouraged APEO’s investment manager to amend its investment policy in H122 to allow an allocation of up to 25% of the portfolio (from the previous 20%). These investments give APEO greater flexibility in terms of the timing of new investments and sector allocation versus primary fund commitments, while still allowing the company to benefit from the expertise of top-performing lead sponsors.

With new capital having flowed into PE in recent years, and some recent repositioning in private investor portfolios, APEO’s investment manager expects that institutional investors will look to re-balance their asset allocations and portfolio weightings over the coming quarters, which in turn is likely to fuel activity in the secondary market. The manager believes that APEO is well placed to take advantage of such opportunities – either to sell some of its positions (to boost liquidity), or to acquire assets at attractive valuations.

More than half of APEO’s portfolio (53%) is allocated to sectors the manager believes are characterised by less cyclical revenue streams (technology, healthcare and consumer staples). APEO’s healthcare exposure mainly consists of medical technology, healthcare services (eg orthopaedics, laboratory diagnostics and elderly care), contract research organisations and more traditional pharma businesses rather than biotech companies. Furthermore, its information technology (IT) holdings are generally profitable and B2B-focused and it has relatively low exposure to higher growth, unprofitable technology businesses (which saw a particularly strong de-rating lately). APEO has limited exposure to southern economies (Italy and Spain) at 5% of the portfolio, with the highest European exposures to Nordic countries (17%) and the UK (17%). Furthermore, it has no exposure to companies headquartered in Russia, Belarus or Ukraine and revenues from these markets account for less than 1% of aggregate underlying portfolio company revenues.

In H122, APEO invested £145.5m (up 171% y-o-y) into new and existing portfolio companies, of which £65.8m was allocated to co-investments. The remaining investments were drawdowns of primary fund commitments and one £5.1m secondary investment. The largest fund drawdown (£8.3m) was made by Vitruvian IV to finance the acquisition of Medison Pharma Group – a global pharma company focused on providing access to highly innovative therapies.

In H122 (to end-March 2022), APEO committed £168.6m to eight new primary funds (see Exhibit 5), 162% more than the £64.4m committed in H121, a period that was affected by the global pandemic. As a result, total outstanding commitments increased by £107.5m to £627.1m (offset in part by £145.5m in drawdowns and £33.2m in commitments to funds sold in the period), which includes minor commitments to co-investments. As at end-June 2022, APEO’s commitments increased further to £663.5m.

APEO follows an overcommitment (defined as commitments in excess of liquid resources as a percentage of NAV) strategy to remain fully invested over time given gradual drawdowns from underlying funds (spread over multiple years) and regular distributions. Its overcommitment ratio stood at 43.6% as at end-June 2022 (March 2022: 38.9%), well within the target range of 30–75%.

However, APEO’s commitments coverage ratio (ie liquid resources to outstanding commitments) of 26% at end-June 2022 (March 2022: 32%) is visibly lower than in recent years (see Exhibit 7). This is partly a function of the investment manager’s increased emphasis on optimising returns by maximising the investment level of the company and retaining a minimum required cash position (APEO’s available resources at end-June 2022 included £13.0m in cash and an available credit line of £162.7m). Moreover, APEO’s temporary increase in the coverage ratio in FY20 was due to a combination of a credit facility upsizing and a slowdown in new investments due to the uncertain environment amid the COVID-19 pandemic. Still, it is worth noting that APEO’s current coverage ratio is below the above-mentioned peers (35–90%). We also note the increase in bridge financing at the level of APEO’s underlying funds (ie debt incurred to help finance investments ahead of capital calls) at £91.9m at end-March 2022, compared with just £47.3m at end-September 2021.

In the context of the unfolding market downturn, investors may be wary of a potential liquidity crunch at listed PE companies if drawdowns exceed distributions over the coming months. We believe it is instructive therefore to look at APEO’s net drawdowns following the COVID-19 outbreak in 2020 as a reference point. Liquidity concerns over capital calls increased massively in the initial stage of the pandemic in 2020, which encouraged some of the PE companies to draw down on their credit lines and withhold dividend payments. This has proven to be a very conservative approach from today’s perspective, as the credit lines were repaid and dividends reinstated in the subsequent months. According to our calculations, APEO’s cumulative net drawdowns peaked in September 2020 at €28m, or 5.1% of outstanding commitments at the onset of the outbreak (end-January 2020, see Exhibit 6). We note that APEO’s coverage ratio was somewhat higher then (42% at end-January 2020). We estimate that a similar peak in cumulative net drawdowns in reference to opening commitments would represent 14% of APEO’s liquid resources at end-January 2022, still leaving a wide safety margin.

Nevertheless, we note the positive impact from extraordinary fiscal and monetary support during the lockdowns, which allowed for a quick economic and financial markets recovery. In contrast, we are currently in the process of monetary tightening across the globe, coupled with limited headroom for fiscal stimulus. This means that net drawdowns could last longer this time than in 2020. However, some support is likely to come from the significant dry powder accumulated by private capital globally in recent years (US$3.4tn at end-2021 according to Preqin). Hence, if sponsor-to-sponsor deal volume remains relatively high, this may help offset weaker demand from strategic buyers and an unfavourable environment for IPOs (as discussed above, this particularly applies to the PE mid-market).

Drawdowns and distributions are highly correlated because they both relate to PE deal activity, albeit there is often a short time lag between the two. We calculate that even in an unlikely scenario in which distributions cease but drawdowns continue for a prolonged period, the company’s available resources (£175.7m) represent close to a year’s worth of investments. APEO’s drawdowns in FY18–21 represented 32% of opening commitments on average, which would now imply c £212m based on the last reported outstanding commitments. The most severe mismatch between APEO’s drawdowns and distributions occurred as a result of the global financial crisis (GFC) during FY08–10, when drawdowns net of distributions amounted to 40% of APEO’s outstanding commitments at end-September 2007. We consider a repetition of this scenario in the current environment unlikely, given better availability of debt funding to private companies, both from banks (which appear less vulnerable now versus the GFC) and private debt markets; higher share of more flexible, covenant-lite debt arrangements; and the significant amount of dry powder in the PE industry. We would also highlight that the PE secondary market is much more liquid and over five times bigger (in terms of annual deal value, according to Greenhill) versus at the time of the GFC, which gives PE trusts greater scope to sell fund positions in the market to generate cash and release outstanding commitments.