Active investment commentary & analysis

Are investors safe in closed-end?

Since Woodford, regulators and investors have worried about fund structure and liquidity management. We now know that open-ended funds are not well-matched to private equity. But are closed-end vehicles any better? Might the listed closed-end funds that have been so successful in attracting retail investors be a problem, too?

Concerns with private equity go beyond individual rogue managers or poorly structured funds. How can unquoted investments be valued consistently? Lossmaking technology and e-commerce businesses are particularly hard to assess objectively. And little attention is given to the risk that conflicts pose to the concept of independent and fair valuation.

The scarcity of growth businesses on listed markets has driven many investors to look at private equity, and vehicles accessing that. Previously, much of this investment was handled in traditional private equity partnership structures with flexible, limited-life funds. Now there is pressure from institutional investors and wealth managers to access high growth opportunities via vehicles with shorter term focus and easier dealing - creating a boom in closed-end funds. In theory, these should be well matched to the challenge of unquoteds, but the Woodford Patient Capital Trust experience shows that even closed-end investment companies have problems.

There may be conflicts in how valuation is managed, flexibility in the numbers, and a desire by boards and managers to expand a fund even if technically closed-end. Boards themselves can have personal interests in portfolio companies. And individual managers may be able to cherry-pick investments in a portfolio to back personally, a bias that could distort professional duty to the whole fund. Surprisingly, managers can commit to follow-on investment without specifying exactly how this responsibility is shared across client funds. This cocktail of conflicts is a huge challenge for fair and consistent valuation. And, it is hard for many auditors to fully check a valuation that is the responsibility of boards, managers and administrators.

Closed-end funds realise that they still need follow-on capital to protect their interests in further fundraising rounds by their investee companies. And a bigger fund brings more management fee income. Shareholders would not approve issuing new shares at a discount, but undervaluing the prospect of imminent mark-ups or realisations, can allow the fund to expand. A share placing at what looks like asset value could really be an undervaluation, meaning existing investors could lose out if they do not follow-on their money. The broker to the fund or its investment bank, while placing the shares, may also write “research” but can be themselves incentivised through warrants or options. It means that many may gain through enlarging a fund at a time when there is a lot of flexibility over valuation.

Traditional asset managers with listed portfolios are already regulated on management of conflicts. But in the new world of private equity, it is not clear that the rules are working. The area is attracting retail investors; without action, public credibility will be undermined.