The diversified fund-of-funds listed on the London market are good proxies for the broader PE market.
Going into mid to late 2021, those funds were trading at between 15% to 20% discounts to NAV and, if you look at them today, they are trading at discounts in excess of 40%.
Some might say that is the market telling us valuations are stale and they will come down to meet share prices, which would mean it is not a real discount.
Although private valuations do lag public markets, they lagged on the way up, too.
Private equity trust discounts ease most among alternatives in H1
Private NAVs did not creep up the same way public markets did, so there was an essence of in-built equity valuation buffer there.
The real damage in public markets was in the unprofitable tech sector, which PE is not particularly exposed to.
Companies with high free cash flow in defensive sectors have held up much better than public markets, and those tend to be overrepresented in PE portfolios.
Secondly, discounts in the private secondary market are materially narrower than they are in public markets.
If listed private equity funds can sell underlying fund interests at low double-digit discounts in the secondary market, and use the proceeds to repurchase their own shares at much wider discounts, that is certainly something we encourage.
From a broader economic environment perspective, the higher rates and tighter credit markets that have been seen over the past couple of years have undoubtedly changed the PE/VC market.
New deals need financing, and if that slows, there is a decline in PE activity.
That means fewer deals are getting done today than at the start of 2022, and certainly fewer than in 2021.
The slowdown means we have to carefully scrutinise the balance sheets of our investee companies.
We want to make sure they can withstand periods where exits dry up, that they have enough cash on the balance sheet to cope with that kind of environment and that they have prudent banking facilities in place.
Scottish Mortgage suffers Global sector's biggest discount widening in H1
In an environment like this, the metrics we use to analyse companies change, so as the backdrop worsens, we focus on the balance sheet much more than we did before.
That said, balance sheets in the sector are in far better shape than they were going into the Global Financial Crisis, and we are also cognisant that the pace of capital calls tends to slow down at the same time as exits.
Many PE managers realised that rates were not going to stay pegged to the floor forever so prudently implemented measures that enabled them to adapt to a higher-rate environment.
The impact on existing portfolio companies has been somewhat mitigated by the foresight of PE managers.
Elevated inflation also brings challenges to the sector, but these challenges are not necessarily unique to PE.
As the UK has not experienced elevated levels of inflation for about 40 years, it is the first time most managers of both public and private companies are having to grapple with it.
When it comes to inflation, the key consideration is whether a company has pricing power, or in other words, can they pass the inflationary cost pressures onto their consumers?
The more differentiated the product, the easier it will be to pass through cost increases.
Private equity trusts under threat as discounts continue to widen
And conversely, the more commoditised the product, the harder it is, simply because competition is greater.
The margin profile of a company is another consideration. Those companies with high operating margins will only see a modest effect on their bottom line, whereas companies with high fixed costs and low margins are going to suffer more.
Overall, PE could present attractive opportunities over public companies in an inflationary environment.
That is because PE-backed companies often supply a service which is deemed essential to the customer, which means they over-index in software as a service (SAAS), tech and healthcare.
Sectors like retail - which disproportionately suffer in an inflationary environment - are generally underweight in PE portfolios.
Although there are genuine concerns out there and there are reasons to be fearful, we think the market reaction has been overdone.
The sell-off in public markets and fears around PE/VC has meant listed companies across the board have become very cheap and some of the discounts to NAV are at extraordinarily wide levels, so we have been ramping up our exposure.
Tom Treanor is head of research at Asset Value Investors