A clever and cheap way to invest in private equity

For those who are intrigued by private assets but are unsure about whether to back a private equity fund, Caledonia Investments (CLDN) is an attractive proposition. A multi-asset investment trust that aims to offer shareholders long-term capital growth while increasing its dividend year-on-year, it had a 59 per cent exposure to private markets as of 31 March, with the rest invested in listed companies plus a small amount of cash.

Caledonia’s unlisted exposure is one of the reasons investors have shied away from it over the past couple of years, resulting in a discount to net asset value (NAV) of 33.7 per cent as of 3 June. This is in line with some of the cheapest private equity trusts, with HarbourVest Global Private Equity (HVPE), ICG Enterprise (ICGT) and Pantheon International (PIN) trading at discounts of 42, 35 and 33 per cent respectively.

But unlike these, Caledonia also has a chunky exposure to very liquid and uncontroversial listed companies, including Microsoft (US:MSFT) and Diageo (DGE). Investec analysts recently deemed the trust a ‘buy’, arguing that “a fair value discount level, in normal market conditions” would be around 20 per cent. The trust traded on a narrow discount of between 13 per cent and 20 per cent before the pandemic struck. 

Three-pronged strategy

Caledonia’s objective is to outperform inflation by at least 3 per cent over the medium and longer term, and to outperform the FTSE All-Share index over 10 years. The strategy involves splitting the portfolio into three key building blocks and taking a very long-term buy-and-hold approach. Steady growth with some income generation is key.

The team in charge of the listed portfolio looks for well-managed companies with strong market positions and pricing power. This portfolio is divided into capital and income sections, although there is some overlap. The capital portfolio has a preference for US companies – after Microsoft, the two biggest holdings are Oracle (US:ORCL) and air conditioning company Watsco (US:WSO). The income portfolio is smaller and more UK-focused, with holdings such as National Grid (NG.) and Unilever (ULVR) in the top 10. Portfolio turnover is low, but in the year to 31 March 2024 the managers added a position in data giant Relx (REL). Relx now makes up 6.4 per cent of the income portfolio and in the region of 0.5 per cent of total assets, and was one of the trust’s top listed performers in the year just gone. 

The private capital portion of the portfolio is far more concentrated, with exposure to just eight UK-focused mid-market companies. The trust is keen to stress its long-term approach even in this side of the portfolio, however. “Able to look beyond short-term cycles and the typical fundraising constraints of most private equity investors, we give these businesses time to fulfil their potential and only sell when the time is right to maximise value,” the managers say. This division is clearly riskier, but its focus on cash generative businesses with relatively low net debt/Ebitda ratios (between 2 times and 2.5 times) should protect it from the worst of the macroeconomic turbulence.

During the year to 31 March 2024, the trust sold its majority stake in wealth manager 7IM at a 32 per cent uplift on its March 2023 valuation, which provides some reassurance on the trust’s valuation discipline. In April 2023, it invested £143mn in Air-serv Europe, a manufacturer of air, vacuum and jet wash machines. This is now the second-largest company in the private capital portfolio, worth an estimated £170mn according to the earnings-based valuation.

The funds section of the portfolio is the most esoteric of the three and comprises 74 private equity funds handled by 42 managers with an underlying portfolio of 600 companies. The strategy is very diversified but arguably racier than that of the direct private capital portfolio, with 41 per cent of the assets located in Asia, including some exposure to venture capital in the region. The remaining 59 per cent of assets are in North America, and the lion’s share of these are in funds focusing on small and medium-sized companies. These typically provide the first institutional capital to small and mid-sized owner-run businesses, supporting their growth and making them more professional.

As the chart below shows, in the long term this section of the portfolio has delivered the best returns, but the last year was more challenging, mostly due to more difficult market conditions in Asia. There are also potential issues with transparency: disclosures offer investors less look-through insight into this part of the portfolio.

A family history

Caledonia’s strategy may appear complicated, but its long time horizon and focus on high-quality, well-run businesses is reassuringly traditional. This is partly because of the trust’s venerable history. 

Caledonia was originally the Cayzer family’s shipping business, founded in the late 1800s. The family still owns 49 per cent of the company, which helps it maintain its long-term focus, but also means that the trust has limited power to buy back its own shares. (The Cayzer family’s holding cannot exceed 49.9 per cent). The trust has been buying back some of its shares and says it plans to continue to do so, but these liquidity challenges – together with the market conditions across the investment trust universe – mean Caledonia’s discount could take some time to close. Investors should be aware that this is a long-term bet.

The trust’s track record is robust, although keeping the FTSE All-Share as a benchmark seems a little disingenuous when the trust has pivoted away from the domestic market, with 46 per cent of overall assets in North America compared with 34 per cent in the UK.

Investec compares the trust’s performance with that of a hybrid index comprising the FTSE All-Share (35 per cent) and MSCI ACWI excluding the UK (65 per cent). This more closely reflects the trust’s geographic allocation, and a comparison found that in the past five years Caledonia’s NAV returned 10.9 per cent a year against 10.2 per cent achieved by the composite benchmark. Investec analysts deemed this “a solid outcome” – particularly taking into account that on average it has held 7 per cent in cash over the period.

Income investors will also like Caledonia’s dividend track record. The trust sits atop the Association of Investment Companies’ dividend hero table with 57 consecutive years of dividend growth. Currently at 1.99 per cent, the yield is less than spectacular, but the income is inflation-linked and fairly secure, making it appealing for investors who rely on their portfolios to fund their lifestyle.

Investors in search of a trust with a long-term approach, a unique strategy and growing dividends will find a lot to like in Caledonia’s portfolio, as long as they are happy not to shy away from private markets. The discount to NAV is the cherry on top, providing a chance to boost investment returns if broader market conditions improve.