Further proof arrived at the beginning of June that very little can be taken for granted in the investment company sector these days, when the board of small-cap specialist Throgmorton Trust announced that it was moving the management contract for its portfolio from AXA Framlington to BlackRock. This was significant, given that AXA Framlington, in one form or another, has managed the portfolio since it was launched in 1957 and, as the group was quick to point out, has followed the investment policy set out by the trust’s board and beat its benchmark whilst doing so.

Indeed, what must be particularly galling for the AXA Framlington small-cap team is that at the same time as the management contract for the trust’s portfolio is being moved elsewhere, the board is changing the mandate to allow up to 30 per cent of the trust’s net assets to be invested in a portfolio of contracts for difference (CFDs), to provide both long and short exposure. At the same time, the trust is making a tender offer for up to 40 per cent of its share capital, at a two per cent exit charge, with the intention of initiating further tender offers in the future, as part of a buy-back policy aimed at keeping the discount at reasonable levels.

To a considerable extent, this is a reaction to a particularly tough period for small-cap trusts. Simon Elliott, head of research at WINS Investment Trusts, reacted thus: ‘We have felt for some time that the UK Small Cap sector was ripe for corporate activity, given its clear oversupply and limited demand. Throgmorton, which has a market cap of £205 million, is large enough, in our view, to withstand a substantial reduction in its size, and by adopting a hybrid approach it is differentiated from its peers. The regular tender offers and an active buyback policy should also ensure a tighter discount than the peer group.’

No shortage of cash
However, judging by the rising tide of new issue activity, there doesn’t seem to be any shortage of cash in the market. There has been a significant amount of capital raising, both new fund launches and additional fund raisings by existing funds, in the past few months, much of it in amongst the more esoteric ‘alternative’ funds, including the largest this year so far, the £534 million launch, BH Global, a fund of Brevan Howard hedge funds.

Indeed, amongst the more established closed-end investment companies, it is these ‘alternative’ investment themes that are looking most interesting. Nick Greenwood, head of investment trusts at Midas Capital, reports that ‘The theme we are increasingly looking to is the overseas property trusts, like Develica Deutschland and Lewis Charles Sofia. A lot of these things are trading at half their realisable NAVs, so you have deep discounts that become even deeper discounts.’

Another example is Dawnay Day Treveria, a fund that invests in income-producing German retail property, but which, at the beginning of June, was sitting on a discount to NAV of close to 50 per cent. Its board announced that it was considering ways to deal with this, including returning cash to shareholders via asset disposals or even selling the entire company. This had an immediate effect on the share price, which rose 20 per cent, before settling at a level that reduced the discount by around seven per cent.

Nick Greenwood also sees some opportunities amongst the small-cap funds: ‘Small caps generally are unloved at the moment, which means that small-cap investment trusts are standing at even deeper discounts than before.’

WINS’ Simon Elliott highlights another fund in this space with the pedigree to ride out the storms: ‘Schroder UK Mid & Small Cap is managed by Andy Brough and Rosemary Banyard, stock pickers who emphasise fundamental proprietary research, favouring companies with good-quality long-term earnings. Current themes include global infrastructure spending, food price inflation, rising oil and gas prices, and companies with management or strategy changes.

This investment trust represents the best ideas of the managers’ open-ended mid- and small-cap funds. It has consistently outperformed its benchmark and, on a discount of around 14 per cent, we believe it is an attractive vehicle.’

Private investigations
Another group of trusts that seems clearly undervalued is those investing in private equity. John Moore, head of collective investments at Brewin Dolphin, confirms that ‘Private equity is looking very good value just now. We are becoming increasingly bullish about things like Electra on a three- to five-year view. They have got a quarter of the trust in cash, £124 million, and with gearing that can go up to £400 million. So they are well set up to benefit from the credit crunch. A trust like Electra, which has been around since 1978, has seen a lot of cycles. So if you think we are in a 1987-94 type recession, it is worth remembering that Electra did very well during that period. And you could say the same about Candover. ’

And it is not just the directly invested private equity funds that look attractively valued. Moore adds, ‘Also some of the funds of funds are very well positioned and very cheap, things like Pantheon, F&C Private Equity and Standard Life European Private Equity. These trusts could have a very poor six months but be very strong on a three- to five-year view. The banks are going to be selling off their crown jewels during the current squeeze, and the private equity trusts will be there to snap them up.’

Opportune moments
Unsurprisingly, this is a view shared by the managers of private equity portfolios. Ian Armitage, a partner at Hg Capital, insists that ‘Private investors are scared of private equity, but institutions see they can make more money from public equity so are turning their backs on private equity because valuations currently look so expensive. The banks will come back, but not yet. So we think we are seeing the best buying opportunity in private equity for 20 years. In a recession, people sell businesses they feel they can’t manage, and this recession will probably be deeper than the last one because of higher inflation. The companies themselves are probably in healthier shape than in 2001/02, because they don’t have so much debt.’

Armitage points out that ‘Listed private equity companies have moved from an average eight per cent premium to a 20 per cent discount. We think this is an overreaction, for while we believe there will at least be a slowing economy, with the healthy companies they are not exposed to the risks for being highly leveraged.'