International investment house 3i Group (LSE:III) has seen its share price tumble almost 20% from the record high achieved in May 2018. Recent analysts’ recommendations are either buy or outperform, so investors might be thinking now is a good time to pick up some of this FTSE 100 company on the cheap. With a current dividend yield of almost 4%, what’s not to like about this debt-free private equity leviathan, for which I used to work?
Quite a lot, as it happens, but you need to look below the surface to spot it. You see, private equity is one of the most cyclical games in town. The best returns for a PE firm come from adding to its investment portfolio during the low points in the cycle — that’s why the industry harps on so much about “vintage years” — and then selling assets at the top. Sure, good portfolio management of the underlying investee companies can move the needle, but it won’t make up for getting the cyclical timing wrong.
Let’s take a closer look at 3i’s recent portfolio activity. In the two years to 31 March 2018, the company realised cash from investments to the tune of £2.6bn, a level some 80% higher than the average of the previous five years. So far so good. It makes sense to offload investee companies when valuations are at their highest and corporate acquirers are out with their chequebooks. And it appears 3i has sold well, achieving a 2.4x money multiple on assets sold last year. My concern, however, is the potential realisation values of those businesses remaining in the portfolio. For it is those that will drive future profits.
I mentioned earlier this is a cyclical business. According to BDO’s latest quarterly private equity price index (PEPI), the average enterprise value to EBITDA multiple on acquisitions made by private equity firms came in at 12x (just a little lower than the FTSE All-Share’s 12.8x). This represents a 50% increase in the average multiple paid since 2013. Competition from other PE houses, flush with cash from record fundraising, and trade buyers, fuelled by cheap debt, has pushed up the value of private companies.
3i doesn’t disclose what it pays for individual portfolio companies, but it is reasonable to assume it has not been immune to escalating prices. While the firm has done well selling into this frothy market, my concern is that it has also stepped up its new investment activity near the top of the cycle. In 2018, it invested £587m of its capital in new deals, compared to only £100m in 2013. Given 3i’s stated target holding period of four to five years and the high multiples it is likely to have paid for recent investee companies, I struggle to see much scope for capital growth or realised profits from the portfolio in the medium term.
If we are at or near this cycle’s peak, and multiples paid for private companies drift lower from here, I expect to see 3i’s share price take a hammering. At that point, I’ll consider owning the stock again, but I’m in no rush to do so.