Is the party nearly over at 3i?

In a bumper year for buyouts, the venture capital giant's next challenge is to weather the downturn
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The Independent Online
MANAGEMENT buyouts are heading for a bumper year. According to the accountancy firm KPMG, a bubbling first nine months means buyouts for the full year are set to reach a value of more than pounds 4.5bn, the highest annual total this decade.

This is good news for 3i. Buyouts and buy-ins, big and small, are the venture capital giant's bread and butter. Its portfolio spans 3,300 unquoted companies, 88 per cent by value in the UK, 11 per cent in mainland Europe and the rest in Japan and the United States.

Its powerful grip on the UK market gave it 63 per cent of MBOs by volume and 21 per cent by value last year, according to the British Venture Capital Association.

Its attractions have not gone unnoticed. Since making its stock market debut last July, 3i has outperformed the FT-SE 100 index - which it quickly joined - by more than 25 per cent. From an issue price of 272p, it reached a closing high on Friday of 419p.

3i was established in 1945 to fill a post-war funding gap for small business. Its many success stories range from Derwent Valley foods, maker of Phileas Fogg snacks, to the airline British Caledonian and the brain scanners group Oxford Instruments.

Now classified as an investment trust, 3i has had its share of failures, too: it lost pounds 73m in the ill-fated leveraged buyout of the Gateway stores group Isosceles in the 1980s, and is sitting on a pounds 16m loan to Eurotunnel.

But investors have not lost an appetite for the unique exposure 3i gives the spectrum of British industry. Even a secondary placing of shares four months ago failed to dull the shine.

The group was owned from inception by the Bank of England and the leading clearers, which retain a 31 per cent stake. In June, they unloaded a hefty pounds 440m of shares, 21 per cent of 3i's total equity at 360p - at a mere 3p discount to the then market price.

Some brokers warned then that institutions were stuffed with stock, and the shares were a sell. They have carried on skywards since, however, and now stand at a small premium to estimated net asset value - the crucial measure of value, not the price earnings ratio, and highly unusual for an investment trust. Most trade at a discount.

Broker BZW's current NAV estimate, based on movements in the FT-SE SmallCap index and other data, is 401p to the end of September. The switch from discount to premium on top of good asset growth has given shareholders a double and unrepeatable bonus.

The shares were floated at a 13 per cent discount to a historical NAV of 313p and are now at a whopping 21 per cent premium to the last reported historic NAV of 346p.

The future price relies on asset growth alone, which depends crucially on the state of the UK economy. Analysts believe the shares to be fully valued now, and the pace of economic recovery is slowing. So are they a sell? The answer depends on how 3i's investments and investment policy fare when the downturn starts and how violently the shares are likely to react. Timing is all.

The 3i Enterprise Barometer, which measures confidence among its portfolio companies, is still moving up, but much more slowly than a year ago. Although company profits growth appears to be levelling off after the climb out of recession, the lag effect of 3i's valuation policy means there should be good news to come.

The group itself has been confident. New investments and stake realisations - by flotation or trade sale - have continued at a "very satisfactory level", the 3i chairman, Sir George Russell, told the annual meeting in July. Market indications are that the same vein continues.

Foundations are also being laid to cushion the impact of a UK downturn. The group is increasingly turning its attention to continental Europe and to managing funds for third parties, for which it earns fees.

It is not just putting its own money on the line: 3i's pounds 150m leveraged MBO fund is 50 per cent funded by outside institutions, and its pounds 270m Eurofund 70 per cent so.

The London Business School claims 3i is actually the lowest- risk stock on the UK market, because of its large number of holdings across a wide range of manufacturing and service sectors. However, on a current yield of 2.15 per cent, 3i is a capital growth stock, not an income one. With growth still to come in asset values over the next year, the shares are a hold.

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