International investment house 3i Group (LSE: III) is trading close to an all-time high. Since December, the price has climbed from the group’s net asset value per share to a staggering 40% premium today. Recent analysts’ recommendations continue to rate the stock as a buy or outperform, but I believe it has reached a pinnacle for this cycle. To understand why I have reached this conclusion, you need to look below the surface.
You see, private equity (PE) is one of the most cyclical games in town. The best returns for a PE firm come from adding to the 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 close to the top. Sure, good portfolio management of the underlying 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 that remain in the portfolio. For it is those that will drive future profits.
I mentioned this is a cyclical business. According to BDO’s latest quarterly private equity price index, the average enterprise value to EBITDA multiple on acquisitions made by PE 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 at 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 in the portfolio in the medium term.
Worse still, 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 reported profits and share price take a hammering over the next couple of years. At that point, I’ll consider owning the stock again, but I’m in no rush to do so.
For investors still intent on increasing their exposure to private equity, I’d be looking for those players trading at or below net asset value, such as ICG Enterprise Trust.
