US private equity firms have taken big hits in the last 12 months, but despite falling 15% on Thursday (13 November) shares in FTSE 100 firm 3i Group (LSE:III) are up. This isn’t an accident and I think it’s set to continue.
The company has a unique business model that involves using its own balance sheet instead of outside capital. And the advantages of this are really showing up this year.
Private equity
Private equity usually involves raising capital from pension funds, insurers, or foundations. This is used to fund investments in companies with the aim of providing a return in 10-12 years.
The first five years is typically spent making investments and the second is spent exiting them and realising gains. But that’s creating a problem at the moment.
Five years ago, interest rates were close to zero due to the Covid-19 pandemic. That meant asset prices were unusually high and investment opportunities were hard to find.
As a result, Apollo Global Management, Blackstone, and KKR have warned that exits are taking longer than expected. And their stocks are down around 20% in the last 12 months as a result.
The 3i difference
None of this is a problem for 3i. Investing its own capital, rather than raising cash from external sources means it can buy and sell on its own timeline.
In other words, it can sit tight when prices are high and it isn’t under pressure to realise a return when they’re low. That’s a huge advantage and it’s a permanent one.
3i’s most successful investment has been its stake in a European retailer called Action. It first invested in 2011, but the investment has still grown almost 300% in the last four years.
If the firm operated in the usual way, it would have been hard to keep holding. But not having to return cash to external investors in a set timeframe means it doesn’t have to sell.
Risks and opportunities
A consequence of 3i’s successful investment in Action is that the firm’s portfolio has become heavily concentrated. The retailer is around 76% of the FTSE 100 firm’s portfolio.
It’s also worth noting that 3i values Action at an EBITDA multiple of 18.5. That’s pretty high for a retailer and the company still trades at 125% of its book value.
The valuation is a risk for investors if the firm can’t find other attractive opportunities to expand its portfolio. But I think the concentration issue is easier to deal with.
3i might not have the most diversified portfolio but investors can achieve this themselves by buying other stocks. So I don’t see this as a major issue.
A UK stock market star
Apollo, Blackstone, and KKR have been terrific investments over the last five years and I expect them to do well in future. But even after this week’s decline, 3i has outperformed them all.
The firm’s unique structure means it can make investments on its own timetable, rather than being forced to buy and sell at the wrong times. And that’s a big long-term advantage.
All things considered, I think 3i is a rare example of a UK company outperforming its US counterparts. My view is that investors looking for quality stocks should take a serious look.
