A cautionary tale

How hard will problems at 3i Group hit its 33% subsidiary 3i Infrastructure, asks Paul Jarvis

In investment fund land, caution is the watchword at the moment and money is tight. Few know the problems better than 3i Group. It has endured a miserable 12 months, posting its first ever loss last year as tumbling equity markets hit the value of its investments hard. The fall out has hit many of its businesses, and forced it to slash its stake in 3i Infrastructure, its dedicated infrastructure vehicle. But it has pressed ahead with launching a new company to invest in India’s burgeoning infra market, even if its European activity looks muted. 3i might be licking its wounds, but it’s far from finished in this market.

At the start of this year, things were going horribly wrong for 3i Group. Global recession sliced 21 percent off the value of the company’s biggest 50 investments, and its credit rating went down the drain. Standard and Poor’s downgraded the group from A- to BBB+. It called the outlook “negative”, and said it expected the firm to post big losses this year. “In our view, the operating environment for private equity firms is very difficult and we believe that this may linger,” it said in a February research report. 3i Group could find it tough to tackle its heavy debts, too, with net debt a scary £2.11 billion (e2.3 billion; $3 billion) at the end of 2008. “Tough market conditions render successful investment exits more challenging.” So offloading investments to lower debt won’t be easy.

The questions have been mounting since 3i sacked its highly-prized chief executive, Philip Yea, in January. He was replaced by an insider, 3i Infrastructure boss Michael Queen, but the bloodletting left many analysts shocked. Certainly, such drastic moves suggested 3i had plenty to be worried about.
In truth, the rot had set in at 3i some time back. Yea never really recovered from his decision to pay out £800m of capital to shareholders in 2007, just before the credit crunch hit. That worried the market when the recession came along. “3i is heavily de-rated due to the concerns about the level of debt,” says Stephen Peters, an analyst at Charles Stanley. The group’s share price collapsed 63 percent in the year to 8  April, with market capitalisation tumbling by £2.1 billion.

The only way to regain market confidence was to hold a fire sale, and use the proceeds to flatten the debt mountain. One result was that 3i was forced to distance itself from its infrastructure activities. 3i Group now holds a 33.3 percent stake in 3i Infrastructure, the FTSE250-listed permanent capital vehicle which floated on the stock exchange in 2007. The group remains the biggest shareholder, but sold a 10 percent stake in the company at the start of this year.

The company doesn’t deny that the sale was prompted by the need to reduce the parent’s debts. And, while 3i says it will maintain its stake for at least another six months, it admits its stake could tumble to 25 percent or so over time.

That said, there’s no particular reason to believe that it sold its stake in another infrastructure vehicle, Infrastructure Investors (I2), in a panic. I2 is a portfolio of operational private finance initiative contracts in the UK, and Barclays decided to buy out the other two shareholders – 3i Infrastructure (which had been transferred 3i’s stake when it was set up in 2007) and France’s Societe Generale. 3I Infrastructure netted £166.7m from the deal, helping it to build up a war chest for when it eventually starts to invest again. “In terms of assets, there’s no problem [with 3i Infrastructure],” says one London-based analyst. “The uncertainty is in the share price, which is due to problems at 3i Group.”
In fact, 3i Infrastructure has enough money squirreled away to shelter from these rainiest of days. Listed on the stock market in March 2007, it raised £703 million in its initial public offering and a further £115m in a subsequent placing in July last year. While much of that money has been put into projects, some £393 million of cash is available for fresh infrastructure investment.

It does not look like using it any time soon. At the end of March, the investment vehicle said it had raised £105m for fresh investment over the past 12 months. That’s down from £512 million in 2007.
There’s talk of looking to the US for investment targets, largely because of President Barack Obama’s grandiose promises. But over the past year, the focus has been on India. 3i has a decent presence there, and the country has ambitious plans to improve its infrastructure. 3i India Infrastructure Fund closed in September 2007 on $500 million, with 3i Group and 3i Infrastructure committing $250 million apiece. Since then, it has picked up three big projects. Most notable of these was the Krishnapatnam Port, where the Fund took a minority stake this February for $161 million. It has also paid $101 million for a minority stake in engineering and construction firm Soma Enterprise, and $227million for a minority stake in the energy firm Adani Power. But generally, 3i Infrastructure has been quiet recently. It sold its inherited portfolio of PFI deals, but is sitting on the other stakes bought from 3i Group when Infrastructure was launched: a 9 percent stake in Anglian Water Group (AWG), bought in March 2007 for £140 million, and stakes in two PFI projects.

In terms of acquisitions it has concentrated on diversifying away from the UK in general and PFI in particular, with a focus on Western Europe. In August 2007 it bought 45 percent of Oystercatcher for £84.5 million, giving it a stake in oil storage depots in the Netherlands, Malta and Singapore. It has also bought stakes in a German waste to energy plant, a university accommodation group and a British renewable energy company.

But it hasn’t bought anything since March last year. And the upside to that caution is that analysts reckon 3i Infrastructure is well-placed to take advantage of market recovery, when it comes. “As investors’ thoughts start to move from deflation to inflation, we believe that the attractions of 3i Infrastructure will grow,” said a note from Citigroup analysts following the March trading update.
Certainly, the share price looks to have hit rock bottom, as problems at parent company level clobber investor confidence. Peters says that the fund was valued at 16 percent less than the net value of its assets at the end of March. Its shares cost 84p apiece, and it was sitting on almost £400 million in cash. “With 811 million shares, that means it’s got around 50p per share in cash,” he says. “Therefore its assets are quite cheap.”

The analysts are also quite happy with the range of 3i Infrastructure’s portfolio now that it has diversified away from UK PFI – in contrast to the likes of Australia’s Babcock and Brown, which one London analyst says is too focused on public private partnerships since a restructuring at the end of last year. “Compared with Babcock and Brown or HSBC Infrastructure, its assets are slightly different,” he says. “A PFI contract is a stream of payments for the term of the contract – it’s an expiring asset.” That’s not the case for several of 3i Infrastructure’s assets.

So it’s diversified enough for investors to reckon it’s a decent punt, and it has enough cash to exploit any bargains thrown up by recession. “If it’s able to pick up assets from distressed sellers, for example Macquarie, it could pick them up at a good value,” says Peters. The group doesn’t deny it’s looking for this kind of deal at the moment.

Its problem remains the long shadow cast over it by 3i Group’s weakness. There’s little doubt that the parent is being forced to sell decent assets to raise cash quickly: it recently announced an offer for the assets of 3i Quoted Private Equity, in which it holds a 45 percent stake. That could give it a much-needed £110 million cash injection.

So might it be tempted to sell off its remaining stake in 3i Infrastructure? Analysts say it could flog off its 33 percent stake profitably. But they also reckon 3i Infrastructure is one of the Group’s few assets likely to be on the up over the coming months, and that the parent will want to keep a toe-hold in infrastructure if it possibly can. Queen recently promised the Group would not sell any shares in the company for 180 days. He also insisted the parent group remains committed to infrastructure. Whether 3i Group remains true to that will depend on how much it needs ready cash now to stop the slide of its share price, and its credit rating.