Friday letter: Still plenty to prove

3i’s credit business is growing rapidly, and will face its first big test in the next downturn. The same is true for the private debt industry as a whole.

In 2012, London-listed private equity firm 3i was over-levered and under-performing. Activist investor Laxey Partners was calling for a freeze on new investment and for cash to be returned to shareholders. A compromise was reached and the firm embarked on an ambitious restructuring plan. Yesterday it declared the plan complete.

Cost-cutting, debt reduction and office closures were all part of it, and the firm appears to have done well in these areas. But new sources of revenue and return were also required, and so 3i has been shrinking the private equity business in order to focus instead on infrastructure investment and, crucially, private credit. 

Fast forward to the present and the credit business, which is known as 3i Debt Management, has emerged as the main driver of 3i’s growth. Results for the 12 months ending 31 March published yesterday showed that 3i Debt Management’s assets grew 12 percent year-on-year to £7.24 billion ($11.4 billion; €10 billion). 

Indeed, credit is now the firm’s primary third-party fund management business, and makes up more than half of the firm’s £13.5 billion in assets under management. Fee income from debt management grew from £32 million to £34 million over the past year, and the firm structured six new CLOs in the 12 months ending in March, including Jamestown VI, at $750 million its largest US vehicle to date. It also reached a €250 million first close on its European Middle Market Loan Fund, and other new initiatives are also in the works, PDI understands.

The firm’s other business lines aren’t faring quite so impressively. In yesterday’s earnings call, chief executive Simon Borrows told investors that stiffening competition in infrastructure had prompted 3i to reduce its infrastructure return objective from 10 percent annually to between eight and 10 percent over the medium term. He also announced that the firm would not attempt to raise a new private equity buyout fund, but continue to fund private equity deals from its balance sheet.

Given these contrasting experiences, the debt strategy looks set to remain centre stage. Granted, it will generate lower yields than the equity-driven infrastructure activity, but as long as credit standards are maintained, it should also be less vulnerable to suffering losses in a downturn.

The market, meanwhile, appears to like the particular blend of three alternative investment strategies 3i is offering. The shares are trading around £5.35, up from £3.68 at the beginning of the year and outperforming the FTSE All-Share comfortably. Investors are evidently rewarding 3i’s restructuring effort, as well as enjoying the solid cash flows and leveraged returns coming out of its private debt/CLO platform. 

The big test will come when the market cools. Just like the rest of the fledgling industry that is private credit, 3i Debt Management hasn’t been fireproofed. Only when it has withstood a meaningful downturn will it have proven itself to be a more solid and resilient operation than the ill-fated third-party private equity business it replaced.