3i seems buoyant - but beware changing times

Last week, when 3i announced its results, its shares nudged up to 938p amid a chorus of approval from banks and brokers. Since then, it has slipped back 7.6%. What happened?

How things change. Last week, when 3i announced its results, its shares nudged up to 938p amid a chorus of approval from banks and brokers. Since then, it has slipped back 7.6%. What happened?

The problem is that, like investment banks, venture capitalists are paid to gamble with other people's money. In times like these, when asset prices are rising, that's great. But what about when a bull market turns into a bubble?

The current City solution is co-investment, whereby managers are required to risk their own money alongside that of their firm. This is the point that 3i has reached. But the devil is in the detail. Requiring managers to invest, say, £10,000 may sound a lot to a layman, but if they've just been awarded a £320,000 bonus, it doesn't mean much. Such a policy should create incentive, if correctly apportioned. Or it could just be a cover to maintain confidence in a relatively high deal flow when genuine value is becoming harder to find.

To be sure, 3i has instituted some prudent reforms by focusing on a smaller portfolio of firms and by diversifying away from the UK. Also, as Heather Connon points out in The Observer, it's in a "slightly different niche" to the likes of KKR and Carlyle, in that buyouts account for just 35% of its business and it has a smaller maximum deal size.

But just as a rising tide floats all boats, so a falling one sets them all down again. At 866p, 3i's shares are at a 17% premium to net assets as at 31 March. That's only slightly less than the 20.4% by which net assets increased last year by almost universal consent, an "exceptional" rise. That means 3i must return no less than 17% on its investment portfolio for at least another year in order to justify its current share price. Can it do it? Perhaps, if today's economic conditions persist; probably not, if they deteriorate to any marked degree.

Peter Klinger in The Times and Edward Simpkins in The Daily Telegraph are enthusiastic, citing "a widely admired management team" and recommending investors "jump aboard now". With a 12-month price target of £10.80, so too is Merrill Lynch. In an environment of rising interest rates, though, Robert Cole, also in The Times, and Heather Connon in The Observer are yet to be convinced.

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