3i Group plc – Annual report – 31 March 2018
C Critical accounting judgements and estimates (extract)
(b) Critical estimates (extract)
- Fair valuation of the investment portfolio
The investment portfolio, a material asset of the Group, is held at fair value. Details of valuation methodologies used and the associated sensitivities are disclosed in Note 12 Fair values of assets and liabilities. Further information can be found in Portfolio valuation – an explanation on pages 150 and 151. Given the importance of this area, the Board has a separate Valuations Committee to review the valuations policies, process and application to individual investments. A report on the activities of the Valuations Committee (including a review of the assumptions made) is included on pages 70 to 72. In addition, sensitivity to a net 1x movement on Action’s multiple, the largest investment in our portfolio, is included on page 23 of the Strategic report.
12 Fair values of assets and liabilities (extract)
The fair values of the Group’s financial assets and liabilities, not held at fair value, are not materially different from their carrying values with the exception of loans and borrowings. The fair value of the loans and borrowings is £718 million (31 March 2017: £741 million), determined with reference to their published market prices. The carrying value of the loans and borrowings is £575 million (31 March 2017: £575 million) and accrued interest payable (included within trade and other payables) is £8 million (31 March 2017: £8 million).
The Group classifies financial instruments measured at fair value in the investment portfolio according to the following hierarchy:
Unquoted equity instruments and debt instruments are measured in accordance with the IPEV Guidelines with reference to the most appropriate information available at the time of measurement. Further information regarding the valuation of unquoted equity instruments can be found in the section Portfolio valuation – an explanation on pages 150 and 151.
The tables below show the classification of financial instruments held at fair value into the valuation hierarchy at 31 March 2018:
The above disclosure only relates to the investment portfolio and the investments in our investment entity subsidiaries. We determine that in the ordinary course of business, the net asset values of an investment entity subsidiary are considered to be the most appropriate to determine fair value. The underlying portfolio is valued under the same methodology as directly held investments, with any other assets or liabilities within investment entity subsidiaries fair valued in accordance with the Group’s accounting policies. Note 11 details the Directors’ considerations about the fair value of the underlying investment entity subsidiaries.
Movements in the directly held investment portfolio categorised as Level 3 during the year:
On a continuing basis, unquoted investments valued using Level 3 inputs also had the following impact on the Consolidated statement of comprehensive income: realised profits over value on disposal of investment of £14 million (2017: realised loss of £26 million), dividend income of £13 million (2017: £24 million) and foreign exchange losses of £12 million (2017: foreign exchange gains of £63 million).
Level 3 inputs are sensitive to assumptions made when ascertaining fair value as described in the Portfolio valuation – an explanation section. On an IFRS basis, of assets held at 31 March 2018, classified as Level 3, 40% (31 March 2017: 33%) were valued using a multiple of earnings and the remaining 60% (31 March 2017: 67%) were valued using alternative valuation methodologies. Of the underlying portfolio held by investment entity subsidiaries, 95% (31 March 2017: 96%) were valued using a multiple of earnings and the remaining 5% (31 March 2017: 4%) were valued using alternative valuation methodologies.
Assets move between Level 1 and Level 3 when an unquoted equity investment lists on a quoted market exchange. There were no transfers in or out of Level 3 during the year.
Valuation multiple – The valuation multiple is the main assumption applied to a multiple of earnings based valuation. The multiple is derived from comparable listed companies or relevant market transaction multiples. Companies in the same industry and geography and, where possible, with a similar business model and profile are selected and then adjusted for factors including liquidity risk, growth potential and relative performance. They are also adjusted to represent our longer term view of performance through the cycle or our exit assumptions. The value weighted average post discount earnings multiple used when valuing the portfolio at 31 March 2018 was 11.7x (31 March 2017: 10.2x).
If the multiple used to value each unquoted investment valued on an earnings multiple basis as at 31 March 2018 decreased by 5%, the investment portfolio would decrease by £43 million (31 March 2017: £18 million) or 2% (31 March 2017: 1%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have a negative impact of £270 million (31 March 2017: £224 million) or 6% (31 March 2017: 6%).
If the multiple increased by 5% then the investment portfolio would increase by £35 million (31 March 2017: £16 million) or 2% (31 March 2017: 1%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have a positive impact of £260 million (31 March 2017: £215 million) or 6% (31 March 2017: 5%).
Alternative valuation methodologies – There are a number of alternative investment valuation methodologies used by the Group, for reasons specific to individual assets. The details of such valuation methodologies, and inputs that are used, are given in the Portfolio valuation – an explanation section on pages 150 and 151.
Each methodology is used for a proportion of assets by value, and at year end the following techniques were used under an IFRS basis: 5% DCF (31 March 2017: 41%), nil broker quotes (31 March 2017: 4%), 45% imminent sale (31 March 2017: 2%), 7% industry metric (31 March 2017: 10%) and 3% other (31 March 2017: 10%).
If the value of all of the investments valued under alternative methodologies moved by 5%, this would have an impact on the investment portfolio of £53 million (31 March 2017: £44 million) or 3% (31 March 2017: 3%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have an impact of £10 million (31 March 2017: £7 million) or 0.3% (31 March 2017: 0.2%).
Portfolio and other information (extract pages 150-151)
Portfolio valuation – an explanation
The valuation policy is the responsibility of the Board, with additional oversight and annual review from the Valuations Committee. Our policy is to value 3i’s investment portfolio at fair value and we achieve this by valuing investments on an appropriate basis, applying a consistent approach across the portfolio. The policy ensures that the portfolio valuation is compliant with the fair value guidelines under IFRS and, in so doing, is also compliant with the guidelines issued by the International Private Equity and Venture Capital valuation board (the “IPEV guidelines”). The policy covers the Group’s Private Equity and Infrastructure investment valuations. Valuations of the investment portfolio of the Group and its subsidiaries are performed at each quarter end.
Fair value is the underlying principle and is defined as “the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date” (IPEV guidelines, December 2015). Fair value is therefore an estimate and, as such, determining fair value requires the use of judgement.
The quoted assets in our portfolio are valued at their closing bid price at the balance sheet date. The majority of the portfolio, however, is represented by unquoted investments.
Private Equity unquoted valuation
To arrive at the fair value of the Group’s unquoted Private Equity investments, we first estimate the entire value of the company we have invested in – the enterprise value. We then apportion that enterprise value between 3i, other shareholders and lenders.
Determining enterprise value
The enterprise value is determined using one of a selection of methodologies depending on the nature, facts and circumstances of the investment.
Where possible, we use methodologies which draw heavily on observable market prices, whether listed equity markets or reported merger and acquisition transactions, and trading updates from our portfolio.
As unquoted investments are not traded on an active market, the Group adjusts the estimated enterprise value by a liquidity discount. The liquidity discount is applied to the total enterprise value and we apply a higher discount rate for investments where there are material restrictions on our ability to sell at a time of our choosing.
The table opposite outlines in more detail the range of valuation methodologies available to us, as well as the inputs and adjustments necessary for each.
Apportioning the enterprise value between 3i, other shareholders and lenders
Once we have estimated the enterprise value, the following steps are taken:
- We subtract the value of any claims, net of free cash balances that are more senior to the most senior of our investments.
- The resulting attributable enterprise value is apportioned to the Group’s investment, and equal ranking investments by other parties, according to contractual terms and conditions, to arrive at a fair value of the entirety of the investment. The value is then distributed amongst the different loan, equity and other financial instruments accordingly.
- If the value attributed to a specific shareholder loan investment in a company is less than its carrying value, a shortfall is implied, which is recognised in our valuation. In exceptional cases, we may judge that the shortfall is temporary; to recognise the shortfall in such a scenario would lead to unrepresentative volatility and hence we may choose not to recognise the shortfall.
In applying this framework, there are additional considerations that are factored into the valuation of some assets.
Impacts from structuring
Structural rights are instruments convertible into equity or cash at specific points in time or linked to specific events. For example, where a majority shareholder chooses to sell, and we have a minority interest, we may have the right to a minimum return on our investment.
Debt instruments, in particular, may have structural rights. In the valuation, it is assumed third parties, such as lenders or holders of convertible instruments, fully exercise any structural rights they might have if they are “in the money”, and that the value to the Group may therefore be reduced by such rights held by third parties. The Group’s own structural rights are valued on the basis they are exercisable on the reporting date.
Assets classified as “terminal”
If we believe an investment has more than a 50% probability of failing in the 12 months following the valuation date, we value the investment on the basis of its expected recoverable amount in the event of failure. It is important to distinguish between our investment failing and the business failing; the failure of our investment does not always mean that the business has failed, just that our recoverable value has dropped significantly. This would generally result in the equity and loan components of our investment being valued at nil. Value movements in the period relating to investments classified as terminal are classified as provisions in our value movement analysis.
Infrastructure unquoted valuation
The primary valuation methodology used for unquoted Infrastructure investments is the discounted cash flow method (“DCF”). Fair value is estimated by deriving the present value of the investment using reasonable assumptions of expected future cash flows and the terminal value and date, and the appropriate risk-adjusted discount rate that quantifies the risk inherent to the investment. The discount rate is estimated with reference to the market risk-free rate, a risk adjusted premium and information specific to the investment or market sector.
Consistent with IPEV guidelines, all equity investments are held at fair value using the most appropriate methodology and no investments are held at historical cost.