3i Group plc – Annual report – 31 March 2021
C Critical accounting judgements and estimates (extract)
b) Critical estimates (extract)
I. 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 13 Fair values of assets and liabilities. Further information can be found in Portfolio valuation – an explanation on pages 188 and 189. 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 in the Valuations Committee Report on pages 103 and 106.
13 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 £1,161 million (31 March 2020: £671 million), determined with reference to their published market prices. The carrying value of the loans and borrowings is £975 million (31 March 2020: £575 million) and accrued interest payable (included within trade and other payables) is £13 million (31 March 2020: £8 million).
The Group classifies financial instruments measured at fair value 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 188 and 189.
The table below shows the classification of financial instruments held at fair value into the valuation hierarchy at 31 March 2021:
We determine that, in the ordinary course of business, the net asset value of an investment entity subsidiary is 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 12 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 are set out in the table below:
1 All fair value movements relate to assets held at the end of the year.
2 Other movements include the impact of foreign exchange and accrued interest.
Unquoted investments valued using Level 3 inputs also had the following impact on profit and loss: realised profits over value on disposal of investments of £9 million (2020: £29 million loss), dividend income of £33 million (2020: £7 million) and foreign exchange losses of £195 million (2020: £36 million gain).
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. In the 12 months to 31 March 2021, two assets changed valuation basis within Level 3, one moving from an earnings-based valuation to a DCF and Action moving from Transaction value which was used as a basis to determine fair value at 31 March 2020 to an earnings-based valuation. The changes in valuation methodology in the period reflect our view of the most appropriate method to determine the fair value of the two assets at 31 March 2021. Further information can be found in the Private Equity and Infrastructure sections of the Business and Financial review starting on page 21.
The following table summarises the various valuation methodologies used by the Group to fair value Level 3 instruments, the inputs and the sensitivities applied and the impact of those sensitivities to the unobservable inputs. We have maintained a 5% sensitivity which is underpinned by the resilient performance of our portfolio. For the small number of companies in our portfolio that are exposed to more challenged sectors such as travel and automotive sectors, our fair value at 31 March 2021, reflects the impact this has had on performance. All numbers in the table below are on an Investment basis.
1 2020 excludes Action which was valued on Transaction value which was used as a basis to determine fair value at 31 March 2020.
28 Financial risk management (extract)
Market risk (extract 1)
The valuation of the Group’s investment portfolio is largely dependent on the underlying trading performance of the companies within the portfolio but the valuation and other items in the financial statements can also be affected by interest rate, currency and quoted market fluctuations. The Group’s sensitivity to these items is set out below. During the year market price risk impacted the valuations of the Group’s investments due to increased volatility within capital markets caused by the global economic impact of Covid-19, this is further detailed on pages 60 and 61 in the Risk management section.
Market risk (extract 2)
(iii) Price risk – market fluctuations
The Group’s management of price risk, which arises primarily from quoted and unquoted equity instruments, is through the careful consideration of the investment, asset management and divestment decisions at the Investment Committee. The Investment Committee’s role in risk management is detailed on page 55 in the Risk management section. A 5% change in the fair value of those investments would have the following direct impact in profit or loss:
Portfolio and other information (extract pages 188-189)
Portfolio valuation – an explanation
The valuation policy is the responsibility of the Board, with additional oversight and annual review from the Valuations Committee. The policy is reviewed at least annually, with the last update in January 2021. 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 IPEV guidelines. The policy ensures valuation methodologies are selected and applied consistently or where methodologies change year on year this is supported. The policy covers the Group’s Private Equity, Infrastructure and Scandlines 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 2018). We have continued to consider the additional IPEV guidelines issued in March 2020 in light of the Covid-19 outbreak. Fair value is 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. A small number of our private equity investments are valued using a discounted cash flow (“DCF”), and for these assets we do not apply a liquidity discount.
The table on the next page outlines in more detail the range of valuation methodologies available to us, as well as the inputs and adjustments necessary for each. The impact of Covid-19 has resulted in a level of uncertainty and in determining the fair value of our investments, we have again considered a broader range of inputs including historical, current and forward-looking data. Where forward looking data forms the base of a valuation, the accuracy, reliability and maintainability of these forecasts has been considered.
Apportioning the enterprise value between 3i, other shareholders and lenders
Once we have estimated the enterprise value, the following steps are taken:
1. We subtract the value of any claims, net of free cash balances that are more senior to the most senior of our investments.
2. 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.
3. 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. 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.
Scandlines unquoted valuation
Scandlines is valued on a DCF basis. This is consistent with the Infrastructure methodology.
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.