3i Group plc – Annual report – 31 March 2020
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 177 and 178. 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 90 and 94.
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 £671 million (31 March 2019: £709 million), determined with reference to their published market prices. The carrying value of the loans and borrowings is £575 million (31 March 2019: £575 million) and accrued interest payable (included within trade and other payables) is £8 million (31 March 2019: £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 177 and 178.
The table below shows the classification of financial instruments held at fair value into the valuation hierarchy at 31 March 2020:
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:
Unquoted investments valued using Level 3 inputs also had the following impact on the Consolidated statement of comprehensive income: realised losses over value on disposal of investments of £29 million (2019: £33 million profit), dividend income of £7 million (2019: £12 million) and foreign exchange gains of £36 million (2019: £17 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 2020 classified as Level 3, 33% (31 March 2019: 77%) were valued using a multiple of earnings and the remaining 67% (31 March 2019: 23%) were valued using alternative valuation methodologies. Of the underlying portfolio held by investment entity subsidiaries, 41% (31 March 2019: 88%) were valued using a multiple of earnings and the remaining 59% (31 March 2019: 12%) 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 multiples are 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. Consideration has also been given to the impact of COVID-19 for the valuation at 31 March 2020. The pre-discount multiple used to value the portfolio ranged between 8.0x and 14.5x (31 March 2019: 7.5x and 18.9x).
If the multiple used to value each unquoted investment valued on an earnings multiple basis as at 31 March 2020 decreased by 5%, the investment portfolio value would decrease by £68 million (31 March 2019: £57 million) or 2% (31 March 2019: 3%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have a negative value impact of £148 million (31 March 2019: £318 million) or 3% (31 March 2019: 5%).
If the multiple increased by 5% then the investment portfolio value would increase by £68 million (31 March 2019: £57 million) or 2% (31 March 2019: 3%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have a positive value impact of £148 million (31 March 2019: £318 million) or 3% (31 March 2019: 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 177 and 178.
Each methodology is used for a proportion of assets by value, and at year end the following techniques were used under an IFRS basis: 55% transaction value (31 March 2019: nil), 10% DCF (31 March 2019: 7%), nil industry metric (31 March 2019: 11%) and 2% other (31 March 2019: 5%).
Transaction value has been used to value Action at 31 March 2020 following on from the Action Transaction. To arrive at the fair value, detailed due diligence was completed by sophisticated investors on the Action business model and its 5-year plan. Further information can be found on page 19.
If the value of all of the investments valued under alternative methodologies moved by 5%, this would have an impact on the investment portfolio value of £101 million (31 March 2019: £14 million) or 3% (31 March 2019: 1%). If the same sensitivity was applied to the underlying portfolio held by investment entity subsidiaries, this would have a value impact of £126 million (31 March 2019: £33 million) or 3% (31 March 2019: 0.6%).
Portfolio and other information (extract pages 177-178)
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 2020. 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 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). IPEV issued additional guidelines in March 2020 given the COVID-19 outbreak. These guidelines were considered when completing the 31 March 2020 valuations. 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 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. Given the higher level of judgement required as a result of the COVID 19 pandemic, the Group considered a broader range of inputs to cover the historical, current and forward-looking data to determine fair value.
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 (“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.
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.