3i Group: Capital in Action - [Business Breakdowns, EP.180]

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1:06This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

1:48This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. This is Matt Russell. And today we are breaking down the publicly traded investment company, 3i. Now you may think if you've seen one publicly traded investment vehicle, you've seen them all. Not so fast. 3i is an investment vehicle where one business, Dutch retailer Action, represents well north of 50 % of their net asset value. And our guest to break down 3i is Luke Bridgman, Portfolio Manager at Hosking Partners. Luke shares the unique origin story of 3i, which goes back to pre -World War II in England, and has a very unique funding story with a consortium of banks.

2:36He takes us up through present day where longtime investment banker Simon Burroughs has taken 3i and completely reshaped the asset management business into something that looks completely different. We end the conversation talking a lot about the philosophical evaluation of this type of business, which is very unique relative to anything else you would look at. We get into the comp sets, valuation framework, and much more. This was a fun conversation, and I think you'll enjoy it as well. Please enjoy this breakdown of 3i. All right, Luke, I am excited to have you here on Business Breakdowns to cover 3i.

3:14And it's not a name I was particularly familiar with before we got into the research process. And as I started to look through, I captured this idea. It's a publicly traded investment vehicle, but there's much more to it. And I thought a good place to start out was just a rough sketch of this business, how they operate, what they do, some things to bring it to life for the listeners that might not be familiar with the name? As you say, 3i is a listed private equity firm, but it's quite different. For a start, its value is dominated by just one investment, which is a European retailer called Action.

3:51For another, it's a private equity firm, which doesn't actually raise private equity funds anymore and invests its own balance sheet, its own money. It's a UK listed company, but its major asset is in continental Europe and not in the UK. And it invests in the US and in Europe as well. So it's one of those investments which is difficult to categorize and perhaps falls between the cracks of different categories. And historically, I think it got overlooked for that reason. But even today, it's a curious beast. Is it an investment company or is it a retailer? I think you captured it well there. I had the action retailer stake as something in mind as a key differentiator.

4:32But I think you pointed to all the different things that make it unique there. And it might be helpful just to go back to the origin story in some way, the history of this business. I think typically investment funds have one key person that was the driving force or a few key players that were the founding fathers of their businesses. What is the backstory to 3i in terms of coming to where they are today? Well, it's got a pretty long and convoluted backstory, But in a way, it's useful because it does explain that it's a difficult to replicate animal. Its origin goes back before the Second World War.

5:06There was a commission set up by the British government called the Macmillan Commission, which was investigating the gap between equity finance and bank finance and the difficulty smaller companies have accessing that. And one of the members of that commission, funnily enough, was John Maynard Keynes, the economist. And they put forward some proposals. A new source of funding was needed for this purpose. And after the war in 1945, what is now 3i was formed. It was originally called the Industrial and Commercial Finance Corporation. The major British banks were instructed to set it up, and that's what they did.

5:38Its initial capital was about 15 million pounds. And over the next few decades, it set up a network of regional offices in the UK. So it's quite a local business, and it really provided capital to smaller and growing companies, often in the form of preference shares. So some hybrid of debt and equity, very long -term capital, placing a large number of bets, fairly patient. And it provided an important source of funding for those companies, but was not particularly dynamic organization. And just so I have the backstory into where we are today in mind, the original funding came from what I assume were the larger banks in England.

6:17And were they equity owners of the business up until that point? Or was there just a funding stake and they removed themselves from there? They provided the equity, the initial capital. And then I think over the ensuing decades, there was a bit of conflict between the banks and this creation which they had put together, a bit of competition and conflict. And that probably made what was then called ICFC slightly more independent and robust. Fast forward to 1983, it was renamed Investors in Industry, which is then shortened to 3III and started to focus on doing buyouts. It floated in 1994 in an IPO.

6:52It had a one and a half billion pound market cap at that point. And then it started to expand. So it started to open a network of overseas offices in Europe, Asia, and America. And it raised its first third party fund in 1994. So over the next couple of decades, it grew. It was investing its own balance sheet as well as third party money. And it was doing more and more deals, larger and larger deals, doing a combination of buyouts, to growth venture capital and infrastructure investing. And then Lehman happened. And 3i found itself in a little difficulty. It had borrowed money on its own balance sheet, as well as investing in leveraged buyouts itself.

7:30And there was too much debt at the holding company and too much debt in the investee companies. And what it found is that it had been investing pro -cyclically. It had been taking on too much debt at the top of the market, and it had been buying companies with too much debt at inflated prices. And that was a major crisis. So the combination of marking down the value of its investments and the leveraged impact of the debt meant that its net asset value halved and had to do a highly dilutive nine for seven rights issue in 2009, which raised about 700 million pounds and really marked the beginning of the reset.

8:04What is a nine for seven? So for every seven shares you own, you have the right to subscribe for nine new shares at a heavily discounted price. American here. Is that a standard practice? Is the nine for seven specific or could it have been a three for two? It could have been any number. But really, what we're saying is this is raising a lot of money relative to its existing capital base and massive dilution to the existing shareholders. So the story really begins in 2011, when the current chief executive, Simon Borrows, arrives at the company. And he sets about implementing some fairly radical change at 3i.

8:42He first of all says, no more fundraising, no more raising of funds for third parties. We've got a balance sheet of our own, and that's what we're going to invest. And the thinking behind that is really interesting. They had a balance sheet. And at the moment, they're trying to invest 750 million pounds a year. So you can invest 750 million pounds a year with the aim of, say, doubling your money over three years. And if you're investing your own money, then that means generating about 250 50 million pounds a year or a 33 % return. Previously, they would have been investing other people's money and getting a carried interest on that of 20 % of the upside.

9:21So that would have worked out about 50 million pounds a year compared with 250 million pounds a year. So a much higher return activity, but actually generating far less profit as it were. And if they have the balance sheet, then that would make a whole load of sense. But beyond that, the decision not to raise funds and invest other people's money had much deeper significance. It took them off the treadmill of pro -cyclical fundraising and investing. So most of their peers find that they're doing most of their deals when the markets are hot, and they're raising most of their money. They're finding it easier to raise money when markets are hot.

9:58Unless you're in the distressed business, you're often finding that that is the case, which makes a lot of sense. especially if you don't manage to control your own tempo and be in control of your timing. So if you're no longer raising funds, you don't have the same pressure to put money to work. And funnily enough, the last couple of years, they've put less money to work than they would normally hope to. You're also making fewer investments so you can ration your capital more effectively and really prioritize the best deals. It really focuses the minds. It meant that 3i didn't have the same pressure to grow.

10:30So having dominated the mid -market area, which it defines as companies with an enterprise value of between 100 million and 500 million pounds, it was able to stay there. And over time, it has seen many of its competitors graduate up from that mid -market area as they want to do more deals and bigger deals because they want to manage more money in bigger funds. And that's taken them away from that relatively less competitive part of the market. So 3i has been able to establish its reputation, be the first port of call so that deals come to it rather than it has to go to them. And it's been able to develop real expertise in that particular area.

11:09So the combination of that has just led to a real focus. And over the last 10 years, they've reduced their number of offices, they've reduced the number of staff, they've reduced the number of sectors they focus on, they've reduced the number of deals they do each year. It's a much simpler business, which has a much clearer idea of what it wants to achieve and how it should achieve it. And when I think of investment vehicles that aren't raising outside funds, that are taking the internal capital and putting it to work, I often associate that with Berkshire Hathaway or what you're seeing become increasingly common in the US, the insurance provider where you have a float of dollars that are coming in that you can then invest.

11:49In the case of 3i, where is the cash being generated to allow for that investment? Is it from the existing investments that they have and whether it's interest payments or some other types of dividends? But what is generating the cash relative to the private equity fund that would have some equity ownership, but not actually see any dollars come in until there's a monetizable event? It all dates back to 1945 and the capital which was originally raised then, supplemented, of course, by the 700 million pounds, which it raised in 2009 in that disastrous rights issue. So 3i was a bit of an anomaly.

12:24It did have a balance sheet, slightly similar to another anomaly, which is a Canadian private equity firm called Onyx, which, funnily enough, was formed by one of the colleagues at Bear Stearns of Henry Kravis and Jerome Kohlberg at KKR called Jerry Schwartz, who, because he was Canadian, went north. And because the Investment Act of 1940 didn't apply in Canada, he ended up forming a vehicle which had a balance sheet as well as managing third -party money. And the idea there was quite neat that the fees which you would generate on third -party funds meant that the public shareholders in the company would get exposure to private equity investments without the drag from fees and carried interest.

13:03That's what 3i was for a while. The model is unstable because there is fundamentally a conflict between alpha generation and growing a business. And I think 3i has resolved that much more effectively than those companies which want to have the best of both worlds. They want to get the fees from managing third -party money, but they also want to have skin in the game from investing their own balance sheet. So that's where the money came from. Incredibly interesting to see how different models have emerged. And particularly as it feels like, especially in the US, asset managers becoming publicly traded entities has become more common.

13:35And different strategies that you're seeing it. And interesting to hear some of the origin stories to all of these. as they have shifted focus, isolated, and started to focus just on their own internal capital. You mentioned a little bit about doing less investments, and we're going to get into action shortly. But when you think about the strategy, it sounds like they're still targeting the same size in terms of the companies or the deal sizes that we go after. Has anything changed, whether it's sector -focused or structure, asset class, anything along those lines that has shifted as they've really focused the strategy?

14:09No, I would say simply less is more. It comes back to that there isn't the need to expand beyond what you are good at. So they articulate a number of sectors which they specialize in where they've developed some domain expertise, and that is consumer, healthcare, industrial technology, services, and software. But no, they've simplified the organization. They've taken away the fundraising. Basically, there is an infrastructure business still there. It's slimmed down and therefore easier to manage and fewer things to go wrong. And maybe it's a good time to introduce action. And I think I read that it represents north of 50 % of the asset value.

14:43You can give me the more correct answer on that. But introducing them into this story, when they came to be, how much they represent, and how important of an investment that's been. It picks up a point which I didn't really make when I was talking about the abandoning of raising third -party money. It's that if you're no longer managing third -party funds, you don't have the same need to exit your investments in order to crystallize the fees, the carried interest, return money to shareholders, and get more money off them for the next fund and that sort of thing. So you're breaking that cycle. And you are therefore able, because you're no longer so exit -focused, you're able to let your winners run and really enjoy the benefits of compounding.

15:26So Action today is a much larger company than it was when it was bought in 2011. So when it was bought in 2011, it had 700 million euros of turnover. And that figure is now about 11 billion euros in 2023. So it's a much larger company than it was. It was founded in 1993. 3i and its funds, which it was still managing, bought it in 2011. And today, 3i owns 55 % of it directly. And it still has some old fund investors who continued to own the rest. It's the fastest growing non -food discounter in Europe. It's in 12 countries. And what it sells are relatively small items. Two thirds of its SKUs, its stock keeping units, are priced under two euros.

16:10It has 6 ,000 SKUs, mix of brands and private label. And they're things like decoration, DIY, garden, multimedia, sports, stationery, toys, a bit of food and drink, laundry and cleaning, personal care and pet products. So a pretty wide range of things. It introduces 150 SKUs to those 6 ,000 each week. So only 33 % of the product range is fixed. So it's all about changing assortment and very low prices. So in each country it operates in, because it's so large, it has the benefits of scale. It's one of those companies which believes that scale economies shared, But its competitors are about 50 % more expensive on comparable products than it is, which gives it a massive advantage and means that its like -for -like growth, as it were, is much higher than it should be.

17:02And it creates the classic moat around it, which is widening. You talked about the staggering growth just in terms of the turnover. 700 million to 11 billion is quite a number. In terms of the portfolio for 3i, how has that changed over time? I assume it was a normal -sized position when they made the investment. How much does it represent today of the 3i business? It's got a value on 3i's balance sheet, which is updated each quarter or each half year, of about £14 billion. And that is in the context of 3i's overall private equity investments on its balance sheet, which are valued at £20 billion.

17:40There are a few other things. So 3i's total investments are about £22 billion. So it's a big chunk. It's over two -thirds of 3i's private equity portfolio. So that's a real vindication of giving up the fundraising. And I think at some stage, Warren Buffett said the best holding period is forever. So 3i was fairly clever in resisting the need to exit action. And when the fund in which an investment came to the end of its life, it engineered a restructuring, which allowed 3i to stay on. And those fund investors who wanted to get out could, and others could stay on themselves. And as an investor, when you think about the business, how much of your time is spent thinking about 3i, the performance of the overall business versus how much of your time is spent thinking about action and the performance of that?

18:29Just trying to separate to your earliest point about how unique of an entity this is and how you can view it many different ways. It certainly seems like the most important segment in a traditional operating business, but how do you frame that from your perspective as an investor? That's a great question. And really, we think about it in two ways simultaneously. On the one hand, we really like the way that 3i is different from other private equity investors, most of whom we wouldn't touch at all. We don't believe that the alignment of interest is there, that minority shareholders are respected, and so on.

19:04But we really like what 3i has done in terms of thinking differently, trying to be counter -cyclical rather than pro -cyclical, and really thinking about the returns it's generating as a multiple of money rather than in terms of IRR, because that's far more significant. And if you can let your winners run and if you can continue to allocate capital to companies you're already familiar with, which you have control of, where you have strong governance, where you can control the capital structure, then that's far more attractive. So we continue to speak to 3i and think about those structures and behavioral features, which should make for an interesting investment.

19:41And then at the same time, we observe the progress of action and how it is one of a kind itself, action. These opportunities don't come along so frequently. But I think if you do the right thing, you're increasing the likelihood that the multi -bagger investments are going to become available to you. And we can talk about other investments in the free -eye portfolio later. But action is similar to, let's say, Costco. I've mentioned scale economies shared, using scale and price to create a flywheel, which is a reinforcing competitive advantage, is incredibly powerful and rare. The other thing is because retail is a negative working capital business, these companies don't require so much outside capital in order to grow and to develop.

20:25And that means that as public shareholders, we're often denied the opportunity to get exposure to them. If you look at the great supermarkets, often they're family businesses, which only come to the stock market once they've gone ex -growth and are mature, and the equity market is simply an exit for them rather than a source of capital. So we keep our eyes open for other growth retailers, which we can get hold of. And often they are in a wrapper such as 3i. Another example would be the pan -European fashion retailer called Primark, which is part of a much larger conglomerate called Associated British Foods.

20:59So it's really exciting having the opportunity to get exposure to such a fast -growing retailer. Because the combination of the like -for -like growth, which is higher than GDP growth because of the pricing advantage it has and the pricing offer it gives to its consumers, the combination of the like -for -like growth with the store growth for the last 12 years, action has entered 12 different European countries at the rate of one country a year. It means that you are getting fairly compelling overall top -line growth of about 20 % give or take. And then that obviously with leverage comes down to a higher EBITDA growth line.

21:34Your point on these being hard to find, I think is so incredibly interesting, where oftentimes these fast growing businesses, you never get an opportunity to own them until their X growth and the public markets are just that monetization event or exit event. And what is particularly unique here is you do find them in wrappers, but it's rare that you find them in a wrapper where they represent such a large percentage of that wrapper. Oftentimes, I feel like, oh, you can have exposure to this, but it might only be 10 % to 20 % of the business. So it's particularly interesting here. On the cash generation or just the uniqueness of the model, has Action distributed capital back up to 3i via its ownership?

22:17Or is all of those dollars that they've generated just gotten reinvested into the Action business? That's a great question. And the answer is yes, it has. The payback on a new store is currently about eight to nine months, which is incredible. They've got an amazing team, which is able to, I think they rolled out 330 new stores last year, and that figure goes up each year. I think this year, they're going to be entering two new countries for the first time. So the pace of growth continues to be sustained, and they get more and more efficient and better and better at And then that creates the scale which they can feed back into the prices because operating on a pan -European rather than a purely national stage just means they're that much bigger and the opportunity is that much greater.

22:59And what's really exciting is I think they've got around 2 ,600 stores at the moment. But the sort of white space in Europe alone is probably 4 ,700 stores, they say. So that's really exciting as well in terms of the runway for future growth. But answering your question about money, 3i invested about 106 million pounds in action in 2011. And since then, it's received back 2 .9 billion pounds. So that's 25 times what it put in. And the value of its investment, which remains on the balance sheet is 14 billion pounds. So that's a return of over 100 times the original investment. So that's truly phenomenal.

23:39It's partly because it keeps re -leveraging action. So action borrows on its own balance sheet and then dividends that back to its shareholders. So there's a degree of leverage there, but it's been phenomenal. There's a beautiful moment in compounding when you start receiving back the total amount of capital or more than the capital that you put in on some type of annual basis, where you're just receiving that initial investment. And they have gone well past that, well beyond that here. You mentioned there's still quite a bit of runway here, just the math of the amount of white space in the stores you have years into the future.

24:15Does the management team ever talk about the endpoint where they think, even if it's 10 years down the line, that they might hit a maturation point or a steady state point where the growth slows down? Is that something that ever gets discussed or ever comes up even from the shareholder side of things? We ask that question, but I think it is a long way off. So there is a lot to go for in the meantime. 3i has recently mentioned potential expansion opportunities in other continents, which we're a little skeptical about. But you can imagine potentially an opportunity in the US exploiting the gap between the dollar stores and the Walmarts.

24:53and if you were to bring over into the US the phenomenal value proposition which action represents, then the dollar stores could be quite an attractive price umbrella to compete against for more frequent everyday purchases. So I think they're looking at doing a pilot in the US with a distribution center in a certain number of stores and it'd be interesting to see how that goes. But I think we all know that the US has been a graveyard for European retailers coming over the Atlantic. So let's not get carried away. Every continent has its nuances. Every country has its nuances. We know that well ourselves, as there's plenty of US companies that have tried to expand abroad and has not quite worked to their liking.