Is 3i Group a good bet for piece of the Action?

3i Group is one of the best performing names in the FTSE 100, with the private equity group returning more than 250 per cent in the past five years alone. But much of this success has come down to just one phenomenal investment: the Dutch discount retailer, Action.
In 2011, 3i invested €279 million (£233 million) in the business. Just over a decade later, 3i values its 57.6 per cent stake in Action at £14.8 billion, implying a total market value bigger than the likes of Tesco, the London Stock Exchange’s biggest listed retailer.
But 3i’s high concentration in Action has drawn the attention of short-seller ShadowFall Capital & Research, with The Sunday Times revealing that it has taken out a multimillion-pound bet against the FTSE 100 business.
ShadowFall, which rose to prominence for its role in exposing fraud at the German payment processor Wirecard, argues that 3i investors have failed to appreciate the extent to which Action’s margins have been boosted by inflation, which is now falling back to normal levels. The hedge fund has also questioned 3i’s valuation of Action in its books, at 18.5 times underlying profits, with the average valuation of rival listed companies closer to 14.4 times. So should 3i investors be worried?
Headquartered in the Netherlands, Action started out in 1993, eventually spreading to parts of Belgium, Luxembourg and Germany before 3i took control in 2011. The group pushed its expansion into France, Austria, Poland, Italy, the Czech Republic and Slovakia. Now the chain sells to millions of customers a week.
Part of the premium on Action is because of its sheer size. Its implied market cap is larger than London’s biggest listed supermarket, Tesco, and more than five times the size of the discounter B&M European Value Retail, its closest peer in the FTSE 100.
Action uses a discounter strategy of stocking a tightly managed mix of small homeware goods, long-life groceries and seasonal lines on rotation. All its stores have a very similar physical format, and the company uses its huge international scale to bulk-buy various goods.
This is not a unique business model, but it is Action’s size that sets it apart. It had 2,608 stores across 12 eurozone countries at the end of its financial year in March. The group claimed at an investor day earlier this year that its ability to buy locally and sell globally meant its products were typically 40 per cent cheaper than domestic competition.
3i places Action at 18.5 times adjusted cash profits. But compare this with B&M and the Polish owner of Poundland, Pepco, which trade at multiples of seven and six respectively. The American discounter Dollar General trades at a multiple of 12.
In this light, Action’s valuation does not look so unreasonable, especially given its impressive rate of growth. For the quarter ended in June, its year-on-year run-rate growth for adjusted cash profits was 24 per cent. Like-for-like sales growth is strong, at 9 per cent in the first half, and the company is expanding at speed: Action added 119 new stores in the period, on track to meet its target of 330 by the end of this year.
3i was created by the Bank of England and high street banks in 1945 to provide equity capital to small British businesses, but it has evolved into a private equity and infrastructure specialist, backing private companies outside the UK, mostly in Europe and North America.
Traditionally, private equity funds aim to buy assets, improve them over five to seven years and then return the money back to investors with a profit. 3i has stuck with Action for an unusually long time, with its concentration in its portfolio steadily growing from less than 10 per cent in 2013 to just over 60 per cent today. Simon Borrows, 3i’s chief executive, has previously insisted that shareholders are happy with this level of concentration, but this may be tested as the years go on: analysts at the broker RBC Capital Markets expect Action to make up 70 per cent of 3i’s investment portfolio by 2026.
Action is a private company, so the only way for ordinary investors to gain access to it is via 3i. The group, which is technically an investment company, is trading at a demanding 55 per cent premium to the net asset value of the portfolio. Excluding 3i, London’s other investment companies trade at an average 14 per cent discount to their NAV.
The price tag on 3i shares is huge, though the portfolio excluding Action seems fairly pedestrian. Behind Action, its second biggest investment was a 30 per cent holding in the listed 3i Infrastructure fund at £879 million, followed by a £586 million stake in Cirtec Medical, a medical device manufacturing business.
Short interest in 3i still remains low, at under 1 per cent of its stock. The shares did slip 3 per cent on Monday morning, though more detail may yet emerge around the logic behind ShadowFall’s bet against the stock.
At the very least the saga should serve as a reminder to shareholders that 3i’s enormous position in Action means its shares have effectively turned into a proxy for the Dutch retailer. 3i has become so lopsided that it has little in common with the more traditional investment trusts listed on London’s market.
Action is a nice problem to have, and 3i is more broadly supported by £1 billion in liquidity, relatively low gearing and some other steady compounders in the portfolio. But its unusually high allocation to a single company means a misstep at Action could knock 3i shares off course. This is an uncomfortable truth that investors must be mindful of, especially given that despite its impressive track record and size, Action cannot lay claim to any particularly wide moat to guarantee its growth in new markets. Since this column rated the stock as a buy in May last year, the shares have delivered a total return of 88 per cent. While 3i has no discernible exit strategy from Action, and its concentration continues on its steady upwards trajectory, investors may be minded to start taking some profits.
Advice HoldWhy Concentration risk is becoming too big to ignore