Make sure that when you are running SP3 setup, on the first screen titled "Computer Name", you select "Local Computer" (By Default, "virtual server" is highlighted as
this is on a cluster). Once you select "Local Computer" and click Next, the screen titled "Instance Name" should list your named instance. I just tried it and it works

Regarding your other qs: "When we check the version of the instance, the numbers are consistant with sp3. Should we be concerned about the instance not having sp3
installed directly?"

Ans. If you haven't applied SP3 for your named instance then your SQL named instance version should be RTM (i.e.build no -- 8.00.194). What are you doing to check
the version of the instance?

Try this:

Connect to the named instance using Query Analyzer and run the following command
select @@version

--If you haven't applied SP3/SP3a to this instance then you should get the build no as 8.00.194.

Connect to your virtual SQL Server instance using Query Analyzer and run the same command. If SP3/SP3a is installed, you will see the build no as
8.00.760

HOW TO: Identify Your SQL Server Service Pack Version and Edition
http://support.microsoft.com/?id=321185

HTH,

Best Regards,

Uttam Parui
Microsoft Corporation

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