“Growing businesses are investing heavily in their futures, thus the denominator of their near-term valuation multiples is necessarily understated, while the implied cost of capital is highly sensitive to near-term changes in rates.
“We think it is better to model out the full revenue and margin potential of the business and then assume that a more normalised cost of capital will eventually reassert itself in the future.”
Westwood says given where we are in the markets, it is arguably very difficult to value companies at the moment,
“More recently any investment linked to innovation has tended to generate excitement and quite high expectations - think Bitcoin, AI etc,” Westwood adds. "Ultimately these companies will impact our lives and the economy significantly so it’s important to consider how we measure their value.
“Clearly multiple scenarios should be looked at to see the impact on business assets and cash flow. For newer businesses this will prove to be more difficult and it’s not an exact science, but the bottom line is that we should be really interested in the profitability of the investment.”
Cash strapped?
Another key factor to consider when investing in innovation funds is liquidity.
As liquidity is a crucial concern when investing in smaller and particularly private businesses, investment managers say it is vital that investors take a long-term view and are willing to tie up their money for several years.
Meanwhile, funds investing in larger, publicly listed companies should be more liquid – but as with any investment and stock market investment, it is a good idea not to invest money that will be needed within at least five years of making that investment.
Fund managers also have liquidity tools available for them to use, which are particularly helpful during times of stress.
Westwood says: “Investing in private businesses will be less liquid so if a fund has a high level of exposure, be mindful of this.
“Listed smaller cap names may also struggle if trading volumes are too high. Overall it’s critical for investors to understand the liquidity terms before investing and be aware of what factors may force a fund to suspend trading.”
Curtis says: “The liquidity of an investment should always be a consideration for the manager, especially as the strategy grows. That said, many of these [innovation fund] strategies are focused on the information technology and communication services sectors, which are some of the most liquid parts of the market.
“In addition, as innovation becomes a core tenet of every business' growth strategy, good investment managers should be able to find highly liquid investment opportunities in more sectors.... the innovation opportunity is very large and offers above-market growth and leverage potential for many years to come."
