What to look for when investing in an innovation fund?

The pandemic had an enormous impact on all facets of society, but amid the chaos that once-in-a-lifetime event was a catalyst for the rise in both client interest in the next generation of big ideas, and in the paceat which companiesare bringing those ideas to market. 

Jonathan Curtis, senior vice president - director of portfolio management of Franklin Equity Group at Franklin Templeton, says as a result of Covid-19, companies, governments, consumers, and healthcare providers were forced to significantly increase their digital acumen and innovation cycles to navigate what was a difficult time.

Curtis adds: “We believe companies, governments, and healthcare providers are in the early days of learning how to use technology-based innovation to better understand their customers, business processes, and patients and then technology-based innovations to radically transform how their businesses, industries, and practices operate and provide care.

“Within this opportunity we are looking for new opportunities across artificial intelligence, cloud computing, fintech, digital media transformation, energy transformation, the Internet of Things, and the life sciences.”

So for those investing in innovation funds, what should their approach be in a higher rate environment and how important are valuations and liquidity?

Nicholas Hyett, investment analyst at Wealth Club opines, funds with innovation in the name usually fall into three broad categories: those backing small, often private businesses, private equity funds backing larger but fast-growing businesses, and mainstream funds backing larger growth businesses listed on the stock market.

The category could include mainstream stock market funds, specialist venture capital funds like venture capital trusts, and earlier-stage private equity funds.

While funds branded as innovation often specialise in a particular sector – with technology, healthcare and biotech being particularly popular. 

Meanwhile, there are broader funds that try to avoid tying themselves to particular sectors.

According to Hyett, funds in this space typically back businesses whose products or technologies that are heavy on promise and lighter on profit -and so are at the riskier end of the spectrum. 

He adds: “As part of a well-diversified portfolio, innovation funds have the potential to enhance returns. Tax efficient innovation funds, like VCTs and EIS funds, offer tax reliefs as well, helping to mitigate the risks and maximise potential upside.”

Many funds which are branded as innovative have only really existed in a world of low interest rates, finding a product that can also perform in a higehr rates world is likely to be a trickier prospect. 

When trying to do this, Franklin Templeton's Curtis places a premium on finding funds run by people whose track-record is longer than just the past decade. 

Sophie Westwood, associate director in the investment management team at Evelyn Partners says the technology investments which have performed best over the past year are those which are more mature, and so less susceptible to higher interest rates. 

Westwood says: “Rates have been low for a very long time but last year provided us with a good opportunity to see how the funds react during stressful periods. As expected, many were volatile but frankly, some volatility should be expected as businesses can develop rapidly.”

Clare Pleydell-Bouverie, a deputy fund manager within the global innovation team at Liontrust says, despite innovative companies’ valuations being hit last year as they adjusted to the increase in rates, with rate hikes now potentially coming closer to an end, innovative companies’ stocks are winning again and she expects them “to win in the years ahead no matter if rates stay high”. 

“This is because a persistently higher level of interest rates simply means that the qualities of truly innovative companies – the ability to grow strongly and drive high returns on invested capital – become even more important,” Pleydell-Bouverie adds. 

“The problems sit with the capital intensive zombie companies on the wrong side of innovation who can no longer pile on debt to stay in the race.”

A capital intensive compny is one which constantly requires new funding, in a higher rates environment this funding becomes harder to obtain. Many market participants take the view that a zombie company is one which has been able to survive due to low debt repayment costs in recent years, but doesn't really generate any profit. In a higher rates world, such companies may not be able to repay their debts. 

Likewise, Hyett notes that in a rising interest rate environment profits in the distant future are given a lower valuation today and so it is harder for young companies to raise capital - hitting the value of innovation focussed investments in the short term, with unprofitable and capital-hungry companies hit hardest.

He adds: “Funds investing in more established, revenue-generating and ideally profitable businesses are better placed when rates are rising.

“As company valuations fall in the start-up and venture space, this results in stronger returns over the longer term for investors willing and able to ride out short term volatility.”

Valuation discipline? 

So, how should investors think about valuations when investing in innovative companies?

The primary valuation tool used by Franklin Templton is a multi-scenario, multi-year discounted cash flow model, which Curtis says is useful because “it demands they think about the long-term potential of the business in a normalized cost of capital environment”.  

He adds: “While we do look at near-term valuation multiples as we seek to understand overall market sentiment, we believe near-term multiples are inapt in evaluating the intrinsic value of a growing and investing business in rapidly changing cost of capital environment.  

“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."

Pleydell-Bouverie adds: “There’s a misconception that innovation is all about flashy start-ups. It isn’t. Innovators are the best companies in their industries driving the world forward. All portfolios should have exposure to innovation because ignoring it is betting against it.”

Ima Jackson-Obot is deputy features editor at FTAdviser