QD view – Growth capital – fast-growing companies at compelling prices?

It has been a tough year for the investment companies in the growth capital sector. By Cherry Reynard

 
Valuations were hit hard by rising interest rates and widespread risk aversion among investors. The sector now offers some apparently attractive discounts to net asset value, but this depends on the continued strength of the underlying companies. Are the early stage companies that form the core of these portfolios struggling? Or is this an opportunity to pick up fast-growing companies at compelling prices?

The discounts to NAV remain significant. Within the growth capital sector, Chrysalis is at a discount of 49%, Schroder British Opportunities is at 32%, while the Baillie Gifford-run Schiehallion Fund is at 24%. The popular Edinburgh Worldwide Investment Trust (which sits in the Global Smaller Companies sector) is trading at a 17.7% discount.
 

Weakness follows exuberance

 
Undoubtedly, this reflects some weak fund performance. There was some exuberance in pricing during the pandemic, as investors over-extrapolated pandemic growth trends into the future. The subsequent adjustment has been painful. Of all of the AIC’s sectors, growth capital has been the worst-performing over the past 12 months, with an average fall of 36%.

It also reflects some scepticism among investors about the valuations placed on the underlying holdings. Unlisted companies do not have daily valuations in the same way as listed companies do. While all companies will be independently valued, the methods can vary. Nick Williamson, co-manager of the Chrysalis Investments, says: “What we are seeing is that investors are looking at these companies and trying to work out whether the NAVs are real.”

The primary driver of this weakness has been higher interest rates. Bill Chater, client services manager on the Edinburgh Worldwide Investment Trust, says: “For early-stage companies, the bulk of their earnings are several years in the future. That’s what makes them interesting. As such, they are more exposed when interest rates rise – that is just the mechanics of mapping present value to future cash flows.”
 

Operational performance

 
In general, Chater says, companies within the Edinburgh Worldwide portfolio are not exhibiting distress, in spite of this share price weakness. “On an operational level, we’re pleased with what we’re seeing, though there has been some battening down of the hatches. Companies are assessing employee numbers, shoring up their balance sheets, paying down debt.”

In theory, this type of growth company shouldn’t be cyclical. In general, managers are looking to tap into significant global trends, such as electrification, demographic change or healthcare improvements. Chater says: “The common theme in our portfolio is disruption, achieved through the novel use of technology and innovation.” He says they like to find businesses with real ambition, tackling those problems that are hardest to solve. That includes businesses such as Space-X, Elon Musk’s space exploration business, and PsiQuantum, a US developer of Quantum computers.

Even where companies have cyclical qualities – Williamson gives the example of buy-now, pay-later group Klarna – most still get a boost from the secular tailwinds. He says that Klarna has seen some slowdown in its growth rate, but is still disruptive and still outpacing similar businesses. Also, some of the more apocalyptic predictions of credit losses haven’t happened.

Williamson says the recent disruption has improved the focus of many companies on profitability over sales growth: “Until recently, everyone was just looking for growth. Companies were given money to expand as quickly as possible. There was a change of tack early on in 2022. Companies started to take a much more balanced approach to achieving profitability. In March 2022, around 40% of our portfolio was profitable. Today, it is around 70%. So behaviour has altered, but generally for the better.”
 

A tougher climate

 
However, smaller companies cannot be immune to considerations around the funding and investment climate. For companies selling enterprise software, for example, the impulse among enterprises to digitise and make their businesses more efficient will not go away, but they may defer spending decisions in a tougher climate. Chater says he sees companies taking longer over the sales cycle or adding another level into the decision-making process.

There have been some sectors that have been able to sidestep these challenges. Chater cites healthcare, which forms a large proportion of the Edinburgh Worldwide portfolio: “People want the best treatment possible and the highest quality outcome regardless of the economic outlook.”

As to whether the valuation adjustment has been made in full, Williamson says it very much depends on the individual trust, the level of the discount, the valuation policy and the underlying companies. He says: “The market will often shoot first and then work through the detritus. There is a spectrum of how managers are valuing their holdings across the sector.” He believes that when companies come back to the market for funding, valuations will become clearer. At that point, investors may start to differentiate more between high and lower quality businesses.
 

More choices for investment managers?

 
A final question is whether the weakness in valuations and share price for growth capital companies has created more choice for fund managers. Chater says it has: companies that the team researched in 2020 and 2021, when valuations were high, look like a more realistic investment prospect now prices have dropped. He gives the example of companies such as Twist Bioscience or Fiver that have come into the portfolio more recently.

It is worth noting that the growth profile of the various trusts will be different. Chrysalis, for example, invests in late-stage private businesses. By and large, the managers aren’t taking a risk on whether the technology will work, but on whether the business can scale-up effectively. Others are closer to VCTs, investing in less mature companies where there is more start-up risk, while companies such as Edinburgh Worldwide has around 20% unlisted and 80% listed, providing ‘crossover’ capital as companies grow.
 

Exciting subsector at a far more compelling valuation

 
This remains an exciting part of the market and a means to get access to the next generation of fast-growing companies. Today, valuations look far more compelling than they did 12 months ago, without a meaningful change in the operational profile of the companies themselves. This would seem an opportune moment to reexamine the sector, but with the caveat that not all investment companies have made sufficient adjustments to their valuations, and there is some refinancing risk coming down the line for the underlying holdings.
 

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