Valuing an idea - do scale benefits apply in IP?

These companies also offer investors diversification benefits by both geography and sector, while facilitating exposure to potentially lucrative early-stage biotech and technology sectors, without the specific risk attached to investments in individual companies. In theory, this pooling of risk should improve on the back of consolidation within the sector. That's where the IP commercialisation market could be headed, if IP Group has its way. Oxford-based IP Group's £466m all-share offer for Touchstone Innovations is being made in the hope of creating an "international leader in IP commercialisation and a combined business with substantial capabilities that is greater than the sum of the two parts", according to IP Group.

Touchstone shareholders will receive 2.1575 new shares for each Touchstone share, providing them with an aggregate 33 per cent stake in the enlarged group. This values the target company's shares at 289p each - below the 295p price at which they were trading the day before the offer. Touchstone's management has rejected the bid, calling it an "unwelcome hostile takeover offer". It argues that the bid undervalues the business and does not reflect the breadth and diversity of the portfolio it has built up. But despite the lack of any premium, IP's offer has gained support from three of Touchstone's largest shareholders by market value - Woodford Investment Management, Invesco and Lansdowne Partners - which represent an aggregate 50 per cent shareholding. IP has indicated that if it gains at least 75 per cent of acceptances it will seek to cancel Touchstone's Aim trading.

How diversified is the basket?

With the market already dominated by a relatively small numbers of players, further concentration will do little to expand the sources of IP funding for newer companies and start-ups. Nor will it necessarily enhance the creation of joint ventures, collaborative research and development, licensing - or, indeed, the sale of intellectual capital. Though arguably beneficial from a risk perspective, are there any other prospective benefits for those wanting to invest in early-stage technology?

A merger between IP and Touchstone could well increase the combined entity's access to novel technologies from a broader range of universities. Touchstone certainly isn't coming to the table empty-handed. It has longstanding links with the 'golden triangle' universities in Oxford, Cambridge and London, including the tech-focused Imperial College. Meanwhile IP Group recently increased its exposure to the US market by signing agreements with the University of Washington and Johns Hopkins University, the latter one of the country's leading private research institutes. What's more, management recently carried out a £200m placing to fund its expansion into Australasia.

Despite the promise afforded by increased scale, Julie Simmonds, an analyst at broker Panmure Gordon, thinks companies with large portfolios of early-stage investments may not offer quite the level of diversification that you might intuitively assume. Because in early-stage development, these types of businesses "are really immature in the lifecycle", so the bulk of the net asset value within a given portfolio is predicated on established technologies. As a consequence, "you're making a bet on these later-stage companies rather than the diversification that you're trying to buy into", she argues.

IP Group's investments are split by maturity between its focus, development and early-stage segments. However, its 20 per cent stake in Oxford Nanopore accounted for 40 per cent of the fair value of the group's portfolio at the end of December. The balance of Touchstone's portfolio is more evenly balanced, although its top three investments - out of a total 112 - still constitute 30 per cent of its net portfolio value. Admittedly, the group has increased the proportion of companies receiving a higher level of funding. Five years ago just three companies received more than £5m in funding, while 19 companies received this level of investment last year. Management also expects cash realisations to be higher during the current financial year, as the portfolio continues to mature.

An unpredictable investment

Given the proportion of companies yet to generate revenue within the groups' respective portfolios, paying too much attention to the statutory sales and pre-tax profit figures can be a futile exercise. Anyone that observed the extreme share price fall suffered by Allied Minds earlier this year will understand the impact newsflow has on a company's fortunes. Instead, more focus should be placed on the fair value of the investment portfolio when valuing these companies. Shareholder dilution is another factor to take on board. Capital raisings are not uncommon, with additional cash needed to bring investments to commercialisation.

IC VIEW: Prior to the share price falls at the start of this year, the sector had become expensive, with all the main players trading at a premium to their net present values. Therefore the decline in share price could be viewed as more of a correction. The extent of these premiums have differed significantly, which is perhaps surprising given the degree of overlap in thematic investments, despite some differences in geographical exposure. There's no point in pretending that these types of investments don't entail a high risk premium, although it is possible for companies in this space to mitigate this through diversification by product, service or geography.