Taming Unicorns: The Chaotic World of Mutual Fund Valuation

Wednesday, November 20, 2019

Over the last two decades, public and private equity markets have changed dramatically. For instance, the total number of publicly listed firms decreased from more than 7500 in 1997 to approximately 3500 in 2018. This precipitous decline can be attributed to a corresponding sharp drop in the number of IPOs. For example, 711 firms went public in 1996, while only 239 did in 2018. And firms that do go public are taking longer. In 1996, the median firm age at IPO was four years, while the median firm going public in 2018 was 10 years old.1 Private capital markets have disrupted the way firms finance themselves, and companies are staying private longer and entering the public markets already at large-cap stage. This has huge implications for investors who now find it hard to access high-growth small companies and gain exposure to the returns (and risks) of those companies during the early stage of their life cycle. While some large institutional investors (e.g., endowments) or high net worth individuals have enjoyed the juicy returns of venture capital funds investing in early stage and startup companies, most investors have watched from the sidelines. Recent trends in pre-IPO participation rates by mutual funds depict a different story, though.

Mutual fund managers have started investing in private companies to reap the benefits of their stellar growth before they go public (and even if they never do so). Given the illiquid nature of investments in private firms, this leads to potential conflicts of interest between investors and fund managers, and among investors. The research paper, “Private company valuation by mutual funds,” coauthored by professors Vikas Agarwal (Georgia State University), Brad M. Barber (University of California, Davis), Si Cheng (Chinese University of Hong Kong), Allaudeen Hameed (National University of Singapore) and Ayako Yasuda (University of California, Davis), looks at exactly this issue. Using data from SEC mutual fund N-CSR and N-Q filings, the authors ask three important questions. First, do mutual funds report different simultaneous prices for the same-round private security and how are prices updated? Second, are there abnormal returns on funds around private firms’ follow-on rounds and do investors trade? And third, do mutual fund families strategically manage private security valuations?

The authors find that there is substantial variation in the valuation of private companies across mutual fund families. This can be as large as 25.6%. For example, the Series-G round for WeWork was valued at $41 billion, $30 billion, and $25 billion by different fund managers during the same quarterly report. Given the stale pricing of private holding, the authors find positive abnormal returns around follow-on rounds. Investors could strategically trade in the mutual fund around follow-on rounds (and make money on average, at least in the 2010-2016 period). However, the authors do not find statistically significant evidence for this. Finally, the evidence seems to point to mutual fund families managing private companies’ valuations, especially so for managers near the top of their cohort to attract future flows of money into the fund.

What are the implications for the global asset management industry going forward? The first big overarching question necessarily deals with the risk-return profile of private investments over the last decade. While many unicorns have performed well, some recent examples have shaken the industry. For example, Softbank Vision Fund I cut its investment in WeWork by 74% in November 2019, from $29.6 billion to $7.8 billion (Source: Softbank). Similarly, Altria, which paid $12.8 billion for a 35% stake in e-cigarette maker JUUL, slashed the value of its shares by $4.5 billion after increased regulatory scrutiny by the FDA (Source: Altria).

Second, mutual funds will have to rethink the risk-return trade-offs inherent in private investments going forward. Recent drawdowns suggest a great deal of downside risk which mutual funds might have not been aware of during the short 2010-2016 time period. This has real implications for investors looking to gain exposure to private markets via investments in mutual funds. Given that the SEC limits investment in private companies to 15% of total assets, and many mutual funds have allocations in the 2-3% range, exposures to illiquidity risks seem small. However, we have been experiencing the longest bull market to date. Whether holdings of private investments in mutual funds complicate the portfolio management process during a large and protracted market downturn is yet to be tested.

Do mutual funds time the mark-ups and markdowns of their investments in private firms? As the paper suggests, valuations of private companies can differ substantially depending on whom you ask. As recent examples suggest (e.g., WeWork), valuations are extremely sensitive to the exact date the valuation takes place and the methodology. One day a private company might be part of the Fortune 500, the next day it could be worth nothing, without observing any meaningful external price signals. But do mutual funds take advantage of this price opacity to manage valuations? It appears they do. Recent examples of markdowns and a few more quarters of filings will shed new light on some of the practices at mutual fund families. For instance, with the large recent swings in valuations, we will see if different mutual funds smooth valuations of their private stakes in a way that could benefit them.

Overall, we should expect that the issues with private companies in mutual fund portfolios will continue to grow in importance. Absent a widely held notion of best practices, funds will continue to follow different approaches that may or may not be in the best interests of fund investors. Ironically, it is unclear if the increased awareness will be good or bad. If shedding light on the subject pushes funds towards a shared (rational) model, investors may benefit. If, instead, informed investors learn how to game the valuations, it will create risks for uninformed investors and fund managers.

1 IPO Data