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(Reuters)

Mutual Funds Now Believe in Unicorns

Industries Reuters

Some U.S. mutual funds are boosting their performance with relatively big bets on private companies such as Uber and Pinterest, which they have been marking up at a rate far greater than the broad stock market.

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Relied upon by millions of Americans to save for their retirement, mutual funds emphasize that their investments in young tech companies ahead of their initial public offerings are relatively small.

A Reuters analysis of fund filings and other data shows, though, that some have taken a more aggressive approach, boosting the share of these companies to more than 5 percent of assets and awarding them rich valuations that in some cases have helped them beat their benchmarks and peers by a wider margin.

Mutual funds' involvement also helped boost the number of so-called unicorns - private companies valued at $1 billion or more.

These private investments come at a risk, though. Many are young companies that have yet to make a profit. They are also harder to price and to sell than publicly traded stocks.

That could hurt investors in a downturn because fund managers forced to meet investor redemptions may have to sell liquid public companies while marking down the unlisted ones, said Larry Swedroe, director of research at Buckingham Asset Management in St. Louis.

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"Private companies typically trade at significant discounts for that reason," Swedroe said.

In a rising market, though, they help shore up performance. Bets on Uber Technologies and other unlisted companies, for example, helped the Hartford Growth Opportunities Fund deliver a 12.7 percent return in 12 months to Oct. 31 compared with a peer fund average of 5.2 percent, according to Lipper.

The $4.5 billion fund cited Uber among top contributors to performance in its report for fiscal 2015, alongside Amazon.com and Netflix. The ride-services company's valuation in the fund surged 156 percent to $82.5 million, Hartford disclosures show. 

Its pre-IPO stakes accounted for nearly 6 percent of net assets while most of its peers have kept their exposure below 1 percent, fund holdings show. Hartford declined to comment.

Pre-IPO investments can amplify a fund's relative performance because they are not included in a comparison benchmark index and some have far outpaced the stock market.

Fidelity Investments' valuation of Contrafund’s Series E stake in content sharing company Pinterest has tripled to $480 million since an initial investment in October 2013, compared to the S&P 500’s 25 percent rise.

In a statement, Fidelity said such investments were “very small positions in the relatively few Fidelity funds that make such investments.” 

Over the long term, the impact of those stakes on performance may be less significant in a fund as large as the $109 billion Contrafund, than in some smaller peers.

OUTSIZED EFFECT

Mutual fund investments, however, have measurable effect on companies' valuations. Those that received such financing last year saw their valuations more than double over their previous funding round. In contrast, valuations of companies that raised cash without mutual fund investors grew 1.5 times, according to PitchBook, a private equity, M&A and venture capital database.

The Securities and Exchange Commission (SEC) has been asking mutual fund companies how they value their stakes in companies like Uber, Pinterest Inc and Airbnb.

The regulator is worried investors could get hurt in case of a sharp tech downturn, according to two people familiar with the SEC's queries. They were not authorized to speak publicly about the matter.

Pre-IPO investments can have an outsized negative impact when marked down, which happened to startups such as cloud storage firm Dropbox or software startup Zenefits.

Facing a tough challenge from index-tracking funds, actively-managed mutual funds led by Fidelity Investments, BlackRock, T. Rowe Price and Wellington Management, began piling into pre-IPO tech companies in 2014, according to venture capital database CB Insights. 

Their investments helped boost inflows that year to $51 billion, a 14-year high, according to Thomson Reuters data. Since then mutual funds have dialed down their pre-IPO deals after several Silicon Valley companies missed growth targets, even though they took part in a $1.3 billion funding of messaging app Snapchat earlier this year and are buying shares from employees and founders to raise their stakes in companies.

Some funds count Uber, Pinterest and WeWork Companies, among their largest holdings, filings show. For example, Uber is a top 15 holding in the $19 billion Fidelity Blue Chip Growth fund.

At T. Rowe Price, private investments made up about 4 percent of assets of its $16 billion New Horizons Fund at the end of 2015. The asset management firm's spokesman Bill Weeks said individual securities typically represented less than 1 percent of any fund's portfolio, but acknowledged such investments could still pack a punch.

"If, for example, you have 2 percent of a fund in private companies and those holdings go up 50 percent in a flat market, that would add 1 percent of relative performance. It works the same way on the way down."

Pre-IPO investments are assessed by mutual funds valuation committees which look at revenue growth, competition, barriers to entry and what others paid in subsequent funding rounds. Fund managers are excluded from the discussion, but like other employees stand to benefit from mark-ups because management fees tend to rise with the value of assets.

Glenn Booraem, treasurer for Vanguard funds, said outside auditors reviewed valuations of the funds' relatively small private investments.

“It’s more art than science, but our objective every day is to strike a net asset value that represents the fair value of all the assets in the fund.”

Fidelity said its process was “rigorous and thorough" but it declined to comment on individual valuations. Mutual funds must determine a value for their private investments every trading day so a portfolio's overall net asset value can be calculated.

Venture capital firms typically value tech holdings quarterly, but share those valuations only with their limited partners - institutional investors with a greater understanding of the risks involved.

“Who doesn’t think Uber has a great thing going?” said David Kudla, CEO of Mainstay Capital Management, which has $2 billion under management. But many got caught off guard when valuations of firms such as Dropbox or Zenefits get slashed, he said. "There is a lot of risk in these pre IPO investments.”

 

(Editing by Carmel Crimmins and Tomasz Janowski)