The structural mismatch between unicorns and mutual funds: James Saft

(Reuters) - Mutual funds which invest in billion-dollar-plus “unicorn” private companies sacrifice control and shareholder protection for liquidity, according to a new study.

In other words, the inherent mismatch between the mutual fund structure, where investors can get their money back at any time, and illiquid private firms requires that mutual fund holders sign on for substantial and often negative tradeoffs.

So-called unicorns, private firms with valuations over $1 billion, have seen surging investment from mutual funds in recent years.

Not only have huge firms like BlackRock and Fidelity Investments taken positions in firms like Uber but more than 250 mutual funds now hold positions of more than $10 billion, according to the study. Mutual funds now participate in about 40 percent of all funding rounds for unicorns.

By examining certificates of incorporation, the study was able to get granular information on the contractual details of mutual funds’ stakes in unicorns.

“Specifically, we find that mutual-fund-participating investment rounds are associated with both fewer cash-flow rights and fewer control/voting rights across many dimensions,” Sergey Chernenko of Ohio State University, Josh Lerner of Harvard University and Yao Zeng of the University of Washington write. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2897254)

“For instance, mutual funds are more likely to use straight convertible preferred stock, which is associated with weaker indirect incentive provisions, than participating preferred stock that is popular among (venture capital funds).”

Mutual funds also have light representation on boards of directors, giving them an underpowered say in unicorn strategy as compared to other investors.

The study looked at U.S. private companies valued at $1 billion or more via investment rounds between January 2012 and June 2016, or about 100 firms at the end of the period. Among the funds that invest in unicorns, their holdings now equal more than 1 percent of their overall portfolios.

It isn’t as if mutual funds are giving up voting and cash flow rights for nothing. The funding rounds they participate in are more likely to be more liquid, often featuring convertible preferred stocks which can be easier for mutual funds to offload. They also have fewer “pay-to-play” provisions, which can lock investors into involuntary future capital-raising rounds. Having a potential future call on capital is a problem for an open-ended mutual fund.

TRADEOFFS

The implication of the findings is that mutual funds are getting a bit more liquidity in their unicorn investments but doing it at the cost of rights to cash flow and their ability to influence the firms. Depending on the value you place on liquidity, this implies that mutual funds are getting a potentially less profitable, secure and manageable asset in their unicorn stakes than other investors like venture capital funds.

What this doesn’t show is that mutual funds’ stakes in unicorns are poor investments, individually or in aggregate. They may well be better bets than their other non-private investment options. It must be said, however, that if you were designing from scratch a vehicle to invest in unicorn-type private firms it would look very little like an open-ended mutual fund. Having to be able to meet redemptions on short notice is a serious disadvantage for private investment, which is why venture capital funds require investors to make long-term commitments.

For that matter mutual funds are less well staffed to provide the kind of granular guidance that unicorns need from directors, so in that respect having fewer mutual fund directors may be better for both the companies and their investors.

Usually when there is illiquidity in an investment there will be, at least in theory, extra compensation. That should be especially true for investors like mutual funds, who need to be able to fund redemptions at the whim of investors. Yet unicorns, due to the perception of fast growth, are being besieged with offers of capital. It is also true that as the valuations of unicorns grow the bid from venture capital funds seems to be, worryingly, falling away.

“Mutual funds appear to be more interested than VCs in investing in late rounds and hot sectors,” the authors write.

Ultimately for mutual fund stakes in unicorns to pay off we will require many more unicorns to go public. A December survey by Sharespost, a firm which tracks data on private companies, showed that most investors expect 10 or fewer unicorn IPOs in 2017, out of nearly 200. At that rate mutual funds’ preference for liquidity makes sense.

It is far from clear that mutual funds’ foray into private investment will prove wise.

(Editing by James Dalgleish)