Kirsten Grind, October 29, 2015
http://www.wsj.com/articles/mutual-funds-flail-at-valuing-hot-startups-like-uber-1446174018
Millions of Americans own a piece of the hottest private technology companies through their mutual funds. But no one knows what those investments are actually worth.
Consider car-hailing king Uber Technologies Inc., the world’s most highly valued startup. As of June 30, mutual-fund managers at BlackRock Inc. valued the firm’s stake in Uber at $40.02 a share. Hartford Financial Services Group Inc. said $35.67. Fidelity Investments said $33.32.
The differences are a sign of growing danger for individual investors as mutual funds scramble to buy shares in new tech companies before they go public. While getting in early gives those mutual funds a shot at a huge profit if a company takes off, which happened with Facebook Inc. and LinkedIn Corp.
Many funds struggle just to put a value on their private-company shares.
In the stock market, prices rise and fall every day in response to company announcements, economic news and jostling by droves of investors. Private companies rarely talk in detail or disclose financial information, leaving their investors in the dark and on their own to decide how much a stock is worth.
Varying valuations
An analysis by The Wall Street Journal of closely held technology startups worth at least $1 billion found 12 instances where the same company was valued differently by more than one mutual-fund manager on the same date.
The analysis was based on data from research firm Morningstar Inc. on about 90 venture-capital-backed companies tracked by the Journal and Dow Jones VentureSource in a project called “The Billion Dollar Startup Club.”The 12 companies with different prices at different mutual funds included Uber, valued at close to $51 billion in a funding round completed in July, and Dropbox Inc., which was last valued at $10 billion. The share-price gap ranged from a few cents per share to more than twice the stock’s price.
Few mutual-fund firms are willing to discuss their valuation procedures in detail, largely because of competitive concerns, but mutual-fund firms say they follow a rigorous process.
Donna Anderson, who manages global corporate governance for T. Rowe Price Group Inc. says it sometimes feels like “being on a teeter-totter” while the mutual-fund firm is carefully trying to determine the right price.
T. Rowe Price valued the stake held in software startup Cloudera Inc. by the T. Rowe Price Global Technology Fund at $27.83 per share on June 30, 2014. That was roughly twice as high as the valuation by Hartford and Macquarie Group Ltd.’s Delaware Investments on the same day.
Big gaps like that suggest “you’re kind of getting a guess from the fund company,” says Katie Reichart, a senior analyst at Morningstar. Mutual-fund valuations of private companies are “pretty opaque,” she adds. The consequences can be dramatic. In last year’s second quarter, T. Rowe Price slashed its valuation of Peixe Urbano from $7.41 a share to three cents after concluding that the Brazilian online discount retailer was likely to be liquidated.
Instead, Peixe Urbano was acquired by Chinese online search giant Baidu Inc. T. Rowe Price and other mutual-fund firms flip-flopped, increasing their valuation on Peixe Urbano to $2.22 a share. For individual investors, the risks are mushrooming as mutual funds buy more startup stocks than ever. Such stocks are highly appealing to managers whose investment returns have been hurt by abnormally low interest rates and this year’s lackluster stock market. Many of those managers also are struggling to compete with lower-cost mutual funds that track a market index.
Five of the biggest fund firms participated in funding rounds worth a combined $6.1 billion at startup companies last year, up from about $1 billion in 2011, according to data from CB Insights. This year’s total was $8.3 billion as of Sept. 30. Mutual-fund firms typically get their shares in private companies when they participate in funding rounds that are open just to a select group of investors.
Regulators require mutual funds to limit their holdings of “illiquid” securities to no more than 15% of a fund’s assets. Most mutual funds have no more than a tiny percentage of their portfolio in startup stocks. Financial adviser Tim Parker says some of his clients have investments in Fidelity Contrafund. He realized only recently that the giant fund has exposure to Uber.
Mr. Parker says he isn’t sure how the fund’s managers decide what Uber shares are worth. Fidelity Contrafund owned $162.2 million of Uber as of June 30 and has total assets of about $103.4 billion. The mutual fund has made a paper profit of $86.7 million, more than doubling its money since buying Uber shares in June 2014.
“I would hope that they’re not jacking up the price to prices they hope to get one day that are completely unattached to recent history,” says Mr. Parker, a partner at Regency Wealth Management in Ramsey, N.J. A Fidelity spokesman says in a statement that the firm has “a rigorous and thorough fair market valuation process for mutual fund holdings.”
Sean McKee, who audits mutual-fund firms’s private-company valuations for KPMG LLP, says it is impossible for any investor to know how much a company is worth until it goes public.
“Until you get to a point where there’s an IPO, there is no one price,” Mr. McKee says.
Like all mutual-fund managers, those with shares of private technology companies in their portfolio must assign a current value to the securities every day so investors get a clear picture of how much the holdings are worth. Changes can affect the fund’s overall net asset value, or price per share.
But the shortage of information about private technology companies and their tiny trading volume create daunting valuation hurdles for fund managers.
At Fidelity, securities prices are valued in “good faith” when officials are trying to gauge the impact of events outside the markets, according to securities filings by the firm.
Mutual funds must disclose their holdings every quarter, though some funds do so more often.
To see how much a private company’s stock has gone up or down, individual investors usually must do the calculation on their own by comparing different securities filings.
Some experts say the rising popularity of private tech stocks is hazardous simply because the shares are hard to sell, lack a broad secondary market and could react wildly if the overall market swoons.
“We’re all waiting to see how that plays out,” says Babak Yaghmaie, a partner at law firm Cooley LLP who represents young private and public companies, including technology startups. Ms. Anderson of T. Rowe Price says mutual funds are in a tough spot because they all get different information from startups. “Sometimes the randomness you’re seeing [with pricing] is we all see different things,” she says.
At some funds, though, private technology companies are one of the biggest single investments. Hartford Growth Opportunities Fund, run by Michael T. Carmen, one of the best-known mutual-fund investors in startups, had 1.7% of its $4.7 billion of assets in Uber at the end of September.
In comparison, about 3.5% of the fund’s assets were in Apple Inc., which has a stock-market value of more than $650 billion. A Hartford spokeswoman declined to comment.
Uber’s steep rise in value among investors who have pumped money into the San Francisco company has bumped mutual-fund returns higher.
Andrew J. Shilling, a portfolio manager at Wellington Management Co., which oversees some of the assets in the Vanguard U.S. Growth Fund, cited Uber as a reason why the fund trounced its rivals in the latest fiscal year.
Securities filings show that Vanguard U.S. Growth Fund owns 1.4 million shares of Uber. The fund boosted its estimate of the stake’s market value by 19% to $55.8 million between Feb. 28 and June 30.
Glenn Booraem, who handles Vanguard Group’s private-securities valuation, says startups are “inherently more difficult to value on a stand-alone basis.” That’s one reason why the firm’s portfolio managers buy private shares “on a relatively limited basis,” he says.
A BlackRock spokesman said in a statement that the firm’s valuation team “has a rigorous and robust process for valuing private holdings and regularly updates valuations based on multiple sources of information.” An Uber spokeswoman declined to comment.
There are no regulatory guidelines for mutual-fund firms to follow, other than to not knowingly misprice securities.
In 2004, Van Wagoner Funds, a large investor in privately held startups during the tech-stock boom of the 1990s, settled civil charges in which the Securities and Exchange Commission alleged that the firm misled shareholders about the size and value of the funds’ investments in illiquid securities.
The mutual-fund firm and its president, Garrett Van Wagoner, agreed to pay an $800,000 penalty without admitting or denying the allegations.
Mr. Van Wagoner says the firm closely followed its valuation policies and procedures. “We thought deep and hard about what was the true value of these securities, but we found out the fundamentals of the companies were going into a nuclear winter, so we aggressively wrote them down,” he says.
An SEC spokesman declined to comment on whether agency officials have any concerns about the valuation procedures now used by mutual funds.
‘Exhaustive’ process
Some mutual funds say it is so hard to value startups from day to day that they limit their investments in those companies or avoid them entirely.
Aram Green, a managing director and portfolio manager at ClearBridge Investments, has invested in just one startup this year, partly because of what he calls an “exhaustive” valuation process after buying such stocks.
“I underestimated how time-consuming the process is,” he says. It includes frequent meetings by the valuation committee of ClearBridge’s parent, Legg Mason Inc., to decide if a stock’s price should be changed.
“It’s a lot of information and analysis on a real-time basis,” Mr. Green says.
Some fund managers turn to private companies for information that could affect the stock price. But different managers often get different levels of detail from the same company depending on terms of their investment, including the type of shares bought by the mutual fund.
In return, some mutual-fund managers get “board observation rights,” which allow them to listen to a company’s board meetings. Lower-ranking investors might get just a copy of the company’s unaudited financial statements every quarter, according to accountants and fund executives.
Sometimes, mutual funds don’t change their price of a startup’s shares for a year or more. Fund executives say that reflects the information shortage.
In 2013, Fidelity Contrafund never changed its quarterly price on Dropbox, according to data from Morningstar. Neither did the MassMutual Select Midcap Growth Equity II Fund, though the two funds’ per-share valuations of Dropbox were about 10% apart.
In contrast, Hartford Capital Appreciation Fund moved its valuation of Dropbox up or down in all four quarters of 2013. The three funds sharply boosted their valuations after the online storage provider completed a new funding round.
Fidelity, Hartford and Dropbox declined to comment. A spokesman for the MassMutual mutual fund, part of insurer Massachusetts Mutual Life Insurance Co. couldn’t be reached.
In March 2014, Fidelity’s flagship Fidelity Magellan Fund valued storage systems maker Pure Storage Inc. at $9.25 a share. T. Rowe Price New Horizons Fund said Pure Storage was worth $6.93 a share—or 25% less.
Pure Storage completed a funding round in April 2014. In June, the two mutual funds valued the company at $15.73 a share. The company went public in October at $17 and now trades near $18.
Fidelity and T. Rowe Price wouldn’t comment on the values they assigned to Pure Storage shares.
The swings in Peixe Urbano’s valuation show how hard it is to piece together an accurate picture of a startup company. T. Rowe Price bought its stake when daily deals sites like Groupon Inc. and LivingSocial Inc. were popular.
But by mid-2014, “it was very clear” that Peixe Urbano was “not on plan,” says Ms. Anderson of T. Rowe Price.
The firm says it has a rigorous, longtime valuation process that examines many factors related to startups.
The firm’s New Horizons Fund owned about 600,000 shares of Peixe Urbano. Morningstar says the 99% slide probably didn’t affect the fund’s overall performance last year because Peixe Urbano was less than 0.5% of the fund’s assets. A Peixe Urbano spokeswoman declined to comment.
T. Rowe Price was taken aback again when Baidu swooped in to rescue Peixe Urbano by buying a controlling stake.
It was “a surprise move, at least to us,” Ms. Anderson says.