Mutual Funds As Venture Capitalists? Evidence from Unicorns

Yao Zeng is Assistant Professor of Finance at University of Washington Foster School of Business. This post is based on a recent paper authored by Professor Zeng; Sergey Chernenko, Assistant Professor of Finance at The Ohio State University Fisher College of Business; and Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School.

The past five years have witnessed a dramatic change in the financing of entrepreneurial firms. Whereas once these firms were financed primarily by a small set of venture capital groups (VCs), who tightly monitored and controlled the companies in their portfolios, in recent years financing sources have broadened dramatically. In the years after firm formation, individual angels—whether operating alone or in groups—have played a far more important role, while on the back end, firms have delayed going public by raising considerable sums from investors who were traditionally associated with public market investing, such as mutual funds, sovereign wealth funds, and family offices.

This change in financing sources provokes some important questions. Over the past two decades, the academic literature has highlighted that venture capitalists are uniquely well suited for the monitoring and governance of entrepreneurial firms. Through such mechanisms as the replacement of management, the staging of financing, and the use of convertible securities and the associated contractual provisions, these investors address the problems of uncertainty, asymmetric information, and asset intangibility that characterize these private firms. This line of work would suggest that mutual funds—which tend to invest in common shares of more mature firms, where the governance issues are quite different, and to have limited engagement with the firms in their portfolios—would be ill-suited to such investing. Moreover, the open-end nature of major mutual funds may be incompatible with investments in illiquid securities, and they may be vulnerable to “runs” if investors become concerned about the nature or valuation of their holdings. These issues have triggered critical articles in the business press about the potential risks of mutual funds “juicing” their returns through private investments, as well as to scrutiny by the U.S. Securities and Exchange Commission. On the other hand, for public firms, institutional investors have been documented in academic research to provide effective corporate governance through activism and other means. Recent studies show that even index mutual funds, which might be seen as the most passive investors, provide significant corporate governance to public firms.

Given the academic debate, it is surprising that there has been virtually no scrutiny in the academic literature of whether and how passive institutional investors provide corporate governance to private firms. Given the increasing popularity of mutual funds directly investing in private firms, this question has an urgency that it would not have had a few years ago.

Our paper, Mutual Funds as Venture Capitalists? Evidence from Unicorns, provides the first attempt at answering this question. We seek to not only identify the volume of mutual fund investments, but the extent of their involvement in the oversight of these firms. To address this, we use novel data—certificates of incorporation (COIs) of these unicorns—to examine the contractual terms between unicorns and their investors (including mutual funds). Using COIs, we focus on the contractual provisions associated with mutual funds’ direct investments in unicorns, examining how contractual provisions, and in particular governance, change after these investments. We first provide a descriptive analysis regarding the trend of mutual fund investing in unicorns. Consistent with anecdotal evidence, our findings reveal a significant upward trend of mutual fund investments in unicorns using many different measures. Mutual funds appear to be more interested than VCs in investing in late rounds and hot sectors. We then explore various fund characteristics as potential determinants of unicorn investments. We find that larger funds and funds with more stable funding are more likely to invest in unicorns. Such results make sense because these funds are more likely to benefit from the highly non-transparent and illiquid unicorn investments.

Our main findings regarding corporate governance provisions suggest that mutual funds are less involved than VCs and provide less governance in general. At the same time, they are likely to provide more indirect incentives to entrepreneurs in some specific dimensions through contractual provisions that are consistent with mutual funds’ unique financing sources. 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. 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 VCs. Mutual funds are significantly less represented on the board of directors; they are thus less likely to directly monitor the portfolio unicorns through board intervention or voting on important corporate actions. These results suggest that mutual funds are not likely to provide governance service similar to VCs. At the same time, we find that mutual-fund-participating investment rounds are associated with significantly more redemption rights: that is, the convertible preferred stocks that mutual funds hold are more likely to be redeemable. Such results are robust across all of our different specifications. Mutual-fund-participating rounds are also associated with fewer pay-to-play penalties, which means they are less likely to be locked into refinancing unicorn investments when the underlying portfolio companies do not perform well.

These results reflect mutual funds’ unique capabilities and weaknesses compared to VCs. On the one hand, mutual fund managers are unlikely to have the skill set to serve as directors of and mentors to managers, particularly ones with the special challenges facing high-growth private entities. Their limited skill set likely leads to fewer governance rights. Their inability to provide governance (as well as other strategic benefits to portfolio firms) may also mean that they are largely undifferentiated from other sources of capital. Their relatively weak bargaining power may translate into fewer cash flow rights as well. But different from VCs, mutual funds’ shares on the liability side are redeemable on a daily basis. This implies that mutual funds have to manage their asset side more actively. Given that the secondary market for private firms’ preferred stocks is likely to be illiquid and characterized by extensive delays, mutual funds demand more redemption rights (possibly at the cost of sacrificing other cash-flow rights and governance provisions). This allows them to more easily redeem their preferred stocks when they face redemption pressures. The absence of “pay-to-play” provisions may also help them better exit illiquid and underperforming investment positions. In other words, the need of illiquidity risk management seems to shape mutual funds’ contractual choices, making mutual funds better able to “vote with their feet” than VCs.

Overall, our findings provide a novel and more balanced view regarding mutual funds’ governance capacity on private firms: although they appear neither as experienced nor as involved as VCs, their unique capital structure on balance pushes them towards certain contractual features.

The full paper is available for download here.

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