Should Mutual Funds Invest in Startups?

Jeff Schwartz is William H. Leary Professor of Law, University of Utah S.J. Quinney College of Law. This post is based on a recent article by Professor Schwartz, forthcoming in the North Carolina Law Review.

Contrary to longstanding practice and to their reputation for investing in public companies, mutual funds, including some of the most prominent, are allocating portions of their portfolios to private venture-stage firms, including famous unicorns like Airbnb and Uber. In my forthcoming article, Should Mutual Funds Invest in Startups? A Case Study of Fidelity Magellan Fund’s Investments in Unicorns (and other Startups) and the Regulatory Implications, I analyze whether the securities laws adequately protect mutual-fund investors from the risks that arise when their funds add this unique asset class to fund holdings.

I argue that mutual-fund investments in startups pose several potential concerns for their investors. One is whether investors are aware that this is happening. Since venture investing runs counter to historical practices, mutual-fund investors might not realize that their funds are purchasing these atypical investments. Another concern is liquidity. Investors expect to be able to redeem mutual-fund shares nearly instantly. Since startups are private, however, their shares do not trade on a liquid market, which makes it more difficult for mutual funds to meet their shareholders’ redemption expectations.

Finally, these investments raise concerns about competence and candor. Mutual fund portfolio managers are not typically experts in venture-stage valuation, which casts their investing decisions in this arena into doubt. Moreover, once they have made these investments, funds are required to value them each day. With no market price to go on, the valuations are in management’s discretion. The values managers posit impact the price that shareholders receive when they cash out and what newcomers pay when they invest. Because mutual-fund managers lack the experience and expertise to appropriately value their startup holdings, these prices may be inaccurate.

Fund discretion in valuation also creates the potential for misconduct. Funds are incentivized to choose high values, which among other benefits to the fund, makes them appear more successful than their peers and increases the fees collected from investors. They might also be tempted to smooth returns, that is, report losses and gains when most advantageous for the fund rather than when they occur.

This range of concerns should sound familiar to the SEC. While mutual-fund interest in startups is a new phenomenon, they have long invested in other illiquid assets, such as mature private firms and thinly traded debt instruments, which expose investors to risks similar to those noted above. That being the case, the securities laws contain rules that are at least partially responsive. The pertinent issues are, therefore, whether the existing, generally applicable, regulatory regime is sufficiently robust to handle VC-type investing or whether, and if so what, specially tailored rules might be advisable. I argue that entry into this new arena presents novel types and degrees of risk and, because of this, suggest targeted reforms that would mitigate the investor-protection concerns that result.

To assess the extent to which risks to investors remain despite existing safeguards, I describe the relevant rules, present a case study of Fidelity Magellan Fund’s compliance therewith, and scrutinize the fund’s startup valuations. It is symbolic of the inroads that venture-stage investing has made that Magellan—perhaps the most iconic large-cap equity fund—is now an active investor in unicorns and, as it turns out, other startups.

The article focuses on Magellan for several reasons. Because it is an industry leader with the resources to hire top counsel, its valuation processes and compliance activities are likely suggestive of larger industry practices, and, more specifically, because it is a Fidelity fund, its practices are likely suggestive of those in Fidelity’s fund family, which has been at the forefront of startup investing. In addition, even if Magellan is an outlier in its approach to these securities, to the extent its practices raise investor-protection concerns, its scale means that a significant number of individuals could be harmed. This alone would warrant regulatory scrutiny.

Based on the above three-step analysis of risk, regulation, and case-study data, I conclude that, while liquidity does not appear to be a concern, there is reason to suspect that investors fail to realize that their mutual funds are investing in unicorns (and potentially other startups), that mutual-fund investments in these securities are inadequately informed, and that the valuations that mutual funds report publicly and serve as the basis of redemptions and purchases may be inflated. The article’s most significant findings are that Magellan’s disclosures surrounding its startup investments and its valuation practices are opaque, and that its reported valuations indicate that the fund has done alarming well with this portion of its portfolio. Its reported returns far outpace its other investments, the venture-capital industry, and the public markets. Such success does not necessarily indicate misconduct—it may owe to luck or skill that belies the fund’s inexperience. Greater oversight, however, would provide increased confidence that the outstanding performance owes to these benign explanations.

While a study solely of Magellan’s practices cannot prove reform is necessary, the findings and analysis herein lend credence to investor-protection concerns and, therefore, suggest that reforms are worth consideration. I argue that stricter rules regarding startup valuation methods and enhanced disclosures related to the venture portion of fund portfolios would go a long way toward protecting investors.

To limit the discretion over valuations that funds enjoy today, I suggest that rules should mandate valuation changes when, and only when, based on publicly available information. Funds would also be required to publicly disclose the information on which such changes are based. To improve investor awareness, I propose rules that would mandate prominent disclosure of the presence of venture-stage investments and the risks they pose. Disclosures of varying length and specificity would be necessary in certain advertisements and in several mandated filings, including the fund’s prospectus and its statement of additional information, the latter of which would contain a separate section devoted to the startup portion of the fund’s portfolio. This combination of substantive restraints and additional transparency requirements would enhance the credibility of valuations and provide investors with adequate notice that their fund is involved in the venture-capital arena.

The full article is available here.

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