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E-MailMichelle Lowry is TD Bank Endowed Professor at Drexel University LeBow College of Business. This post is based on a recent paper authored by Professor Lowry; Yiming Qian, Associate Professor of Finance at University of Iowa Tippee College of Business; and Sungjoung Kwon, Drexel University LeBow College of Business.
While going public is without question a watershed event in the life of a firm, the lines between private and public listing status have become increasingly blurred in recent years. The number of publicly listed companies has decreased, but at the same time private companies are increasingly raising funding from investors who traditionally focused only on public companies. This study seeks to provide systematic evidence on the time-series trends in mutual funds’ investments in private firms. We examine the types of private companies in which mutual funds are most likely to invest, and we estimate the effects on the underlying companies, including the extent to which these mutual fund investments enable companies to stay private longer.
Across 16 mutual fund families (including the largest families such as Vanguard, Fidelity, T Rowe Price, etc.), we document a dramatic increase in the tendency to invest in private venture capital backed firms. In 1995, only 2 mutual funds held shares in a total of three different private VC-backed companies. This increased to 20 funds holdings shares within 21 different companies in 2010 and 92 funds holdings shares within 93 different companies in 2015. Thirty-eight percent of the IPOs by VC-backed firms in 2016 had received funding from this set of mutual funds prior to the IPO. Moreover, mutual funds provide a substantial amount of capital to the firms in which they invest: the funds provide an average 33% of the total financing raised (measured across funding rounds with mutual fund participation) over the 2011–2015 period.
Mutual funds concentrate their investments in companies that have demonstrated some level of success, e.g., in firms that have applied for more patents and in firms that have received more funding from VCs. Mutual funds also concentrate their investments geographically; they are significantly more likely to invest in companies located in California, a practice that is consistent with the efficiencies of conducting due diligence on companies located in close proximity to each other. Finally, we also find some evidence of funds relying on the certification effects of intermediaries, for example being more likely to invest in companies backed by higher quality VCs. Consistent with mutual funds focusing on companies that have already demonstrated some level of success, the companies with such investment are significantly less likely to fail and are more likely to go public via an IPO. Interestingly, these companies are less likely to be acquired, compared to companies without mutual fund investment.
As a first step toward assessing the effects of these investments on the underlying companies, we seek to determine whether the mutual fund investments provide incremental capital to the company. We find that the vast majority of mutual fund investments represent purchases of primary shares, rather than purchases from existing shareholders. Moreover, the capital provided by mutual funds appears to be incremental to that provided by venture capitalists. Funding round amounts at every stage (Series A, Series D, etc.) are larger when they include mutual fund participation. Using venture capitalists’ connections with mutual funds as an instrument for mutual fund participation, a 2SLS analysis similarly indicates that mutual fund participation has a positive effect on funds raised. In sum, the investments by mutual funds provide companies with more capital than they would have raised solely from the venture capitalists.
The finding that mutual funds provide incremental capital to companies suggests that this capital should enable companies to stay private longer. The last section of the paper examines this conjecture directly. We employ three different measures of mutual fund participation: an indicator for whether one or more mutual funds invested in the company, the total capital invested by mutual funds into the company, and the number of mutual funds invested in the company. Across all these measures and controlling for endogeneity, we find that mutual fund participation enables companies to stay private significantly longer. In terms of the magnitude of the effect, a mutual fund investment enables a company to stay private 2.8 years longer. In a similar vein, mutual fund investment decreases the probability of exiting private status in a particular quarter by approximately 6%.
These changing dynamics affect multiple parties: regulators who are faced with policies that are largely based on a relatively strict line between public and private listing status, firms who are faced with potential changes in both sources of capital and costs of capital, and investors who face changes in their investment opportunity set.
The complete paper is available for download here.
