It used to be that almost all mutual funds invested their
capital only in securities of public companies. But that’s been changing—which
could be good news for some small businesses that have big plans.
Thirty-six percent of firms going public in 2016 received
mutual-fund financing before their IPO, according to a recent research
paper by Michelle Lowry and Sungjoung Kwon, both at LeBow College of
Business, Drexel University, and Yiming Qian at the University of Iowa.
This practice of investing in private firms has become
increasingly widespread. Specifically, the authors say, fewer than 15 funds
invested in private companies each year through 2000, compared with around 90
unique funds in 2015 and 2016. The research used data from 16 fund families
from 1995 to 2016.
“The interest of mutual funds is driven by two things: the
possibly of investing in unicorns and the fact that these firms are going
public later and later,” says José-Miguel Gaspar, professor of finance at Essec
Business School in Paris. In other words, mutual funds want to get in early on
companies with potential for fast growth.
If this trend continues, it’s likely to be good for some,
but not all, small businesses. To get an investment from a mutual fund, a
company will need to offer something rather special. “I am not sure this is a
development for the average startup,” says Prof. Gaspar.
For instance, a small chain of pizzerias probably won’t get
too much interest from a mutual fund (other than when buying pizzas).
On top of that, the level of mutual-fund investment in
private firms, while growing fast, is still relatively small and likely to stay
that way. “Under the terms of a law from 1940, mutual funds are allowed to own
15% of their assets in private firms; guidance that came later suggested 10%,”
says Richard Evans, professor of finance at the University of Virginia’s Darden
School of Business in Charlottesville. “They can only put a small allocation in
But for those companies that can get a mutual fund
interested, there is plenty of good news.
Lower cost of capital. Prof.
Evans notes that the availability of more capital to fund businesses ultimately
means a lower cost of capital for the businesses. It goes back to economics
101—more supply lowers the price of the capital needed. In this case, the
potential returns that the investors want to see in the companies they buy will
Stay private longer. “What
the paper shows is that having mutual-fund investors shows that companies can
stay private 1½ to 2½ years longer than otherwise,” says Prof. Lowry.
That allows the firms the potential to grow without the
pressure of reporting earnings each quarter. That means that profits can be
reinvested into the business and so help boost longer-term growth.
Less regulatory filing. Public
companies must file many documents each year. Staying private allows managers
to concentrate on growing the business rather than filling in government forms.
The longer they stay private, the longer they can avoid the paperwork.
Help with growing pains. Any
small company that wants to grow will see growing pains, but with a mutual-fund
investor, there are seasoned managers available to offer advice.
IPO prep. The advice isn’t just there
when there is a misstep. Perhaps most important, the advice and coaching can
help companies with their debut on the stock market, aka the IPO.
“The transition [from private to public] can be quite a big
change,” says Sonu Kalra, portfolio manager of the Fidelity Blue Chip Growth
Fund. He adds, “The leaders are used to sitting in a room with a few people,
whereas when they are public, it will be with a big group of people.”
Mr. Kalra says he and his team try to prepare company
managers for what to expect when their stock is listed. They hold mock earnings
conference calls, and mock roadshows where company leaders will talk with
Longer-term capital. Venture-capital investors are typically
involved for only a small part of a company’s life cycle. “As soon as the
company goes public the VC exits,” meaning they sell their stake, says Mr.
Kalra. “Whereas when the company goes public we’ll probably invest more
capital.” In other words, the relationship continues beyond the IPO.
for the original article from Wall Street Journal