Monday, March 23, 2015

Mutual Funds In the Venture Capital Business: “Eye-Popping Valuations”

Maximizing expected future returns.
One of our favorite topics, along with agricultural commodities and production, materials science, really, really fast computers, advanced manufacturing technology, energy and Dogbert's schemes for world domination. 

One of the most profound facts of investing is that the growth is in the new companies.*
Not small companies, new ones.
So the question is: How to capture that growth?
And while you're at it, maybe mitigate some of the risk inherent in new ventures?
This is probably not the answer.

From ValueWalk:

Large mutual funds are taking positions in risky private tech firms which might never go public
Once staid mutual funds are exploring new — and potentially riskier —  territory in search of higher returns. An increasing number of major mutual funds are pulling the trigger on investments in higher risk-higher return tech firms, according to a March 23rd article in the New York Times.
Some of the biggest money managers in the industry such as Fidelity  and T. Rowe Price have recently made multi-billion dollar deals to acquire shares of privately held tech companies such as Air BnB and Pinterest. These shares are pooled into mutual funds that end up in the retirement accounts of millions of Americans. With earnings in many other sectors of the stock market slowing down, mutual fund money managers are looking to boost their returns with high-flying tech stocks.

Mutual funds: Landslide of investments in private tech firms
Of note, industry giant Fidelity’s Contrafund has $204 million worth of Pinterest shares, $162 million in Uber shares and another $24 million in Airbnb shares. There were 29 deals last year in which a mutual fund bought into a privately held firm totaling to $4.7 billion, based on data from CB Insights. In 2012 there were only six deals worth a combined $296 million.

T. Rowe Price made 17 separate investments in private tech companies in 2014.
Mutual funds
Private companies are not required to issue financial reports and are not traded on stock exchanges, and have not historically been found in retirement accounts. These major investors, however, have decided to make significant wagers that these companies will be bought or go public at prices above their latest funding rounds, but there are no guarantees.

Statement from finance professor
“I think it goes beyond what mutual funds were set up to do,” commented Leonard Rosenthal, a professor of finance at Bentley University. “It’s great for the portfolio manager, but it’s not necessarily in the interest of the shareholders of the fund. If investors are looking for a portfolio of risky securities, there are plenty of stocks to trade in the public market.”...MORE
*My preramble to "Growth of GDP per Capita vs Stock Prices since 1871":
Following up on last Sunday's "Long term Growth in U.S. GDP per Capita 1871-2009" we revisit Visualizing Economics.
The question embedded in this chart is:
"How can the aggregate of investment portfolios grow faster than the economy?"
The long term answer is "They can't".

As GDP is the sum of all the profits, those accruing both to capital and to labor, the only way capital can garner a larger proportion is for labor to accept a smaller percentage. This is a self correcting cycle, too extreme at one end and you get a capital strike, at the other, labor walks out.

Another mean-reversion is the price paid for the expected (sometimes hallucinated) income stream.
P/E ratios don't go to infinity (for the total market, individual issues sure can) nor do they go to zero (implying  the reciprocal fantasy, an infinite rate of return)

There are two methods of enlarging the total pie.
1) Increase revenues while maintaining profit margins.
2) Increase profit margins, usually by some combination of productivity enhancement e.g. capital investment, labor force education, waste minimization etc.

These are especially effective if combined, ie expanding revenue+rising margins.
Unfortunately at the corporate level there are upper bounds to both.

For portfolio investors the situation is even worse than for the overall economy.
You miss all the growth of private companies.

On the one hand private companies are often fine businesses which the owners have no desire to share and on the other hand the universe of private companies is where you find the younger, smaller, more dynamic and thus faster growing entities.

These two attributes are what private equity and venture capital, each in its own way, attempt to capture. 
However, with large enough pools of money in the game aggregate private company returns can be lower than those found in the public markets, a widely known example were oil companies in the 1980's after the oil bust,
You could buy oil on the stock exchange cheaper than the cost of finding it via exploration & production.

Some folks are wondering if we are building to a similar overvaluation in Silicon Valley right now.

Anywho, that's a longer than usual intro, your patience will be rewarded by a short and sweet chart from Visualizing Economics:
RealStock_GDP-per-capita_Log-650x442.png

See also the intro to: 
Barron's Cover: Tech Stocks--The Bubble Is In the Private Market
There are two things that have changed over the last couple decades in valuing soon-to-be-public companies:
1) Long gestations to accrue every bit of hyper-growth from successful business to the private owners.
2) Late round valuation bumpers, a tactic we first saw in Kleiner, Perkins deals, note below.

From Barron's:...