BM Research

I was tidying up some stuff and came across this draft article that I wrote in 2017. For some reason my management didn’t like it and nothing happened with it. Sadly, it now looks remarkably prescient though being unpublished it is difficult to claim credit for that. I haven’t edited it, so apologies if it is a bit rough and ready in places.

12 June 2017

The last few years have seen a remarkable rise in funds focussed on listed equities that have added exposure to private companies. This is most prominent in the US, where a plethora of Unicorns (private companies worth more than US$1bn) have attracted investments from such luminaries as Fidelity Investments, BlackRock and T. Rowe Price. 

Some in the UK have followed suite. Neil Woodford’s Patient Capital Trust probably has the highest profile, but his Equity Income Fund also has exposure approaching 9%. And other managers are also doing similar things. ** add a bit more here? **

So what does this mean for investors? Well there are two characteristics of these companies that will affect the fund’s value.

Earlier stage companies

The first is that most of these investments are in early stage companies. As they are less mature, the businesses are riskier than comparable listed companies and more likelier to fail. The flip side, and for most managers the reason for investing, is that if successful they are likely to give better returns than listed equities. Some mitigate this to an extent by only getting involved at the last funding round before an expected IPO.

Many also mitigate by keeping their exposure to unlisted companies small in the context of the fund as a whole. This can be a mixed blessing. On the plus side this means a limited exposure for investors. But the lack of diversification can be an issue – a typical venture capital return profile usually has a small number of very large winners and larger number of less successful investments. A fund with only a handful of such investments may actually not have very good odds of finding enough winners.

The second characteristic is the defining one that there is no market in the company’s shares. This has multiple consequences for investors.

Consequences of illiquidity

The first consequence is that selling or buying shares cannot always be done when the fund would like. For this reason unquoted equities have historically largely been held in closed-end vehicles, such as investment trusts, rather than open-ended funds. This has changed, though most open ended funds keep the unquoted proportion of the fund relatively small to protect investors in the event of redemptions. 

In extremis the risk is that a liquidating fund could not sell the investments to allow it to return cash to investors. However, in a shrinking fund the proportion of unquoted investments could rise, changing the risk profile for the remaining investors. For most funds the shrinkage would have to be significant for that to happen, but some funds that have fallen out of favour have done that.

Although less dramatic, a fund with significant inflows will have the opposite issue. As a fund grows the existing unquoted investments could be diluted, as adding shares to the existing holdings may not be possible. On one level this is easier for a manager to deal with though, as they could make other unquoted investments if they wish. It isn’t always that simple – many early stage companies need support from their investors beyond capital or have limited reporting abilities. Both of these require a greater investment of resource from the fund manager. A larger number of unlisted investee companies may require additional resource from the manager.

Consequences of more subjective valuations

The issue that has concerned the SEC, and maybe at some point the FCA too, is how these investments are valued. Many venture capitalists believe that valuation is more of an art than a science, which will naturally concern investors who would like a truly objective view. For open ended funds both too high a price or too low a price is a potential issue. In the former performance is inflated, under the latter existing investors may be diluted by new ones.

Under some circumstances there can be objective prices. Where there has been a recent transaction that price may be used, though that does need to be substantial and between independent parties to avoid manipulation. Where a company fails a complete write down is in order. For more mature companies, price to revenue / cash flow / earnings ratios can be compared with listed equivalents, though the discount to them for being unquoted is somewhat arbitrary.

But how much more is a bio-tech company worth for progressing through a trial stage? A software company for releasing a new game? Or how much less for a company having a patent being contested? While some evidence can be drawn from similar situations, every situation is a at least a little different there is inevitably a degree of subjectivity. At this point investors may look to see what independent verification there might be. 

What is less appreciated is the effect this may have on risk statistics. The prices of most of these positions will only change infrequently, which will have the effect of suppressing volatility. Of course, if there were an active market these, as early stage companies, would probably be more volatile than the listed holdings. But its not that simple – when the price of a position moves it will often be by a lot. When discretion is involved, justifying a 5% price change is very hard. Justifying a 20% or 50% move is actually easier. 

What is clearer cut will be the effect on the fund’s correlation with markets. It seems likely that unquoted investments will reduce a fund’s correlation with relevant markets or benchmarks. Again, this may be more of an artificial effect of pricing rather than reflecting the reality of the fund. It seems that unquoted investments will mean that risk statistics should be treated with greater caution than usual.

Time will tell on how the unquoted trend will work out in practice. It seems likely that, as normal, for some it will add tremendous value while for others it is an accident waiting to happen. This means that investors do need to be clear about what they are getting in their fund investments and what effect it is has on their portfolio. In too many cases this is not clear yet.