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The emerging scope for institutional investors in the secondary markets
The growth and performance trajectory of start-ups have increased significantly in the recent years as compared to what it was a decade ago. As a result, the secondary market for private equity has witnessed a steep upward trend as the value of private equity is booming. It is expected that the secondary market volume will reach $100 Bn this year. While there are several parties involved in private equity investments, our focus for this article will be around VCs and Mutual Funds. We will also try to analyse the extent of involvement of Mutual Funds.
Liquidity and return on capital serve as major factors that affect investment decisions of institutional investors. To ensure greater liquidity, it is important that institutional investors have easy access to the private markets, either directly or through their advisors. Mutual Funds help provide these benefits to investors. As a result, it has started to gain traction as a new asset class in the market with aggregate valuation of mutual funds’ investments in private firms increasing from $16 Mn in 1995 to over $8 Bn in 2015.
VC Funds versus Mutual Funds – Which brings more liquidity?
With growing participation of Mutual funds in private equity, it may seem that they are following the track of VC firms. But let us understand how the two differ in terms of their rights in the private markets.
While VC firms support startups from their early stage to their growing stage, Mutual Funds specifically focus on later stage investments in startups. The latter are distinctively concerned about the liquidity benefits. As a result, Mutual Funds are more concerned about redemption rights compared to VCs. These redemption rights not only help with liquidity management, but also protect the investors from consequences of down-IPO.
The IPO-related rights are given much more importance in Mutual Funds. They are more likely to have at least one of the two IPO-related rights, which includes a promise to investors about certain return in an IPO, and veto rights on down-IPOs. But in order to win some, one has to lose some. Therefore, Mutual Funds enjoy lesser direct control rights compared to VCs.
What kind of unicorns do mutual funds invest in?
Mutual funds are more likely to invest in the later stages of startup funding, as during a firm’s later stage funding rounds it is easier to assess their performance and it also guarantees higher growth than young startups. These generally include large firms that are closer to a potential IPO. Firms that have greater workforce and are looking forward to doubling its size, have a higher probability by 4-5% of mutual fund participation in rounds.
VCs play an important role in the investment participation of Mutual Funds as they are more likely to invest in funds that are backed by experienced VCs. The experience and intellect of the VCs ensure more credibility, better monitoring and greater social capital. Moreover, with greater resources, larger funds are more likely to invest in unicorns. Particularly, larger funds with less volatile fund flows are more likely to invest in private firms, consistent with liquidity concerns.
Source: Chernenko et al (2020)
Benefits of Mutual Funds that serve as gateway for average investors
Pre-IPO investments are difficult to access for average investors. Mutual fund investors provide a chance to these investors to put their funds in unicorns indirectly. They make PE investments easy to access, without compromising on the liquidity. Fidelity’s Contrafund, is one of the biggest and widely-held mutual funds. Another example is The New Horizons Fund.
With a booming market of private equities, more and more investors are moving to the space as they too want to be benefitted from the hyper-growth phase of unicorns before they go public. Mutual funds are responding to the needs of the investors to grab on the early access by allocating a portion to private space. They provide transparency to investors as they publicly disclose their portfolio holdings. These benefits of easy accessibility to private markets and greater transparency are the reasons why mutual funds are gaining traction among investors.
Returns and Benefits attracted by Mutual Funds through Pre-IPO Investments
As mentioned earlier, Mutual Funds focus more on contractual provisions, particularly the redemption rights that would allow them to escape the sticky situation if the IPO is delayed, or IPO ratchet that protects them from down-side IPOs by issuing additional shares that places the investor in the same or nearly same position had the IPO been priced at the previous valuation.
It is important to note that Mutual Fund investments essentially take place in the later rounds of funding, before the company goes public. This ensures greater returns than the public market returns. It is estimated that mutual funds’ returns swell up by 67% to 161% higher in the private equity market, compared to those on broad public market indices. Another positive aspect of such pre-IPO investments is that the fund is able to obtain optimum allocation in a company’s IPO as they are underpriced by an average of 15%. Thus funds are able to enjoy greater equity ownership than they would, had they invested in the company post-IPO.
Are founders comfortable selling their stakes to Mutual Funds and why?
It seems that the private firm owners don’t mind mutual funds investing into their businesses. This is evident from the figure below that shows a steep rise in the aggregate holding of mutual funds in unicorns since 2014. The main reasons why these companies go public is that it provides provision of capital, greater liquidity, and a more dispersed shareholder base. Mutual funds provide all these benefits to these firms, while staying private.
Source: Chernenko et al (2020)
Even though participation of Mutual Funds in the private markets is often compared to that of VCs, we can see that they both differ in their objectives and the investment preferences. Data suggests that about 149 funds across 14 largest fund families have invested in 270 unique, VC-backed private companies over the years 1995 to 2016. Looking at the trends, the growing need for higher returns in new asset classes will push more investors to adopt this route towards private equity investment.
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This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.