Vanguard, a mutual fund based in the US, marked down the value of its investment in Flipkart, an Indian e-commerce company, by 33%. Another fund, Morgan Stanley, cut its valuation of Flipkart. Vanguard brought down the valuation of Flipkart from $11 billion to $7.3 billion. While Morgan Stanley is a little more conservative by placing a value of $5.5 billion. The difference in the valuations arrived by the two fund houses accommodates a unicorn.
Why are Mutual Fund houses cutting down the valuation of these private entities?
Sometime in the year 2015, SEC, the capital market regulator in the US, fired warning shots at Mutual Fund houses, asking them to explain their rationale and processes behind valuing unlisted entities.
One must realize that shares in such unlisted entities are not traded on a marketplace. Once the shares are issued in a particular round price discovery takes place only in the subsequent round. But, Mutual Funds prepare monthly statements disclosing holdings and value. To achieve parity of returns, unlisted shares are valued at fair value every month. A secret committee, at each fund house, composed of non-fund managers (for independence sake), value unlisted shares.
Over the last couple of years, Mutual Funds, including retirement funds (and 401K), wouldn’t want to be left behind in the start-up mania that gripped everyone . These funds participated in late stage rounds (Stage G, H) picking up stakes. On hindsight, it appears it overpaid for these stakes.
Rounds simply divide the life of a company before it hits public markets. Rounds A, B, C are familiar to most of us. ‘A’ for commercial production, B, analogous to growing big, and C for going national or international and so on. These categories are fluid in description.
One can only imagine the prudence of G and H rounds and how a company would justify such extended series.
Mutual funds, per se, are conservative vehicles of investment for the masses. And thankfully, mutual funds and the regulatory structure surrounding it have retained sanity when it comes to asset pricing and valuation methodologies. Metrics like Operating Cash Flow, Profitability, Return on Equity and others are still respected and adhered. This ecosystem has somehow ring-fenced itself from the persuasive vocabulary of star venture capitalists, comprising of clicks, views, subscribers and many more.
But nevertheless, some of the fund houses, notably Fidelity, Vanguard and Morgan Stanley have got drawn towards chasing unicorns. If the folks at Vanguard were evangelizing passive investing and indexing (ETFs) why did they choose an ultra active investment such as a unicorn – in this case – Flipkart? There could be more in their portfolios.
The SEC has taken an interest because these risky investments have moved from private portfolios (hedge funds, private equity funds) to public portfolios (mutual funds, 401Ks). This has taken place through secondary and primary purchases. An illiquidity problem or a panic due to fear of loss of capital could cause a stampede at the exit gates. And, a loss of faith in capital markets in general. Remember, it is small investors who invest in mutual funds. The regulator must be commended for acting in this manner.
The regular markdown of valuations that we hear in the news is because Mutual Funds are mandated to review and report their illiquid holdings every month. Now, whether it causes disruptions in the investee company’s fundraising plans is not known. Their cohort of investors (VCs, PEs) may continue to use different metrics to value unicorns and see fund markdowns as an academic exercise.
But they must remember that the information asymmetry between the general public and the private equity investor is slowing being torn down by actions such the one by the SEC. The experience of general investors have now been enriched, and these investors would be cautious before picking a public offer of a unicorn.