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Is Private Company Ownership a Risk for Mutual Funds?

A recent Morningstar study shows most funds tread lightly in private-firm investments.

Katie Rushkewicz Reichart, CFA, 12/05/2016

With high-profile private firms such as Uber and Airbnb appearing in some mutual fund portfolios in recent years, investors may be wondering what to make of such exposure. Mutual funds provide daily liquidity that allows investors to contribute or withdraw money each day, so the inclusion of less-liquid private firms has come under scrutiny.

There are other reasons this has become a more visible issue. First, private companies have delayed IPOs, opting to raise capital in the private market and build their businesses without the pressure that comes with being publicly traded. Second, private firms have increasingly become part of fund managers' due-diligence efforts, as some of these firms have changed the competitive dynamics in their industries and grown larger than even their publicly traded peers. Third, active managers, who have faced a picked-over public stock market and widespread underperformance against passive funds, have found appeal in the performance edge that private-firm equity investments can potentially offer.

This trend has not gone unnoticed in the media, which has questioned the risk mutual fund ownership of private firms could pose to investors. Morningstar recently examined the prevalence and magnitude of private-firm equity holdings in U.S.-domiciled open-end mutual funds to gauge whether these investments present risks or challenges not envisioned by the traditional mutual fund format. The study excluded exchange-traded funds, money market funds, fixed-income, alternatives, and funds of funds, and it used holdings data from Morningstar Direct as of 2016’s second quarter. The screening list included 163 private companies, of which 133 had mutual fund ownership (see the full paper for more information on methodology).

Few Mutual Funds Invest in Private-Firm Equity
As of 2016's second quarter, we found 194 funds that had some level of investment in 133 private companies on the screening list. Those 194 funds equate to 3.6% of the 5,378 equity and allocation funds in Morningstar's database and account for $11.48 billion in assets in aggregate, or about 0.13% of the industry's $8.6 trillion tally, as of June 2016. To put that $11.48 billion in perspective, U.S. equity and allocation funds had about $254 billion staked in publicly traded biotech stocks as of June 2016, or 22 times the sum invested in private-firm equity.

Overall, we found 26 fund companies offered funds that invest in private-firm equity, with Fidelity leading the way (59 mutual funds owned $5.19 billion in private-firm equity as of June 2016), followed by T. Rowe Price ($2.08 billion spread across 25 funds) and Hartford ($848 million invested in 14 Wellington-subadvised funds).

Fidelity and T. Rowe Price spread their investments across many funds run by different managers. Similarly, Alger and Putnam, while representing much smaller sums, had a relatively high number of funds on the list, at 21 and 15, respectively. By contrast, the bulk of Morgan Stanley's $420 million private-firm equity stake was claimed by funds run by a single management team led by Dennis Lynch.

While Fidelity and T. Rowe Price, the third and fourth biggest fund firms by U.S. mutual fund assets (excluding ETFs), may have deeper resources to evaluate private companies, there are plenty of bigger firms that have limited or avoided such investments. For example, Franklin Templeton, the fifth-biggest by U.S. mutual fund assets, invested just $64 million in private-firm equity across four mutual funds. J.P. Morgan and MFS, other top-10 firms by assets, were not on the list at all.

Katie Rushkewicz Reichart is a senior mutual fund analyst with Morningstar.

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