How Mutual Funds Can Paint Themselves into a Corner

The SEC says that mutual funds can invest only 15% of assets in illiquid securities, and I wonder whether that level isn't too high by, oh, maybe 15% or so.

Mutual funds provide a number of services to investors, and one of the biggest is daily liquidity. Every day that the stock market is open, mutual funds sum up their portfolios' value and let investors buy and sell at that price. We don't think about it much, but it's one of the reasons that the fund industry is so huge. Even long-term investors feel comforted knowing that the option to get out is there when they want it.

Sometimes, though, investors and fund companies forget about what daily liquidity means. Mutual funds are so popular that we want them to invest in everything--even things that don't trade every day. I'm not talking about securities that trade most days or that you could trade if you needed to.

But when talking about something that absolutely can't be traded quickly, such as venture capital, it's a huge headache. The 15% limit is based on how much the fund paid. It doesn't require the fund to sell down that position should it grow above the 15% cap. So, if that figure grows, that means that the fund is increasingly dedicated to securities that it can't sell. In addition, it has more of the fund's portfolio locked into securities that are very hard to price.

Put another way, you're going to get a bad result whether the fund's venture capital investments rise or fall. In 1998, a fund called IAI Value hit it big with venture capital investments that thrived. When they filed for initial public offerings, IAI raised the estimated price on the stocks to match the expected investment range. That boosted returns and the size of its illiquid stake beyond 15%. It wisely closed the fund because investors who bought afterward might overpay should the stock fail to fetch the expected price. In fact, the IPO market later cooled off, and it had to write the value of the investment down significantly. IAI seemed to handle the situation about as well as possible, but it illustrates just how difficult the issue is. It had to close the fund when assets were small, and I'd imagine that it had to struggle to price the holdings accurately.

A few years later, Van Wagoner funds got in hot water for marking down a venture capital investment more than the SEC said it should have, thus hurting those who sold at that time. The SEC also said that it purchased illiquid securities after it breached the 15% barrier.

But not all lessons are learned, and today  Firsthand Technology Value  has painted itself into a corner with venture capital positions in solar energy that represent about 35% of the portfolio. To be fair, it has fully disclosed and explained its venture capital investments, so potential investors should be well aware of the situation. That's actually down from a peak of 46% at year-end. At that time, two venture capital positions, in SoloPower and Silicon Genesis, accounted for 30% of the fund's assets. The good news is that some of that increase is due to appreciation of the investments. The bad news is that some of that is because management has sold its liquid publicly traded stocks to meet redemptions. Moreover, it's probably not manager Kevin Landis' intent to have such a big weighting--it just happened.

Interestingly, it has not chosen to close the fund. That makes it even more important that it accurately prices the venture capital positions each day. It has disclosed the liquidity challenges and venture capital investments in its SEC filings, and it also explained that manager Kevin Landis sits on the board of these holdings. That gives him a greater say in the way that they are run, but it also means that the funds would not be able to sell shares when he is aware of nonpublic information.

The situation would seem to put a lot of stress on the fund's three-person board. Besides Landis, it has two trustees listed as disinterested who only joined the board in November 2008 after two previous board members quit. Besides being responsible for pricing, the board is also mandated to review whether redemption fees are appropriate for the fund. The liquidity issues would seem to make this a textbook case of where a fund should have redemption fees given the liquidity issues and potential for arbitrage in the fund. Yet, the fund doesn't have a redemption fee and merely states that it will kick out those who get in and out frequently such as someone who does two round-trip trades in less than 90 days.

The fund has a pricing committee that consists of one disinterested director, two officers of the fund, and Kevin Landis. It met 11 times last year, which seems like a low number given the challenges of pricing a big chunk of the portfolio.

The SEC filing says that the fund board and fund management are seeking ways to reduce the venture capital stakes. That's encouraging, but meanwhile the fund remains vulnerable to redemptions and faces the difficult task of putting a fair value on shares each day. They have also warned that they could be forced to provide in-kind redemptions in which they return a portion of portfolio holdings rather than cash to fundholders who want out. Another option they didn't mention is that, like any mutual fund covered by the Investment Act of 1940, they could also suspend redemptions when disposal of securities is "not reasonably practicable."

We've said that investing in focused funds requires that you really have a lot of faith in managers to pick just a few stocks. I'd say that goes double for funds investing in venture capital.

That's why I'd suggest that the SEC change its illiquid rule to exclude venture capital holdings above, say, 1%. There are better formats than open-end mutual funds for really illiquid investments. Closed-end funds, interval funds, and, of course, venture-capital funds where redemptions are severely limited are fine places for these kinds of investments.

 

 

 

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