Is Your Fund Buying Private Companies?

If you're a Silicon Valley insider, it's no longer enough to be on the inside for a red-hot initial public offering. The true A-list investors buy the hottest companies long before they go public, racking up big gains before any mere individual investor can buy a single share.

The rewards are lucrative enough that some fund families, such as Fidelity and T. Rowe Price, are investing in companies before they sell shares to the public. Is this something fund owners should be concerned about? In most cases, no.

Rising values of hot Silicon Valley companies (and, to a lesser extent, biotech companies) are becoming the stuff of legend. Consider Uber, the ride service. The company is private, but as of this writing, experts value the company at about $50 billion, based on the results of a recent funding round, according to The Wall Street Journal. Using the same methodology, the company was worth $60 million in 2011.

Many fledgling tech companies leave the nest and promptly get run over by a steamroller. But a handful--think Pinterest, Airbnb, and, of course, Uber--soar. In Silicon Valley, startups worth $1 billion or more are called "unicorns," because they are so rare.

An individual outside of the industry has about as much chance of investing in a unicorn as, well, riding a real unicorn. But some fund companies, such as Fidelity, T. Rowe Price, Janus, and BlackRock, are starting to nibble at untraded startups, too. And they can get those bites because big fund companies are a big market for IPOs and other offerings, and investment banks like to keep their customers happy.

For example,

T. Rowe Price is also a big investor in nontraded tech stocks. Last year, it invested a total of $2.5 million in 16 private tech companies, according to CB Insights. Through the end of the second quarter in 2015, T. Rowe participated in six deals that totaled $2.3 billion, and Fidelity participated in 12 deals that totaled $4.6 billion.

Securities law says that a mutual fund may only put 15% of its assets into untraded stocks at the time of initial purchase. For a fund like the $113 billion Contrafund, that's an opening big enough to drive a supertanker through. But Contrafund keeps its positions in untraded stocks extremely low and is willing to hold for the long term. "They buy hoping for a company to go public in three years," says Russ Kinnel, Morningstar's director of fund research. "If it's four years, they're fine with that."

One problem with investing in private companies is that they can be difficult to sell, especially if the market goes sour. Because they're not traded on an exchange, you have to call various investors to see if they're interested in buying your stake--and in a bad market, it's unlikely you'll get the price you're looking for. If a fund has just a 0.25% position in an untraded company, that's not a problem.

On the other hand, if a smaller fund has large positions in untraded companies and gets hit by redemptions, it will have to sell its tradable holdings to pay departing shareholders. The end result is a fund that's heavily invested in companies it can't sell.

And even in funds that specialize in investing in private companies, such as the closed-end Firsthand Technology Value SVVC, can have difficulty in realizing their premarket gains. The fund owned 600,000 pre-IPO shares of

The other problem with owning untraded securities is putting a price on them--which, by law, mutual funds must do every day.

In a frothy, overinflated market--and many think the pre-IPO tech market is just that--funds may appear to be doing better than they actually are, luring more investors in. If the bubble bursts, prices could fall faster than investors anticipate.

For most funds, the investments in nontraded companies are small enough to be relatively benign. But for smaller funds, the danger of going too far is always present, thanks to the 15% rule. "If I were making the rules, I'd take that 15% limit down to 5%," Kinnel says.

For most fund investors, the dangers of getting trapped in a pre-IPO tech wreck are fairly small. But if you own a smaller technology-heavy fund, pay close attention to your fund's holdings and keep an eye out for private companies.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.