Mutual funds delve into private equity
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A growing number of mutual funds are venturing into the risky world of private-equity investments.
Most mutual funds limit their holdings to widely traded stocks and bonds. But as private financiers -- from hedge funds to buyout firms -- increasingly reshape the world of corporate finance, more mutual-fund managers are getting in on the action. These managers say they are willing to take on the greater risks of private investments, including the difficulty of unloading them in a pinch, because of the prospects for higher returns.
Private-equity investments have traditionally been the domain of large buyout firms, such as Kohlberg Kravis Roberts & Co., which last week joined with other investors in the planned $21.3 billion buyout of hospital chain HCA Inc., one of the biggest such moves. Such fevered activity has set off a scramble by institutional investors and rich individuals to get in on the private-equity world. Overall, the U.S. Private Equity Index, a measure of private-equity funds' performance tracked by Cambridge Associates LLC, gained about 27 percent last year, compared with about 5 percent for the Standard & Poor's 500-stock index.
Some mutual funds are investing directly in private companies. Firsthand Technology Innovators fund bought a stake in Silicon Genesis Corp., a nanotechnology concern, that jumped 50 percent to $2.6 million in the six months ended March. But the fund, which has assets of $31 million, also lost virtually all of a $3.2 million investment in communications-equipment company Luminous Networks Inc. when that company's stock plummeted. The fund had an annualized three-year return of negative 5.2 percent through last month.
"If things don't go according to plan -- and for a lot of younger companies, they don't -- then you have limited options" because the holdings are so hard to trade, says Kevin Landis, chief investment officer at Firsthand Capital Management Inc.
Other funds use different strategies to build up private investments. Legg Mason Opportunity fund and T. Rowe Price New Horizons fund are buying shares offered privately by public companies. Newly launched Giordano fund has about 10 percent of its assets in private company debt. "It would be very difficult to sell" the bonds, says manager Joseph Giordano. "The only market for these would be to sell them back to the company."
Meanwhile, some funds, including some run by Morgan Stanley and Deutsche Bank AG's DWS Scudder, are relaxing their investment restrictions in ways that allow managers to make bigger bets on private investments.
Private holdings are permitted to make up only a fraction of a mutual fund's portfolio. That's because Securities and Exchange Commission guidelines limit to 15 percent a mutual fund's total assets that can be invested in "illiquid securities," or securities that are thinly traded. Many funds have internal rules that place even lower limits on private investments, and most mutual funds don't invest in them at all.
Mutual funds face a number of possible pitfalls in making private investments, besides the possible difficulty of finding a buyer. The holdings are difficult to price -- a problem for mutual funds, which must assess the value of their holdings each day. Indeed, some funds have faced regulatory sanctions for mispricing private holdings. The investments also could push up expenses, since funds often need lawyers to review the complex deals.
Individual investors can glean how much their funds own in private investments by examining quarterly reports, where any restrictions on the sale of holdings must be disclosed. Experts say there's no rule of thumb how much a fund should limit private investments. Instead, this depends on an individual's risk tolerance. One possible red flag: If restricted securities appear in a fund's report for the first time, the manager might be adopting a new investment approach.
One strategy that has grown in popularity among mutual funds seeking private holdings is to buy securities privately from a public company. Companies like the transactions, called private investment in public equity, or PIPEs, because they raise money quickly and more cheaply than a public share offering. Funds like them because they can pick up the stock at a discount. PIPEs also allow a fund to acquire a significant position in a small public company without driving up the listed share price.
But in most cases PIPEs "are highly risky," says Bill Miller, manager of Legg Mason Opportunity fund, which has made recent PIPE investments in software company Convera Corp., oil-equipment concern Syntroleum Corp. and telecom firm Level 3 Communications Inc. Another fund, T. Rowe Price New Horizons, recently made PIPE investments in various biotechnology and pharmaceutical companies, including Inhibitex Inc., MannKind Corp. and Acadia Pharmaceuticals Inc.
Companies issuing PIPEs are often small and unprofitable. The securities can't be sold in the public market until they are registered with the SEC, which can take 90 days or longer. "You can have long delays and the stock can plummet, and the investors can't get out," says Mark Wood, a partner at law firm Katten Muchin Roseman LLP who specializes in PIPE transactions.
Overall, mutual funds invested more than $3 billion in PIPEs last year, accounting for 21 percent of the PIPE market, according to Sagient Research Systems, which tracks such investments. In 2004, funds invested $1.1 billion in PIPEs and made up 10 percent of the market.
Some fund managers are betting on private-equity-type investments without buying private securities. They are buying so-called special-purpose acquisition companies, or SPACs, which are public companies that typically raise money to acquire private firms. Though the companies are publicly listed, trading volume often is quite low until the company makes an acquisition, which it generally must do within 18 months. One SPAC, Services Acquisition Corp. International, which has agreed to acquire closely held Jamba Juice Co., had attracted investments from Fidelity OTC fund and Hartford Capital Appreciation II fund as of the end of April, according to fund filings.
Despite the SEC's guidelines on illiquid securities, it's possible for funds to build up a substantial allocation in private investments. The rules for determining a security's liquidity aren't black and white. Any investment -- even one that's not publicly traded -- can be considered liquid if the fund determines there are enough potential buyers who would pay fair value for the holding. And as the value of public holdings decline or the value of private investments increase, a fund's allocation to illiquid holdings may move past the 15 percent limit. As of March 31, the Firsthand Technology Innovators fund had devoted about 18.5 percent of assets to restricted securities.
Valuing private investments is also a challenge for mutual funds. A number of fund managers who hold private investments say they do an in-depth review of private-investment valuations only once a month. In 2004, the SEC charged Van Wagoner Capital Management Inc. with deliberately undervaluing private investments in its mutual funds, making it appear that the funds were under the 15 percent limit on illiquid securities. Van Wagoner settled without admitting or denying wrongdoing. The Van Wagoner funds no longer invest in private companies, a spokeswoman says.
The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund.
More mutual funds are making private-equity investments a part of their strategy.
Private investments can offer higher returns in exchange for taking on greater risk.
Shares offered privately by public companies can be bought at a discount to the regular stock price.
Private holdings are generally difficult to trade and hard to value.
SEC guidelines limit how much mutual funds can invest in illiquid securities.
First Published August 2, 2006 12:00 am