VCs have been watching with great interest as mutual funds mark down the value of some of their privately held, illiquid investments, including shares of Dropbox, Zenefits, and Snapchat. Turns out the SEC is watching, too. A new Wall Street Journal report says the agency “has been asking more questions of large fund firms about how they value startups and whether their process ensures an accurate estimate of a company’s worth.”
According to the WSJ, examiners from the agency’s enforcement division are not yet involved in the inquiries. And asked yesterday if the SEC is investigating mutual funds’ pricing of private companies, a spokeswoman responded to us this morning, saying the agency isn’t commenting on its plans.
But some think it’s only a matter of time before a full-fledged investigation is launched into possible violations of federal securities laws, given the difference in prices that some funds have assigned their holdings, how they’ve timed their markdowns, and the opaqueness around both. The whole matter may give pause to other investors who’ve been looking to access the private markets, too.
Lowering Prices
Much of the recent handwringing over markdowns ties specifically to Fidelity, the mutual fund giant that — as Fortune reported last week — recently slashed the valuations of a surprising number of its illiquid holdings in high-flying companies that include Zenefits, Snapchat, and Dropbox.
Based on Fortune’s review of Fidelity’s holdings, Fidelity marked down Snapchat’s valuation by roughly 25 percent between the end of July and the end of September based on an investment it had made just this past spring. Fidelity also marked down its investment in Blue Bottle Coffee by 43.4 percent as of late September — just five months after Fidelity had invested in the company.
The markdowns seemed to catch the venture community by surprise, partly because of their breathtaking scope but also because venture capitalists tend to hold their investments at cost. What that means: They tend to value companies at what they paid for them, unless urged by their auditors to mark up deals based on outside data points like the acquisition of a company in a similar space, or what other investors have decided a particular portfolio company is worth.
Put another way, the same company can be valued very differently by its backers, who needn’t move in lockstep. Fidelity’s numbers are “an interesting data point but they have no bearing on how we might think about valuations,” says one VC from a top five venture firm who asked not to be identified for the story. “Everyone looks at market conditions and performance, but everyone has different policies” regarding how to get to the right valuation.
“It’s not that different than one analyst of a public stock issuing a buy rating, two issuing a hold rating, and five issuing a sell rating,” adds a third-party valuation expert who also asked not to be named in this story.
Worth noting: Valuations don’t tend to differ all that much in the early stages of a company’s life. “Smaller companies with smaller boards typically [peg a company’s valuation] at a similar [number],” says Bob Raynard, the managing director of the fund administration services company Standish Management in San Francisco.
It’s when investors invest in later-stage companies with much bigger cap tables and more investors that thing change, says Raynard. “Then you have different people with different objectives, and some are much more aggressive when it comes to valuations.”
Another Shoe to Drop?
Which brings us back to Fidelity. One of its markdowns involves Blue Bottle Coffee. As it happens, Fidelity marked down its investment in the company nearly three months after Blue Bottle decided to shut down its wholesale business.
That decision might or might not have factored into Fidelity’s decision to value the company differently. (The firm doesn’t publicly discuss its valuation methodologies.) But if it did, that’s notable, suggests Raynard. Though a mutual fund can’t exactly re-evaluate its private companies’ value daily as it does with its liquid holdings, Fidelity may have let the lofty valuations it had set for certain private companies grow “stale,” suggests Raynard, meaning newer shareholders in Fidelity’s mutual funds may have overpaid for those assets.
It’s a very real issue, says Jacob Frenkel, a former senior counsel in the SEC’s Division of Enforcement who today works at a white shoe law firm in Potomac, Md. “Where you have inconsistencies and disparities in valuation process and the perception of staleness in pricing, those are the types of issue that the SEC would examine. It’s certainly would be of interest to them.”
Stale prices are “considered a red flag for a flawed valuation process,” Frenkel says.
There’s much that we still don’t know, of course. For example, as Frenkel notes, it’s almost certain that Fidelity regularly prepares what’s called a “stale price report” that lists those of its securities whose price hasn’t changed for a defined period, and Fidelity surely has extensive procedures to determine when and whether those assigned prices are still valid.
The big question — for investors like Fidelity, for the SEC, and for other mutual funds that may be interested in getting more involved in privately held companies — is whether those procedures are sufficiently effective and, if not, where they are failing the individual investors who park some of their savings in mutual funds.
Raynard, who was formerly a senior manager at PricewaterhouseCoopers, suggests it’s something the SEC might have taken an interest in even sooner. “I used to audit mutual funds [at PWC] and I don’t think the mutual fund boards have a good process.”
In their “race to compete with index funds and [asset managers like] BlackRock,” it’s very possible that certain mutual fund companies have “been subjecting mom and pop investors to risks” that they shouldn’t, he adds.