MFs buy hot stocks like Snap ahead of IPOs

Some mutual funds already have stakes as companies go public

Snap acquired loads of new investors when it went public last month, including people who own mutual funds that bought shares. But while the stock had just been listed for trading, those new owners were not the first fund investors with a stake in the image messaging service.

They were beaten to it by shareholders of about two dozen mutual funds, including several run by Fidelity and T. Rowe Price, that held pieces of Snap going back at least to last June, according to Morningstar. The practice of purchasing privately traded equities is fairly common among large fund companies, albeit usually in small amounts relative to their assets.

A Morningstar study found that private-firm equity holdings accounted for just 0.13 per cent of assets in stock or asset allocation funds in the middle of last year. Among funds that made such investments, the median ownership was 0.51 per cent of assets, and only nine funds, out of more than 5,000, invested more than 5 per cent.

With positions so modest, private-firm equity purchases may hardly be worth talking about, except that the companies that funds invest in are often the sort that get talked about: buzz-worthy tech stocks with highly anticipated initial public offerings, such as Facebook in 2012, Twitter the year after that and Snap most recently.

The next crop of next big things to go public may include the ride service Uber, the biggest object of private-firm equity investment cited in the Morningstar study, and the service Airbnb.

Buying ahead of the crowd carries great reward potential but also significant risks, analysts and fund managers say. It's a useful way to gain access to tomorrow's hot stocks today, as long as it's done in amounts that are small enough to keep participants from getting burned if something goes awry and the crowd fails to show up.

"Being early to the table can benefit fund owners," said Katie Reichart, associate director of equity strategies research at Morningstar and the study's author. "Funds can buy into a company at a much lower valuation." Highlighting the main drawback, she added, "It might not go public or fizzle out."

With no liquid market to continually set prices, it's hard for funds or their shareholders to know what a private company is worth at any moment. This can result in stale pricing, or a valuation based on a stock's last trade that occurred so long ago that it can no longer be considered an accurate gauge of its worth. At times when investors are dumping stocks across the board, there could be no one to take a privately held stock off a portfolio manager's hands, ultimately leading to a total write-off. Even if a stock goes public eventually, owning it can create difficulties, Reichart said. If a fund must sell stocks to meet redemption requests, for example, there may be no choice but to sell publicly traded issues that the manager would rather keep, causing private-firm equity to become an undesirably large proportion of total assets.

A successful public offering and further gains thereafter, on the other hand, can produce returns many times as great as a fund's initial investment. The prospect of getting a piece of such a stock early and making a huge score explains why private companies are sometimes called unicorns.

To try to strike the right risk/reward balance, funds generally invest after a company has established a history of generating solid and growing revenues. Once a position appears to be meeting a manager's expectations, further capital is likely to be invested, before or after the hoped-for public stock sale. "We're trying to find something we can continue to buy and make a bigger portion of our funds," said Andy Boyd, the head of global equity capital markets at Fidelity, the largest private-firm equity investor by far, with stakes totaling roughly $5 billion across several funds, according to Morningstar.

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