Tuesday, June 30, 2015

Why Do I Keep Seeing Fidelity on Every VC Deal?

I follow the news regarding startups and venture capital firms fairly closely - and lately I keep seeing something that confuses me. It's not the increasingly eye-popping valuation numbers, or the fact that every article is obsessed with declaring the next unicorn, but more often its who is in on these later rounds.

More frequently, it's not your typical VC firm, but a more traditional investment firm - one that you'd expect to see advertising on the Sunday morning news shows, not being mentioned in TechCrunch.

There have been articles on the trend - but I was particularly interested in Fidelity - who I think is doing it the most. I feel like every other day I read about Fidelity putting another bunch of capital into the later round of a 'unicorn'.

Crunchbase confirms that if they aren't the biggest recent VC investor, they've got to be pretty darn close.

June 28 - AirBnB -$1.5B round
June 25 - WeWork - $400M Series E
June 10 - PaxLabs - $47M Series C
June 9 - Blue Apron - $135M Series D
May 29 - Snapchat - $338M Series E
May 8 - Pintrest - $186M Series G

Now those totals are the whole round, not Fidelity's specific commitments, but that seems like a LOT of deals in a very short time span.

And I've been trying to wrap my mind around how/why they are putting out so much money so fast, in seemingly every big deal that gets announced.

The first argument would be that they're investing to generate a return. OK sure, but is that really possible?

I decided to do a little digging. One of the things that makes tracking Fidelity's VC investments difficult is that they operate so many different funds. When Fidelity announces an investment - it's not always in the same mutual fund bucket (which to me raises an interesting question as to how they allocate deals, but that's another subject altogether). I saw a reference to three primary funds for VC investments - the Contrafund, the Growth Company Fund, and the OTC Fund.

So I pulled all those funds most recent Holdings reports - which list all their investments as of May (so I missed out on some of the more recent deals).

I did a rough filter to try and ascertain how much VC exposure each of the funds had:

Contrafund ($112B total) - about 1.1% or $1.2B...largest investments are a 0.35% of the fund in Pintrest Series E and 0.14% of the fund in Uber Series D
Growth ($43B total) - about 1.7% or $740M...largest investments are in a 0.36% of the fund in Uber Series D and 0.2% of the fund in YourPeople Series C
OTC ($13B total) - about 2.1% or $280M...largest are a 0.56% in Uber Series D (that really got spread around) and 0.27% in AppNexus Series E

So we're talking about small concentrations here. All of these funds hold more of each of Apple, Facebook, Google, and Amazon than their entire VC portfolios.

So the argument that you need to invest here to get returns doesn't really seem necessarily true. Let's set aside the fact that these investments are in later rounds than average, which means there isn't as high a ceiling on some of these valuations. Let's assume the Fidelity VC portfolio in aggregate generates an average return (which is giving the Fidelity VC and mutual fund teams the benefit of the doubt and assuming they're as good as the average dedicated VC investor).

The average return on a VC portfolio over ten years is ~8%. So if we assume an 8% growth rate on the VC portfolio in those Fidelity funds, their collective $2.3B in investments will be worth $4.7B in ten years. That's essentially doubling your investment...and it moves the aggregate value of the overall Fidelity portfolio a little more than 1%. That's it.

These are for funds who average 12-13% returns over their lives, so I can't imagine these returns would really cut it (especially because I think we're dramatically overstating the potential gains).

Well, if it's not returns, is it just to ensure access? I saw a recent stat that the average time for a startup until its IPO has moved to 11 years. That's a long time. So there's a thought that if you aren't investing in these startups now, you're going to have a tougher time getting access to the stock when it goes public - if it even goes public at all.

I suppose you could make that point - but is it really so tough for these major institutional investors to get allocations when these stocks come up? I have zero banking background - so I honestly don't know.

My thought, is that its more a question of optics than returns. Differentiating your mutual fund from many others is difficult, and with increasing interest in low-cost index funds or ETFs - mutual funds need to push the envelope further and further to demonstrate their value add. (I'm asserting the point about inflows into low-cost mutual fund alternatives, I don't have the data, but I believe I've seen evidence of that). What's a great way to demonstrate the benefits of active management? How about including private company investments that index funds or smaller mutual fund companies literally CANNOT invest in??? Let's see Vanguard try to do that one.

It's a small investment for the Fidelity's of the world, like I said, it's ~1% of the portfolio. If it blows up, it's a blip on the radar. But for an investor making the marginal decision about which growth-targeted funds to invest in, the fact that you've got Pintrest in the portfolio might be enough to sway the decision.

Of course, what that means for the rest of the VC community (probably bad) and startups (probably great) has yet to be seen.

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