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No, Mutual Funds Aren’t “Dumb Money” Startup Investors

Aug 03, 2017

This article first appeared in Term Sheet, Fortune’s newsletter on deals and dealmakers. Sign up here.

After we wrote about mutual fund markdowns to Uber’s share price, a few readers wrote in asking how mutual funds determine their markdowns.

A couple things to note:

• This isn’t just a bunch of people sitting around a table saying “15% sounds right I guess…” Each firm has its own process. Many firms use an internal cross-disciplinary valuation committee that operates independently of portfolio management. Sometimes portfolio managers or analysts are involved. They base their valuations on factors like the offering price (in a subsequent investment round, the secondary market, or company-sponsored liquidity events), financial performance and valuation of peers, and other factors. (Fortune’s Jen Wieczner wrote about that here.)

• Remember late 2015, when mutual funds started slashing the holding values of many of their portfolio companies? The press started reporting on it and everyone freaked out. On the holiday party circuit, startups debated whether they should include mutual funds in their next rounds of funding, given the negative signal a markdown could create. After all, startups were staying private longer so they can maintain that sweet appearance of momentum, even when they have a bad quarter or two. Public markdowns defeated the purpose. (In a world where venture investors are supposedly not allowed to criticize startups, markdowns were practically a declaration of war.)

Then the markdown reports died down. Two reasons why: First, journalists realized mutual fund valuations weren’t necessarily a great reflection of the company’s performance (the process, as described above, isn’t always consistent or transparent, many startups don’t have any "public comps" to be compared to, and the firms do not use inside information on the company to make their assessments).

Second, mutual funds realized the damage they were doing. Jen emails:

Fidelity seems to rarely change its private valuations on its high profile portfolio companies anymore. Several of the others hadn’t touched Uber’s valuation in at least a year, or in some cases, not since its last fundraising round. And [this week's mutual fund markdowns at Uber], it was weirdly consistent among three funds, which makes me think that they were actually basing it off some specific data point, whether a secondary market sale or something else. Otherwise I don’t know how they would all have independently arrived at the exact same share price, down to the cent.

Which is why this week's Uber news was significant enough for us to report on.

• A 15% drop is not a problem for the mutual funds. Any paper losses are tiny compared to the overall size of the funds that T Rowe Price or Fidelity are investing out of. Plus, they plan to hold for long after the IPO. (Is this a good time for me to break out my favorite gif again?)

In other words, the narrative that the mutual funds are “dumb money” is wrong. They’re not dumb, they just have a totally different strategy than venture capitalists. And now, two years after they poured giant sums of money into many late state startups, we’re starting to see the negative effects of those conflicting strategies.

One example: Blue Apron’s last round of funding. In 2015, the company went out to raise its Series D, and a number of late stage venture capital firms put in bids that were a premium to the company’s prior valuation of $500 million, but still under $1 billion. They were all outbid by Fidelity, which submitted an outlier bid at $2 billion.

Fast forward two years. After dramatically reducing its planned IPO price, Blue Apron is currently trading at a valuation of $1.16 billion. That’s not a problem for Fidelity – the firm can wait for a long time for the stock to rise or for Blue Apron to sell for a premium.

But it’s bad news for employees that joined after the Fidelity round and were granted shares that are now underwater, as well as any investor that bought shares at the $2 billion valuation on the secondary market.

Here’s a study (via Bloomberg) that explains that problem in more detail. The moral is: Inflated valuations hurt startup employees the most.

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