Mutual Funds Pump Money Into Small Companies Before IPO

It used to be that almost all mutual funds invested their capital only in securities of public companies. But that’s been changing—which could be good news for some small businesses that have big plans.

Thirty-six percent of firms going public in 2016 received mutual-fund financing before their IPO, according to a recent research paper by Michelle Lowry and Sungjoung Kwon, both at LeBow College of Business, Drexel University, and Yiming Qian at the University of Iowa.

This practice of investing in private firms has become increasingly widespread. Specifically, the authors say, fewer than 15 funds invested in private companies each year through 2000, compared with around 90 unique funds in 2015 and 2016. The research used data from 16 fund families from 1995 to 2016.

“The interest of mutual funds is driven by two things: the possibly of investing in unicorns and the fact that these firms are going public later and later,” says José-Miguel Gaspar, professor of finance at Essec Business School in Paris. In other words, mutual funds want to get in early on companies with potential for fast growth.

If this trend continues, it’s likely to be good for some, but not all, small businesses. To get an investment from a mutual fund, a company will need to offer something rather special. “I am not sure this is a development for the average startup,” says Prof. Gaspar.

For instance, a small chain of pizzerias probably won’t get too much interest from a mutual fund (other than when buying pizzas).

On top of that, the level of mutual-fund investment in private firms, while growing fast, is still relatively small and likely to stay that way. “Under the terms of a law from 1940, mutual funds are allowed to own 15% of their assets in private firms; guidance that came later suggested 10%,” says Richard Evans, professor of finance at the University of Virginia’s Darden School of Business in Charlottesville. “They can only put a small allocation in such firms.”

But for those companies that can get a mutual fund interested, there is plenty of good news.

Lower cost of capital. Prof. Evans notes that the availability of more capital to fund businesses ultimately means a lower cost of capital for the businesses. It goes back to economics 101—more supply lowers the price of the capital needed. In this case, the potential returns that the investors want to see in the companies they buy will be lower.

Stay private longer. “What the paper shows is that having mutual-fund investors shows that companies can stay private 1½ to 2½ years longer than otherwise,” says Prof. Lowry.

That allows the firms the potential to grow without the pressure of reporting earnings each quarter. That means that profits can be reinvested into the business and so help boost longer-term growth.

Less regulatory filing. Public companies must file many documents each year. Staying private allows managers to concentrate on growing the business rather than filling in government forms. The longer they stay private, the longer they can avoid the paperwork.

Help with growing pains. Any small company that wants to grow will see growing pains, but with a mutual-fund investor, there are seasoned managers available to offer advice.

IPO prep. The advice isn’t just there when there is a misstep. Perhaps most important, the advice and coaching can help companies with their debut on the stock market, aka the IPO.

“The transition [from private to public] can be quite a big change,” says Sonu Kalra, portfolio manager of the Fidelity Blue Chip Growth Fund. He adds, “The leaders are used to sitting in a room with a few people, whereas when they are public, it will be with a big group of people.”

Mr. Kalra says he and his team try to prepare company managers for what to expect when their stock is listed. They hold mock earnings conference calls, and mock roadshows where company leaders will talk with investors.