Nizar Tarhuni November 23, 2015
There's been quite a storm set off with recent media reports covering the markdowns that Fidelity Investments has undertaken for private companies in its mutual funds. A couple of the notable valuation stake write-offs in Fidelity’s portfolio include Snapchat, marked down 25% since May, and Dropbox, marked down just under 20% in the same timeframe. While these markdowns have caused a big reaction from much of the media, the valuation write-offs aren't as overly indicative of an actual decline in the performance of these privately held companies—rather simply an accounting measure these funds have to abide by. Sure, some of these companies likely have their own business issues but the story is a bit overblown, so let's provide some context.
Let’s start with some of the rules.
Under the SEC’s Investment Company Act of 1940, “An open-end fund must reflect changes in its holdings of portfolio securities in the first calculation of net asset value no later than the first business day following the trade date.” These private stakes don’t trade on an exchange, sure, but Fidelity and its counterparts still have to account for them. Is it unfortunate for these private companies that mutual funds have to publicly disclose this? Maybe. But there's an anecdote that publically traded tech companies don't care about Wall Street and focus on their core businesses; these private unicorns should probably think the same.
The next question is how do these mutual funds land on these valuations, which are only a hot topic now due to the steep markdowns? Let’s go back to the basics.
Trading securities, defined as securities acquired with the intent to profit over the near term, are reported on balance sheets at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability.
To value these securities, there are three primary valuation techniques, according to the Financial Accounting Standards Board:
This approach uses information generated by market transactions involving identical or comparable assets or liabilities. An example of this is using market multiples derived from a set of comparables. Multiples from a set of comps can lie in ranges, and thus the selection of where within the range the appropriate multiple falls requires judgement, considering both qualitative and quantitative factors specific to the measurement.
A great example of this approach would be a discounted cash flow (DCF) method, where one would discount a company’s expected future cash flows to a single present value. This measurement is dictated by the value indicated by current market expectations about those future amounts.
This approach is based on the amount that currently would be required to replace the service capacity of an asset. From the perspective of a market participant, the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence, which includes physical deterioration, functional/technological obsolescence and economic/external obsolescence, and is broader than depreciation for financial reporting purposes or tax purposes.
The cost approach is likely not the approach used to best value these companies.
The income approach alone probably isn’t best practice to value these companies, but it can certainly be used in combination with another method for certain companies, depending on where they are in their lifecycle. Here’s why. For many high-flying private startups, much of their value can be based on an enormous amount of intangible assets that their balance sheets can’t value, such as user growth and user loyalty. Think about Snapchat; the user base it has amassed could generate substantial profits if the company is able to adequately monetize it. Yes, it is an “if,” but many investors are certainly factoring this in, while a DCF isn’t going to capture that potential value.
Last, we’re left with the market approach and the use of comparables. The most adequate comps with the most readily available financials are going to be on the public side, yet the stock market has struggled over the last quarter in light of varying uncertainties across the globe. Public equities have also performed fairly well in recent years, so a pullback isn’t too alarming, but declining public valuations are going to hurt those on the private side.
As mutual funds have to make judgement calls on the best way to value their private holdings, the markdowns we’ve seen are far more indicative of the comps they have to measure these holdings against, and shouldn’t be taken as a be-all and end-all notion. As mentioned, there's a qualitative component to pricing these private securities, so the overly publicized inflated “environment” around unicorns plays a role in how these companies may be valued, but we should be careful in judging these startups solely off of mutual fund pricings. Just because Fidelity has to follow the law with their reporting, let’s not blow this out of proportion.