Nazanin Sangestani

Law & Finance of Venture Capitals and Start-Ups

Reaction Paper to Mutual Funds as Venture Capitalists? Evidence from Unicorns by Sergey
Chernenko and others of Pursue University, October 2017

April 10th, 2022

Introductory Remarks

The current paper is written in reaction to Chernenko’s article titled Mutual Funds as Venture

Capitalists? Evidence from Unicorns (hereinafter the “Article”). I will primarily investigate the

findings of the study which is presented based on contract-level data and will later evaluate the

consequences presented as results of open-end mutual fund investments re corporate governance

concerns.

Mutual Funds; a Contribution to the Fairytale of Unicorns or a Taste of Reality?

There is no denial in the fact that we have been witnessing a significant rise in the number of

mutual funds that invest in unicorns in the past decade. This Article investigates the potential

reasons for such rise with focus on the structural reasons. It is interesting that the shift from

specific VCs with historically predictable line of investments in the realm of entrepreneurship has

now become more unpredictable as broader ranges of investors have become key players in stages

before going public.

This dramatic paradigm shift is rooted in the fact that more start-ups are taking longer to go public

and entrepreneurial success is no longer limited to doing so. As more start-ups tend to avoid

revealing their information as required by the IPO process, investors that are traditionally expected

to invest in the public market enable such delay.

The traditional expectation and association that the Article mentions, is rooted in the structural

nature of startups where much risk shall be taken when making any investment and the fact that

VCs have long been more compatible with the uncertainty that forms an integral part of such

investments. The authors then point out how mutual funds have a record of merely engaging with
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firms as common shareholders and hence not directly being engaged with governance issues put

together with the reluctance of investors for illiquid securities; would make mutual funds primarily

incompatible.

Mutual funds are not equipped with the ability to provide private firms with governance and hence

will not be able to provide the firms with certain strategic benefits that VC could for the portfolio

companies, which the authors translate into fewer cash flow rights as well. Nonetheless, mutual

funds invest in private firms despite their high illiquid securities and in order to be able to manage

their asset side more actively given their daily redeemable shares. Accordingly, mutual funds

actively sacrifice much of their governance rights in order to gain stronger redemption rights.

Yet, it is positively surprising how the authors view this need as a feature for mutual funds. They

portray such illiquidity risk management in mutual funds’ contractual choices, as making mutual

funds better able to “vote with their feet” than VCs.

However, it shall not be disregarded that this Article primarily investigates and draws its conclusion

from mutual fund investments in US-based unicorns. While certainly on the rise, the number of

unicorns is limited and not much comprehensiveness is expected (98 firms in the current study).

It could have been interesting to have more inclusive data collection that could cover a larger

number of private firms as authors suggest by including another 55 “almost-unicorns”. This is

stated in understanding of the issue of lack of publicly available information that could be

investigated and studied. Consequently, it is important to bear in mind the limitations of the study

and its inapplicability to any private firm with less than one billion dollars valuation. On the other

side of the study, the sample of mutual funds includes all actively managed US domestic equity

funds which is as inclusive as it can get.

Another interesting point of the data collection is the selected contractual provisions which best

specify the ex-ante allocation of cash flow and control rights between firms and their investors;

namely the cash flow rights that include dividend rights, liquidation rights, anti-dilution protections
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and the control rights including redemption rights, voting rights with particular focus on director

elections.

Conclusion

The fascinating finding of this Article; the fact that mutual funds could be recognized as more

compatible with private firm investment than venture capitals in certain areas, given their unique

capabilities for later stages, struck me as the reader particularly in light of the fact that mutual funds

are less likely to benefit from as wide of governance rights as VCs and it still remains very much a

fact that VCs have more experience in managing portfolio companies and could actively provide

better and more engaged governance to the private firms. Nonetheless, the Article correctly

concludes that the trend of mutual fund investments in unicorns is limited to larger size mutual

funds with stronger redemption rights and significantly weaker cash flow rights. Yet, it is important

to recognize the soft power gained by mutual funds as they invest in more and more private firms

which provides them with a much necessary certification.