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John C. Coffee Jr. John C. Coffee Jr.

For some time, high-tech, start-up firms have slowed in their progression to an IPO, typically going through multiple rounds of private financings (sometimes six or more). Concomitantly, mutual funds have become significant investors in these later round private placements, in the hopes of stealing a march on those rival funds who wait for the IPO before investing. Finance scholars have noted that mutual funds behave very differently than venture capital firms in this process. While the VC firms focus their negotiations on board representation and monitoring, Harvard Business Professor Josh Lerner and his co-authors in a recent study find that mutual funds largely ignore monitoring rights, but focus instead on contractual protections that protect their expected rate of return. In particular, mutual funds seek two types of provisions: (1) redemption rights that allow them to escape (possibly if the IPO is delayed), and (2) a pricing “ratchet” that entitles them to additional shares in the event that the IPO prices below the valuation reflected in the final private-equity round. See Chernenko, Lerner and Zeng, “Mutual Funds as Venture Capitalists: Evidence from Unicorns” (available on SSRN). Thus, a poor IPO outcome (a “down round” in the vocabulary) may entitle the holders of this ratchet provision to additional shares that place them in the same (or nearly the same) economic position as if the IPO had priced at a level equal to the last private-equity round valuation. Effectively, they are held harmless (or relatively so) from the risk of a “down round,” but public investors suffer twice (both when the IPO price falls and again when dilutive shares are issued under the ratchet).

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