A number of hedge funds, special purpose feeder funds and venture capital funds have had the good fortune of recently seeing one or more of their portfolio companies undertake an initial public offering. Think Alibaba, for example. In many instances, these funds are distributing to their investors the stock held in these new public companies, rather than attempting to sell the stock and then distributing cash proceeds.
It is worth looking at the valuation policies of these funds to get a sense of one reason why these stock distributions may be happening. Most fund valuation policies value publicly traded securities that are distributed to fund investors in kind based on the trading price of those securities as of the date of the distribution or, at the average trading price for a trailing period of trading days (for example, 10) immediately prior to the distribution.
In the case of a company that has recently gone public, the trading price of the stock typically drops significantly immediately after the underwriter lock-up period or Rule 144 holding period expires. Funds often distribute securities immediately after these expiration dates. With a backward-looking test for valuation, a fund manager gets the benefit for purposes of its incentive allocation or carried interest calculation of the higher trading pricing before the drop. The institutional investor can be left with the undesirable prospect of selling the distributed securities into a market that has a significantly increased inventory of those securities. This excess inventory may prevent pricing from recovering to pre-distribution levels for months or even longer. We continue to be reminded that for these and other reasons, institutional investors often view a stock distribution as a burden, not a benefit.
We were intrigued to recently see a valuation policy from a private fund manager along the following lines:
For distributions of marketable securities, the initial price will be the closing price the trading day before the distribution is effected. Once post-distribution open market trades have reached a total volume of at least two times the number of marketable securities distributed, the volume weighted average price of these open market sales will be a “second” price. For Partnership valuation purposes, the distribution price will be the lower of the initial price and the “second”/volume weighted average price.
Similarly, the valuation policy in another fund limited partnership agreement we recently reviewed valued distributed securities based on the average trading price for the five trading days before and after the distribution. Valuations policies like the ones above reinforce the alignment of the manager and investor in the eyes of the institutional investor.
Kristen M. Chatterton