The disruptive promise of WeWork — the real estate startup founded in New York City by a failed entrepreneur who dreamed of creating a global social movement of millennials looking for cheap office space and free beer pong — captured the wallets of many serious money men before reality brought the company close to ruin this fall.
It wasn’t just SoftBank’s Masayoshi Son, the Japanese venture capitalist who began plunking billions into WeWork in 2017 and famously told CEO Adam Neumann that he wasn’t “crazy enough.” None other than the U.S.’s largest and most prestigious bank, Jamie Dimon’s JPMorgan Chase, wrangled the lead on the IPO and also extended a personal credit line to Neumann of $500 million. Wizened real estate investor Mort Zuckerman was an investor, as were veteran venture capital players Goldman Sachs and Benchmark Capital. Even Harvard’s endowment was onboard.
But there is a little-known player in the saga that sheds a different light on the era that the excesses of WeWork have come to represent: the Hartford Capital Appreciation Fund, a Wayne, Pennsylvania–based $7.1 billion mutual fund loaded with investments in unicorns. These private companies, each valued at more than $1 billion, were placed there by subadviser and Wellington Management senior managing director Michael Carmen, a star VC investor of the mutual fund world.
The Hartford fund’s investment, made in December 2014, came to represent the biggest stake, on a percentage basis, that any mutual fund had in WeWork. And on September 30, the same day the once-fabled disruptor said it was postponing its troubled IPO indefinitely, Hartford Capital Appreciation — a publicly traded, open-end fund whose investors can sell whenever they want — quietly disclosed to the Securities and Exchange Commission that Carmen would no longer be advising the fund.
The dollar amount invested by the Hartford fund — some $25 million — is small in comparison to the $12.8 billion raised by WeWork over the past eight years. But as SoftBank began pouring billions into WeWork, the startup’s purported value skyrocketed, turning the company into one of the Hartford fund’s top-ten investments.
By November 2018 the Hartford fund deemed WeWork to be worth $42 billion, or $110 a share. The following January, SoftBank said the company was worth even more — $47 billion.
Uncertainty about WeWork’s upcoming IPO led Hartford to write down the position to $68 per share at the end of July. But the company still represented one of the Hartford fund’s top-ten investments and 1.2 percent of its assets — much bigger than the fund’s stakes in other unicorns, including ride-hailing company Uber Technologies, instant messaging platform Slack Technologies, and social media app Pinterest. It didn’t help matters that these had gone public and their stocks were nose-diving. Or that other mutual funds that’d also chased these unicorns, like the $116 billion Fidelity Contrafund, held only a 0.41 percent stake in WeWork — though that was plenty large.
As details emerged about WeWork’s huge losses, questionable accounting, and myriad conflicts of interest in its August S-1 filing, more stories about founder Neumann’s megalomaniacal behavior were splashed around the media, darkening the cloud over the company’s prospects. By the end of September, Hartford Capital Appreciation had sliced the value of WeWork even more — to $37.80 per share, according to Morningstar Direct. (It’s worth much less now.)
At the same time, the fund disclosed — in a terse SEC filing — that Carmen would no longer be one of its advisers. Wellington’s Stephen Mortimer, the portfolio manager who will be taking over Carmen’s duties at the fund, “will not invest in nonpublic firms, at least to the same degree,” noted Morningstar senior analyst Alec Lucas in an October report on the changes.
Hartford and Wellington declined to comment on the change.
But Lucas says that WeWork was a favorite play of Carmen, who also placed it in the portfolios of other mutual funds, including Hartford International Equity, Hartford Growth Opportunities, and a John Hancock fund. “He thought highly of WeWork,” notes the Morningstar analyst.
Carmen remains at Wellington, where he focuses on private equity. He will continue advising Hartford Growth Opportunities until the spring, according to a Wellington spokeswoman. With The Wall Street Journal reporting that unicorns have lost $100 billion in recent weeks, there is bound to be more fallout.
“One firm that has invested significantly in private placements told me . . . they were probably going to cease doing any investments in open-end mutual funds in private placements,” says Lucas, who declined to name the firm.
The question being asked now, though, is whether it is appropriate for open-end mutual funds to put money into companies like WeWork in the first place.
Given the daily liquidity of mutual funds, their investing in illiquid, hard-to-value private companies was one of the riskier developments of the recent unicorn boom — one fueled by the funds’ own efforts to fend off stiff competition from passive investments like exchange-traded funds and index funds.
“The mutual fund industry is just at a point where if they don’t have performance, an investor says, ‘Why would I pay you the fees? Why not go into the index fund?’” explains Derek Hageman, a veteran financial analyst with the American Association of Individual Investors, an educational group based in Chicago.
With private investments, he says, mutual funds “thought they were going to beat their benchmark. The assumption was that the higher the risk, the higher the reward.”
Taking such risks, however, couldn’t have happened without the deregulation of private placements via the Jumpstart Our Business Startups Act of 2012. That law opened the floodgates for money from Main Street to pour into companies newly unburdened by SEC rules and regulations designed — among other things — to protect investors from fraud.
Mutual funds rushed in just as unicorns started to proliferate. Before then unicorns had been a rare occurrence, according to Silicon Valley investor Aileen Lee, who coined the term in 2014. At that time she found only 39 companies that fit the bill, with just four unicorns born per year in the previous decade. Facebook, worth $100 billion at the time, she deemed the breakout “super-unicorn.”
Soon everyone began clamoring to get in on the next Facebook, and today CB Insights reckons there are 419 unicorns whose combined value exceeds $1.3 trillion.
The $20 trillion mutual fund industry is an enticing pot of gold for young companies looking for more capital, yet the percentage of mutual fund dollars invested in unicorns is still small. According to a 2016 Morningstar report, only 3.6 percent of the industry’s assets were then invested in private securities, and these were held by 194 funds. By December 2017, Morningstar calculated, 70 large-cap equity funds had some level of investment in private companies, accounting for $7.7 billion in assets.
The SEC caps an individual mutual fund’s private unregistered securities at 15 percent of its total assets, and none of them have hit that level. As of June 2016 only nine funds had invested more than 5 percent of their assets in such companies, with Alger’s Mid Cap Growth sporting the largest stake, at 11.3 percent of assets, according to Morningstar. (Alger wasn’t invested in WeWork. It is now down to 1.5 percent privates.)
Yet by sheer virtue of their size, mutual funds still have become some of the biggest investors in private securities, including unicorns. Fidelity ranks as the eighth-largest investor in terms of the number of unicorns it has invested in — 18 — and Wellington ranks tenth, with 16 unicorns, according to CB Insights. As of June, Uber, Airbnb, Slack, and WeWork were among the most highly valued unicorns owned by both of them.
The Hartford Capital Appreciation Fund isn’t the only one that appears to be rethinking the wisdom of such investments now. In addition to the management changes surrounding Wellington’s Carmen, Fidelity’s top unicorn hunter is also on his way out.
Andrew Boyd, Fidelity’s head of global equity capital markets, is leaving at the end of December after 15 years at the firm, a spokesman says, confirming a recent report in tech newsletter “The Information.”
Though Fidelity and Wellington were the mutual fund world’s big fish, they were hardly alone in buying into the WeWork story. Based on the fund managers’ valuations, as of June 30 the top-ten mutual funds owned WeWork shares worth almost $470 million, a recent PitchBook analysis shows. Morningstar’s Lucas says he counted 22 mutual funds invested in WeWork, including some bond funds. (Unusual for a unicorn, WeWork also gorged on debt.)
If the WeWork fiasco does curtail mutual fund interest in unicorns, it will be part of a withdrawal of capital for companies that have operated under the assumption in recent years that more capital is better. But that hasn’t turned out to be the case.
The more money the unicorns have raised, the worse they have performed once they went public. “You’ve had a flood of money. Guess what’s happening now? The returns suck,” says former hedge fund founder Enrique Abeyta, who is bearish on several unicorns that have hit the public market.
Abeyta, who now runs an investment newsletter for Empire Financial Research called “Empire Elite Trader,” believes that even Uber — once touted as the safest unicorn investment — could go bankrupt and recommends shorting it, along with Lyft and Slack.
Forty-three unicorns have gone public since 2015, according to Abeyta’s research, which uses Crunchbase data. On average the group is up 102 percent, according to an October presentation Abeyta made. But the 12 super-unicorns have done far worse, with a median decline of 31 percent. Three fourths of them have produced negative returns.
Abeyta likens the unicorn fad to the dot-com bubble of the late ’90s. He recalls the first day of his first Wall Street job in 1995, which happened to be the same day pioneer web browser Netscape went public. “I think it traded from like 25 to 75, and everyone’s like, ‘What the fuck is going on?’”
As in a previous era, he explains, “the fledgling companies thought, ‘We can lose a ton of money, but the capital markets will finance it and we can basically achieve exit velocity, like a ship going to space, where we get enough scale that now we dominate the market, but we don’t have to make money.’ That’s the fundamental premise of the super-unicorns for sure,” he says. “That’s over. WeWork was the end of it.”
Should mutual funds ever have gotten involved?
Morningstar’s Lucas notes that mutual funds appear to have adopted the VC model, which spreads capital among several companies, knowing that some will be bombs but others will be home runs — “spray and pray,” as the venture capitalists like to say.
That worries some observers. “With VCs you’ve accepted that level of risk. You know that’s the model. I don’t think the average investor, when they invest in a mutual fund, thinks that they’re signing up for that level of risk,” explains AAII’s Hageman.
Moreover, though VCs typically start off investing in early rounds, mutual funds often invest much later. With WeWork, for example, Wellington and Fidelity were part of a series F round in 2016 — five years after WeWork received its first VC investment. At the time, the company was already said to be worth $16 billion, twice its value today.
Mutual fund stars like Wellington’s Carmen and Fidelity’s Boyd have argued that their experience in the public markets gives them an edge.
In an interview with the Boston Herald in January 2015, Boyd said Fidelity could help private companies prepare for the glare of public scrutiny. “We treat them like a public company, and they need to answer questions from our analysts, and they’re probing questions, and this is what they need to get used to for earnings calls,” he said, adding that Fidelity was planning to increase its investment in privates.
As for Carmen, as recently as June he was touting his strategy in a Q&A that was posted on the Wellington Management website. He called the type of late-stage private growth companies the firm invests in a “potential sweet spot.”
He explained, “We see several potential advantages to investing in these types of companies. Late-stage companies typically trade at a lower valuation relative to their publicly traded peers, due to their inherent risk. Investors with the appropriate experience and skill set may be able to identify companies that are attractively valued, have high return potential, and are at the lower end of the risk spectrum. Additionally,” he continued, “they may be able to capture a larger portion of their growth potential by investing before an IPO. And finally, they may be able to provide these companies with the opportunity to accelerate their growth prior to an IPO or other liquidity event.”
His views are contradicted by recent IPO flops and the WeWork disaster. So where did these seasoned investors go wrong?
Of course, it’s difficult to value private securities. The Fidelity Contrafund makes a detailed effort to explain its process to investors in its December 2018 semiannual report, noting that it uses “alternative valuation approaches” for unregistered securities. It goes on to say that that includes both “the market approach and the income approach. . . . The market approach generally consists of using comparable market transactions while the income approach generally consists of using the net present value of estimated future cash flows, adjusted as appropriate for liquidity, credit, market, and/or other risk factors.”
The reality is far less technical. “Overall, the venture world is very loose,” says a VC investor for a prominent family office. When it comes to valuation, “it’s driven off FOMO,” he notes.
“No one wants to miss the next Uber,” says this investor, who did well with an early round in that company, despite its sell-off after going public. “If Andreessen or Sequoia [two prominent VCs] throw down a term sheet, someone else will offer a term sheet at a higher price. The fundamental way of valuing companies gets thrown out the window.”
Even though “a lot of smart money was in WeWork,” the investor adds, “all of the last couple of rounds have gotten crazy valuations, which was done by SoftBank marking up its own position.”
He says that happens because venture funds have to show gains to raise money for subsequent funds. “They’re not going to have distributions or liquidations in three years,” but they need performance numbers to lure investors into the next fund, he explains. “These are ten-plus-year funds, so these funds hold their marks at their last valuation.”
Given its valuation of WeWork, the Hartford Capital Appreciation Fund appears to have accepted the SoftBank valuations pretty much at face value. Although the fund last November pegged WeWork at $42 billion, others were not quite so generous. At the same time, Fidelity calculated WeWork was worth $28 billion, and T. Rowe Price, another big mutual fund investor, came in at $25 billion, according to Pitchbook.
Industry veteran Hageman says the wide difference in valuations shows a major problem mutual funds face. “At the end of each day, they have to value the NAV for each fund, but you don’t have one set price that you can say, ‘This stock is worth x.’”
Experience in the public markets, which the mutual funds tout, might help portfolio managers ask the right questions. But that doesn’t really help in coming up with the right valuation, the VC investor says.
As the Fidelity boilerplate suggests, companies could be valued on future cash flows. “But can you believe the future cash flows if they’re projecting some pretty ridiculous numbers?” he asks. Many of the companies do not even have updated, audited financials, he adds.
And when it comes to the disruptors that have been so prized by investors, there’s typically no history to judge them by and often no comparables in the public markets.
Still, it should have been easier to come to an agreement on the value of WeWork — if only because unlike most unicorns, a publicly traded comparable did exist. And in contrast to Carmen’s view that private companies are priced lower because of their risk, the WeWork example shows the opposite to be true.
In a recent scathing 25-page critique of WeWork’s August S-1 filing, Harvard Business School’s Nori Gerardo Lietz and Sean Bracken show that real estate company Regus, now known as IWG, is already profitable, had $3.4 billion in 2018 revenues versus WeWork’s $1.8 billion for the same year, and offers the same kind of co-working spaces that made WeWork famous. In the public market, the paper notes, IWG is worth only $3.7 billion. Meanwhile, WeWork’s prospectus suggests a $47 billion valuation despite a loss of $1.9 billion.
The Harvard authors also take aim at the JOBS Act, as the prospectus argues that the company was allowed “material nondisclosures” because it qualifies as an “emerging company” under the act. “If the prospectus complies with the JOBS Act, there is something seriously wrong with the JOBS Act,” they say in their introductory remarks.
WeWork even came up with a newfangled way to analyze its dreadful numbers — the “contribution margin.” The metric excludes depreciation, amortization, and capital expenditures, part of a plethora of financial details the Harvard authors find “troubling.”
“The S-1 read like The Wizard of Oz,” says Abeyta.
The WeWork saga still mystifies Amit Anand, co-founder and managing partner of Singapore-based VC firm Jungle Ventures. “I honestly cannot justify in my head why people ignored what was happening at WeWork for such a long time,” says Anand, whose funds focus on profitable companies. “At the risk of sounding controversial, I think it’s either pure greed or pure laziness.”
If ever there were a morality tale about the foibles of capital, the rise and fall of WeWork would certainly fit the bill. But even if an investor did get squeamish and wanted to sell his stake in WeWork (or any other unicorn for that matter), it wasn’t that easy.
That presents another thorny issue for mutual funds, which showed signs of cooling on privates even before the recent downturn. The dollar amount of investments by Fidelity peaked in 2015, according to CB Insights. That was the year the Fidelity Contrafund invested in WeWork for the first time. Pitchbook now calculates that it is facing a loss of 29 percent on that stake.
Wellington’s top year was also 2015, when Pitchbook says it participated in 31 VC rounds.
By 2016 the Wellington-subadvised Hartford Capital Appreciation Fund had investments in 34 privates, representing 3.7 percent of its assets, and was telling investors that WeWork was one of three investments that was helping it beat its benchmark. “The Fund’s fair valuation of WeWork, a U.S.-based shared workspace provider, increased as the company has been expanding and growing at a rapid pace,” it wrote in its semiannual report.
About that time, Morningstar calculated that 20 mutual funds were invested in WeWork, their stakes representing a market value of $660.7 million, just below Uber at $2.56 billion and Pinterest at $857 million. Airbnb was next, with $524.5 million. The Hartford fund held all four.
Worried about the risk, some fund managers wanted out. Morningstar’s Lucas says that Wellington portfolio manager Kent Stahl told him in a February 8, 2018, conversation that he wanted to “take privates to zero over the next three to five years” in the Hartford Capital Appreciation Fund. (Wellington has long managed Hartford’s equity funds while Hartford is responsible for distribution of the funds, notes Lucas.)
Stahl took on an oversight and risk management role at the fund when Wellington began transitioning it from a single-manager to a multimanager fund in 2013. One of the six managers was Michael Carmen, who was responsible for about 20 percent of the fund’s portfolio and placed it in WeWork and other unicorns, as well as other growth companies, according to Lucas. (Stahl retired at the end of 2018, and Gregg Thomas took over the oversight role.)
But even if one wanted to get out of privates, doing so would be tricky. Months after Stahl was talking about exiting privates, WeWork had reached peak valuation. “The shares maxed out at $110 per share in November, so at that point he’s probably thinking, ‘We’re glad we didn’t sell it,’” says Lucas.
That’s assuming, of course, that it would have been possible to sell many shares in the illiquid secondary market that exists for private unregistered securities.
“You can’t really trade size,” notes the family office VC investor. “There are secondary brokers always fishing around, but it’s hard to get any deal done. You can maybe get a million or five million of liquidity.”
According to its public disclosures, over time the Hartford fund did manage to sell a few million shares of WeWork. The fund’s portfolio managers no doubt worried about what would happen in the event of a market downturn or other problems in the portfolio. “It doesn’t take a rocket scientist to realize these are early-stage growth companies and priced infrequently,” says Lucas, adding that if the portfolio runs into difficulty for any reason, the private portion can be an added problem.
When private securities can be sold, investors say the effort usually entails a massive discount, so mutual funds typically prefer selling publicly traded stock instead. “Investors can be fickle and may not stick around when the fund is going through a rough spell,” Morningstar associate director Katie Reichart wrote in 2018. “Managers can be forced to sell publicly traded stocks they may have preferred to keep.”
Therefore, she says, illiquid holdings “can drive more of the fund’s performance than perhaps was initially intended.” As an example she cites the Morgan Stanley Institutional Mid Cap Growth fund. When it was faced with a “rough patch” between 2014 and 2016, she wrote, “investors yanked billions of dollars from the fund. As a result, its once reasonably sized stake in private companies ballooned to 9 percent of assets by mid-2016.”
No doubt the Hartford fund was hoping WeWork’s IPO would provide an exit. Even if the IPO debut “wasn’t the greatest,” suggests Lucas, “they could have gotten out at a market-beating gain” given the cost of their initial investment. Now that the IPO has been postponed indefinitely and SoftBank is shoring up the company with more loans, Hartford could end up with losses on its remaining WeWork stake. According to calculations from its SEC disclosures, the fund paid close to $16.65 per share for its original stake.
Certainly, WeWork is now worth far less than the $37.80 per share Hartford accorded it at the end of September, given that its value has sunk from $47 billion in January to about $8 billion. Some critics — including seasoned real estate investor and Pershing Square Capital CEO Bill Ackman — even predict it will go bankrupt.
At the end of October, Hartford Capital Appreciation wrote down its WeWork stake to $18.65 million, or $14.55 per share — more than 12 percent less than what it had paid for it in 2014.
The fund also is about $1 billion lighter in assets than when Wellington announced Stahl’s retirement in August 2018, when it held $8 billion. And as it turns out, those big investments in unicorns haven’t always helped it beat its benchmark index, the Russell 3000, either.
Despite its wildly optimistic valuation of WeWork, the Hartford Capital Appreciation Fund over the past five years has underperformed the Russell 3000 by 172 basis points on a total return annualized basis, according to Morningstar, which gives it a “neutral” rating. This year the fund slightly trails both the S&P 500 and the Russell.