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This is the secret on how mutual funds are juicing their returns you should know about

  • As of the end of 2016, 3.7 percent of U.S. equity and allocation funds had some money in private operations.
  • With less companies coming to market today, there will be an uptick in mutual funds buying into private operations.
  • The number of companies listed on U.S. exchanges has fallen by about 37 percent over the last 20 years.

On Monday, space fans and Elon Musk devotees watched yet another satellite-carrying SpaceX shuttle launch into orbit. While most surely breathed a sigh of relief after seeing the shuttle reach its intended target — previous flights haven't gone as well — one group that was no doubt thrilled to see its success were the retail investors who have a stake in the still private operation.

Most Americans think that only venture capitalists and wealthy businesspeople can buy into unicorn companies like SpaceX, Uber and Airbnb, many of which are on CNBC's 2017 Disruptor 50 list. But a growing number of mutual fund operations are offering investment into these companies, giving their unit holders — often average Americans — access.

A SpaceX rocket sits on launch pad 39A as it is prepared for the NROL-76 launch on April 29, 2017 in Cape Canaveral, Florida.
Getty Images
A SpaceX rocket sits on launch pad 39A as it is prepared for the NROL-76 launch on April 29, 2017 in Cape Canaveral, Florida.

According to Morningstar, as of the end of 2016, 3.7 percent of U.S. equity and allocation funds had some money in private operations. While that's a small amount compared to their overall holdings, the number is rising every year, says Katie Reichart, an associate director at Morningstar.

We'll likely see even more mutual funds buying into private operations, because there are simply less companies coming to market today. In 2016, there were only 128 IPOs in the United States, down 65 percent from 2014, while the number of companies listed on U.S. exchanges has fallen by about 37 percent over the last 20 years.

Instead of companies listing after four years of business, which was typical, they're now waiting until they're more mature, coming to market after eight or 10 years in operation. "We have seen an uptick in mutual funds investing in private firms," says Reichart. "Part of the reason is that firms are staying private for longer and delaying their IPOs."

Data from CNBC's Disruptors List shows that several investments have been made by mutual fund businesses into unicorn companies. Fidelity Investments has stakes in nine companies, including SpaceX, Uber, Airbnb and Pinterest. T. Rowe Price has bought into seven businesses, such as WeWork and Houzz. Franklin Templeton Investments and Brandes Investment Partners own part of IEX, while several others have stakes in at least one or more unicorns.

In most cases, a firm's investment team will decide that a company looks attractive and will then go to its managers to see if they want to allocate any of their fund's money to the purchase of shares. Managers are free to say no, but the ones who say yes will get an allocation of those shares in relation to how much they put in.

Generally, it's large-cap growth-oriented managers who are interested in unicorns, says Reichart, though several mid-cap funds own private operations, too. For instance, according to her research, large-cap funds such as Hartford Growth Opportunities and Davis International hold more than 6 percent of their assets in private companies, while the Alger SMid Cap Growth Fund has more than 10 percent of its assets in non-listed operations.

How can you tell if your fund owns a unicorn? Start by looking at its quarterly SEC filings. Some other companies, like Fidelity, also publish monthly holding reports on their website.

Giving growth capital

While Fidelity has been investing in private companies for more than 20 years, it has been buying into more unicorns lately due to the lack of IPOs, says Andrew Boyd, head of global equities capital markets at the Boston-based mutual fund firm.

In many cases, these companies could be public and would have been already if this were a decade ago, he says. Executives, though, want to grow the business for longer, away from prying eyes and daily market ups and downs. "You have this space where companies are large and could go public, but they decide not to, yet they still need capital," he says.

More from CNBC Disruptor 50:
Uber vs. Lyft: A race that isn't anywhere near over
Why Warren Buffett is betting on this software start-up
Forget Silicon Valley, this is the red-hot market US start-ups are flocking to

That's where fund companies can help. Boyd makes it clear that Fidelity doesn't invest in start-up operations or even in early venture capital rounds. He wants to own later-stage companies that are generating revenues and will likely go public. They'll already be proven operations, but they might need money to help them grow even larger. "We are not a venture capital firm," he says. "We want to see the tech risk already taken off the table — we're providing capital to expand and go to market and scale."

"These can juice returns, and these are opportunities that you can't get anywhere else." -Robert Stammers, Director of investor engagement, CFA Institute

He's also not looking to cash out when the company lists. Fidelity invests in private businesses in the same way it might invest in a public one: It wants to buy a long-term holding at a good price with the hopes that it will appreciate over time. In many cases, a company's pre-IPO price is cheaper than its price after listing.

While there's no certainty that their investment will come to market, Fidelity only buys into operations that it thinks will IPO within a "reasonable time frame," he says. What that is he can't say – he doesn't want to pressure companies to list – but he needs to have an expectation that they will go public at some point. When a company does hit the market, Fidelity will often buy more of the stock, says Boyd.

Hard-to-sell shares

Investing in unicorns does come with a considerable amount of risk, says Robert Stammers, the CFA Institute's director of investor engagement. These are illiquid investments, so it can be difficult to cash out if something goes awry. Managers may also have to sell off public investments to meet redemptions, instead of hard-to-sell private operations.

The SEC tries to protect against these issue, by saying that only 15 percent of a fund's total assets can be in illiquid investments. Fidelity doesn't allow its mangers to have more than 10 percent of a fund's assets in private companies, though most of the dozen funds that do hold private companies only have about 1 percent to 3 percent in non-listed businesses, says Boyd.

Valuation confusion

The other risk is valuation, says Reichart. Because these companies aren't listed, they don't have to follow the same disclosure practices as public operations do, which can make these companies hard to value.

It's up to companies to place their own value on a business — that's done by a valuation committee, not the managers themselves — which is typically based on funding rounds, public company comparisons and a firm's own internal metrics.

"A company is valued at any point in time, and that can be a challenge because there're no standard," says Reichart. "Different asset managers can do different valuations at any point."

However, Boyd adds that because of its private status, he can ask a CEO anything he wants, such as information on detailed monthly user data, which isn't typically disclosed after a company goes public. "I can get whatever I want," says Boyd. "Stuff I'll never get from a public company."

Still, you don't know what a company is worth until it goes public, and there could be better entry points after an IPO. For instance, Fidelity bought into Facebook at about $25 in March 2011. It IPOed in May 2012 at $38 but fell to $18 in August of that year. While it could have made more by waiting, with Facebook now at $150 a share, it still made a mint off the company.

Even with the risks, Stammers says private businesses can help boost returns, as long as managers keep their positions relatively low. "These can juice returns, and these are opportunities that you can't get anywhere else," he says. "It risky, but then again, most aren't making huge bets on these companies."

As for Boyd, private companies are now just part of his investible universe. "This kind of investing is here to stay," he says.

— By Bryan Borzykowski, special to CNBC.com

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