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Scott Kirsner | Innovation Economy

Is Fidelity pumping the tech bubble?

A roster of today’s hottest startups would have to include Airbnb and Uber, which allow anyone to become a hotelier or chauffeur, and Pinterest, which lets you create virtual pinboards tied to topics you care about.

SpaceX has visions of becoming the FedEx and JetBlue of outer space. Dropbox makes it easy to store files online and get access to them from any device, and Snapchat lets you send photos that are visible only for a short of time.

Two threads connect that circle of startups, all of which are privately held and have valuations of $10 billion or more.

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The first is skepticism that the profit potential of these disruptors justifies the sky-high valuations. Investors, for example, think Airbnb is currently worth $24 billion. Can a website for renting vacation homes and spare bedrooms really be more valuable than Marriott, with a $20 billion market capitalization and more than 3,700 hotels around the world?

The second thread is Boston’s Fidelity Investments, whose mutual funds own shares in each of them.

Fidelity is either helping its shareholders get in on the next Facebook — whose stock Fidelity bought before the social network landed on the Nasdaq exchange — or helping pump up a new bubble in the tech industry. Or a bit of both.

It’s not hard to find media reports expressing shock at discovering that mutual funds like Fidelity, Janus, and T. Rowe Price are buying chunks of risky startups, a couple hundred million dollars at a time. But rules set by the Securities and Exchange Commission allow stock in private companies to compose up to 15 percent of a mutual fund. Fidelity says its house rules limit those holdings to 10 percent.

The job of a mutual fund manager is to hunt for better-than-average returns, and the reason some Fidelity funds are buying shares of these companies is simple, says Andy Boyd, head of global equity capital markets at Fidelity. Tech companies are waiting longer to go public, and if you sit on the sidelines until the initial public offering, you’ll have missed out on much of the appreciation of their value.

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How do these deals go down? Sometimes, the companies or their venture capitalists approach Fidelity. Other times, Fidelity initiates discussions after its analysts identify fast-growing private companies that don’t have comparable peers in the public stock markets.

Boyd said his group tries to get in on young companies that have the potential to be “long-term winners” by creating new marketplaces or software platforms that could endure for decades. He sets up meetings with the management teams, often in Boston so that Fidelity fund managers can pepper the executives with questions.

Fidelity makes several dozen investments in private companies each year, with individual fund managers ultimately making the decisions about whether to buy shares of a Dropbox or a Pinterest. Boyd asserts that Fidelity is conservative about the price it will pay for shares; there’s always plenty of internal debate about whether a given company has what it takes to succeed over the long haul. “If the price is too high, we just don’t buy it,” he says. Instead, Fidelity may choose to wait until the IPO or later.

The day before I spoke with Boyd, one of Fidelity’s private holdings, SpaceX, suffered a setback when one of its cargo rockets exploded en route to the International Space Station. Isn’t a rocket-building startup that plans to put humans on Mars by 2026 the classic example of a high-risk venture?

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He compared SpaceX to Fidelity’s initial $74 million investment in Facebook, which people thought might be a passing fad with limited revenue potential. (Fidelity today owns more than $5 billion of Facebook shares.) “Ten years from now, we’ll have another conversation” about SpaceX, Boyd says.

Todd Dagres is a founder of Spark Capital, a Boston venture capital firm that was an early backer of companies like Twitter and Wayfair, the home goods e-commerce site. Private company valuations, he says, may have sprinted too far ahead of public companies, based on revenues and cash flow.

But Dagres says timing is everything: “Investors that get in early tend to do well as momentum builds and private company valuations take off.” Those who join in closer to the end of a boom cycle “get their heads handed to them,” Dagres says, and are left holding illiquid assets that plummet in value. “Are we there yet? Probably.”

Boyd says that Fidelity has been looking at more private investments, but getting more selective, in part because valuations have continued to rise. “Our hit rate has gone down,” he says. Boyd believes we’ll have reached the peak of this current boom when Fidelity stops making these investments, “because everything will be priced ridiculously.”

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Most Fidelity funds own none of these young, private companies, spokesman Charles Keller says. For the funds that do, private shares represent 1 or 2 percent of their total assets. Still, funds like Fidelity’s Blue Chip Growth own more stock in Uber than they do in stalwarts like Boeing Co. or Bank of America Corp. (Fidelity doesn’t disclose what it pays per share when it buys into private companies, though it does report estimates of the value of each mutual fund’s holdings in monthly reports.)

If you buy shares in Fidelity’s Contrafund, you’ve got more exposure to Dropbox, which was founded in Cambridge before it moved to San Francisco, than Dunkin’ Brands Group Inc. of Canton. And if investors care about how much Fidelity and other mutual companies are putting into startups? Well, it’s easy to read the complete list of a fund’s holdings before you buy in.


Scott Kirsner can be reached at kirsner@pobox.com. Follow him on Twitter @ScottKirsner and on betaboston.com.