A pioneer of the strategy of mutual funds writing big checks for startups before they go public, Henry Ellenbogen's returns at T. Rowe Price lured other investors into the fray. The billions of dollars in new capital from funds are largely responsible for skyrocketing valuations, fewer initial public offerings and talk of a bubble.
"The asset class is scary," said Ellenbogen, who manages $18.7 billion. He acknowledged that increased competition has made his job more difficult. "We're not just buying the basket - we're being highly selective and trying to invest in the best ones."
Ellenbogen closed his New Horizons Fund to new investors at the end of 2013 and has disclosed only two private investments in 2015, eyeglass retailer Warby Parker and salad-restaurant chain Sweetgreen, compared with 14 last year. He said he's wary of rapid revenue growth at startups. Returns from private investments, which make up about 5% of his fund, probably will be lower this year than in the past, he says.
New Horizons, which invests mostly in small-cap stocks, has outperformed 99 percent of peers over the past five years, according to data compiled by Bloomberg.
When Ellenbogen backed Twitter Inc. six years ago, only five other investors were interested, he said. Today, given the same metrics that the microblogging service had, there would be about 50 suitors. He's earned more than a 1,000% return in Twitter. Luckily for Ellenbogen, only one company ever turned him down.
Almost everyone in Silicon Valley knows who Ellenbogen is, even though he's 3,000 miles away. Getting an introduction to "Henry," as he's known, is a big deal, and bankers often use their connection to him as a way to impress corporate clients..
Ellenbogen is pensive when he talks, leaning back in his chair and gesturing with one hand. He said he saw that he could capitalize on private companies about a decade ago. He was spending time with startups to understand how and if they were disrupting public companies.
In 2007, he met the management team of Bill Me Later, which had developed a way for consumers to buy online and pay later. It became his first private investment - and a success. EBay later bought the company for $1 billion and merged it with PayPal.
Now he instructs his team of analysts to look for companies that have what he calls an Act II, "a second leg of growth in a new product or market that they can enter once they have exhausted Act I."
He spends about 100 days a year on the road, often in search of private companies perched below the hype, such as Diplomat Pharmacy, which provides drugs for rare and complex diseases. Ellenbogen invested in the company last year, after meeting CEO Phil Hagerman in 2013. Hagerman started the Flint, Mich.-based company with his father four decades ago as a corner drug store.
Hagerman says he accepted T. Rowe's cash before going public as a validation for investors who would come in later. The company's shares have tripled since its October IPO.
"We hadn't taken outside money before T. Rowe," Hagerman says. "We weren't shopping Diplomat to raise capital. But the fact of having a partner of T. Rowe's stature and the confidence that T. Rowe would bring is a good solid step for us."
Not all of Ellenbogen's investments thrive in public markets. Shares of Zulily, an e-commerce site for parents, are down 43% from their November 2013 IPO price. Still, Ellenbogen has kept most of his stake in the company and says spending more time advising management is the key. New Horizons Fund's return on that investment has been more than 124%.
"He has stuck with us through the ups and downs," said Zulily CEO Darrell Cavens. Ellenbogen agreed to speak with employees this week to boost morale, Cavens adds.
The company's history of investing in private companies dates back several decades, though on a much smaller scale, according to Roger McNamee, who started at the firm in 1982.
Private financing "was by exception and with an extremely high bar," McNamee, who later went on to start private-equity firm Silver Lake Management and venture-capital firm Elevation Partners, said in a phone interview. "The culture of doing things in the private market has always been there, which explains why the firm is so supportive of Henry doing this."
At first, T. Rowe didn't need to write big checks because companies were going public more quickly. In 1999, the median age of firms having IPOs was five years, according to data compiled by the University of Florida. In 2014, it was 11. All the capital flowing to into private investments lessened the need for companies to to tap public markets. For many investors today, waiting until an IPO to buy equity would mean missing critical periods of growth.
Mutual funds such as T. Rowe, BlackRock, Fidelity and Wellington Management invested $5.5 billion in the private markets from 2012 to 2014, according to Pacific Crest Securities. The flood of capital has led some venture capitalists to point out the heightened risk.
"The very act of dumping hundreds of millions of dollars into an immature private company can also have perverse effects on a company's operating discipline," Bill Gurley, a general partner at Benchmark, wrote in February.
"We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising."