If you’re not familiar with the recent Destiny saga, you’ve missed a wild ride.
Back in February, we were one of the first to cover this company; exploring their idea to launch the world’s first ETF for pre-IPO secondaries.
Boy, has a lot happened since then:
Along the way, Destiny picked up a ton of press — and indeed launched a revolution in bringing pre-IPO shares to the masses.
But there’s a lot more going on behind the scenes that investors should understand.
Today, we’re conducting an in-depth analysis of DXYZ’s post-launch journey. We explore how the fund’s mechanics allowed the price to soar so high, and uncover clues about the future hidden deep in DXYZ’s public filings.
This detail-heavy issue is not sponsored or endorsed by Destiny. (DXYZ is a previous sponsor of Alts, but our requests for comments on this article were not answered).
If you’re serious about investing in private alternative markets through public structures, these are details you can’t afford to ignore.
By the end, you’ll understand why DXYZs shares got so high, why they sank, and a whole lot more.
Let’s go 👇
Note: This is a paid issue. The first half is complimentary. But there is way too much good stuff in this second half for it to be free. Get the All-Access Pass to read the whole thing.
Table of Contents
The problem with premiums
To really understand DXYZ, you need to discuss a basic financial truth that’s often conveniently ignored:
Without an arbitrage mechanism, there’s no reason a claim on an asset needs to trade in line with the value of the underlying asset.
That might sound technical, but here’s what I mean…
Suppose I create two near-identical digital tokens, one called TSLA1 and the other called TSLA2.
I conduct an ICO for both tokens, announcing that the proceeds will be used to purchase Tesla stock, with each token representing a 1-for-1 claim on the underlying shares.
Reading carefully, though, you notice a big difference between the coins:
- TSLA1 is freely convertible into actual TSLA shares at any time (and vice-versa).
- TSLA2, meanwhile, isn’t actually convertible into TSLA shares at all.
Given the above, what should we expect the price of each token to be?
TSLA1 is clearly going to trade at a price very close to TSLA stock.
If the price between the token and the stock ever diverges, you could buy the cheaper one, and convert it to the more expensive one to earn a profit.
But what about TSLA2?
Since converting the stock is impossible, there’s no reason the price needs to track the underlying stock.
This illustrates a crucial point about valuing fund shares:
The trading price for a fund’s shares depends not only on what the fund invests in — but on the conversion process that links those shares with the underlying investments.
Why open-end funds work so well
Which brings us to open-end funds (OEFs).
You’ve almost certainly invested in an OEF before. Exchange-traded funds (ETFs) fall under this category.
OEFs are unique because they’re allowed to create and destroy shares on a continuous basis.
As a result, OEF shares trade at a near-identical price to the fund’s underlying net asset value (NAV, or the actual value of the assets in the fund).
With an ETF, “authorized participants” (typically investment banks) can create or destroy shares. This lets them profit from any difference between the share price and the NAV.
They do this by:
- Delivering a basket of the underlying assets to the fund in exchange for fresh shares (creation), or
- Redeeming existing shares for a proportional share of the underlying assets (destruction).
To illustrate how powerful this continuous share adjustment is, the gap between the daily closing price and the NAV of the AGG ETF (one of the most popular bond funds in the world) has averaged just 0.08% over the past five years.
Here’s the bottom line: because they’re open-ended funds, ETFs can dynamically adjust their number of shares to link share prices to the actual NAV.
But know who can’t do this? Closed-end funds.
They simply don’t have that luxury.
Arbitrage is hard for closed-end funds
Unlike OEFs, closed-end funds (CEFs) cannot continuously create or destroy shares. (Only rare corporate actions can adjust share count.)
As a result, these funds can’t use the same dynamic system as ETFs to keep share prices in line with NAV through arbitrage.
That leads some CEFs to decide to stay off exchanges. It’s not worth the hassle.
But there are plenty of exchange-listed CEFs. And as you’d expect, their trading prices don’t always align with the underlying fund value.
If OEF shares are trading at a discount, there’s an easy arbitrage opportunity: Just snap up as many shares as you can, and redeem them with the fund for your share of the NAV.
But to do a similar arbitrage with a CEF, you’d need to:
- Buy a majority of outstanding fund shares, then
- Replace the fund’s board of directors via proxy fight (fun!)
- Force the fund to liquidate at NAV, paying out the proceeds to shareholders.
Although out of reach for individual investors, this is actually a well-known strategy employed by hedge funds — and is a big reason why CEF discounts can’t grow forever (the bigger the discount, the more attractive the arb!)
But here’s the thing: this arbitrage doesn’t solve for premiums.
Unlike a CEF discount, a CEF premium (where shares are overpriced relative to NAV) has no investor-led arbitrage process that can force prices to converge to their true value.
Buying up shares and liquidating at NAV would yield negative returns – and shorting fund shares, while creating selling pressure that could drive the price down, won’t force convergence on its own.
This is why share price of DXYZ was able to go so high.
At one point it exceeded a 2,000% premium over the underlying NAV!
- Because DXYZ is a closed-end fund, and
- Because shares traded at a premium, not a discount
- There was no investor-led conversion or arbitrage mechanism to ensure price ever tracked NAV.
The price was allowed to go higher and higher, completely disconnected from the underlying assets.
Why did DXYZ have such a high premium?
According to DXYZ’s own latest calculation, their net asset value per share was just $4.84.
But at its peak, DXYZ’s shares traded at more than $100.
In other words, if you bought at $100, you got about 5 dollars in exposure to the underlying portfolio of private companies. The remaining $95 you spent was entirely to DXYZ’s premium.
At the time of writing, DXYZ’s share price has fallen to around $14, which still leaves a premium of around 200%.
Since each share of DXYZ includes exposure to the fund’s premium, understanding that premium (and the extent to which it will grow/shrink) is paramount for investors.
We’ve established that a lack of arbitrage opportunities makes it possible for a high premium to occur.
But what’s actually driving the gap between price and NAV?
Was this all just another case of excitement and hype?
Or is there something else going on?
Is DXYZ’s NAV price fundamentally wrong?
The most generous explanation here is that the NAV is fundamentally wrong; that that the market has reason to assign a higher value to DXYZ’s shares.
Was it calculated incorrectly?
To me, it seems unlikely that DXYZ’s NAV has been calculated incorrectly.
This is a team of very smart people, and their valuations are roughly in line with mutual funds that hold the same companies (especially for SpaceX, which makes up more than 30% of the entire portfolio.)
Was the NAV just outdated?
Remember, DXYZ’s last reported NAV was at the end of last year. Has the underlying portfolio seen huge growth in the past few months?
I don’t think so. If it was, we’d see evidence of that growth in places like Forge’s Private Market Index.
Perhaps the NAV is simply wrong for a liquid retail product? Non-accredited investors have fewer options for investing in private shares, so they probably place a higher value on the few avenues they do have.
Furthermore, retail investors may simply be more optimistic than VCs about the growth potential for the underlying companies.
We recently spoke with Will Snape of OpenVC, a firm building indexing solutions for private markets.
Will largely agreed with the this retail demand-driven hypothesis, saying:
“There’s no silver bullet answer to the frenzy around DXYZ for the past ~7 weeks, but we believe a large component of the price is reflective of the massive retail demand that has been pent up for decades. We’ve seen similar structures overseas like LITs in the UK trade at significant premiums — but none as high as this. DXYZ’s runup is undeniable proof of profound pent-up demand, and, in our view, you’re going to see more strategies pop up to try and service that demand in the coming years.”
– Will Snape, OpenVC
Attributing DXYZ’s premium to a supply/demand imbalance sounds perfectly logical.
But this is not the full story.
There are other explanations which are, shall we say, less-generous.
How much was irrational exuberance?
Famously coined by Fed chairman Alan Greenspan to describe investor enthusiasm driving the dot-com bubble in the late 90s, the phrase irrational exuberance might best capture why DXYZ shares got bid up so high.
Under this model, we shouldn’t look to fundamentals to understand DXYZ’s premium — instead, it’s driven by the same dynamics as a meme stock.
It’s not like there’s a scientific test to differentiate how much of the premium is fundamental how much is irrational.
As DXYZ CEO Sohail Prasad recently said on Bloomberg: the market is undergoing a “discovery process” in trying to figure out what these shares are worth.
Why did the stock price tank?
In my view, there are three factors contributing to DXYZ’s shrinking premium, each occurring successively:
1) Fading exuberance (Apr 8-16)
DXYZ’s closing price peaked at $99.79 on April 8th.
By April 16th, it had fallen by more than half to $43.5 – likely on fading enthusiasm & excitement about the fund’s novelty.
2) Registration statement to issue new shares (Apr 16-25)
On April 16th, DXYZ filed a registration statement with the SEC to issue up to $1 billion of fresh shares.
For reference, DXYZ’s market cap at the time was a bit under $500 million.
(Psst — Remember when we said it takes a corporate action for a CEF to adjust its share count? Here you go.)
Selling new shares shrinks the premium in two ways, impacting both the numerator (price) and denominator (NAV):
- By increasing the supply of tradable shares, share prices should fall.
- By raising fresh capital, the fund’s NAV will rise.
From April 16 to April 25, DXYZ’s closing price fell from $43.5 to $24.56.
3) Share lock-ups lifted (Apr 25-Present)
A little-noticed provision in DXYZ’s offering docs kicked in on April 25 that unlocked a big chunk of shares for sale.
Early investors in DXYZ were subject to restrictions preventing them from dumping all their shares immediately for a profit.
When DXYZ went public, early investors could sell just 25% of their shares.
But…
If the share price stayed above $15 for a 30-day period after listing, restrictions would lift on 50% of the remaining shares (or 62.5% in total).
On April 25, this qualification was hit.
April 26 the first day early investors could sell the next tranche of shares – although notice only appeared on the SEC’s website four days later.
DXYZ opened at $23.60 on the 26, but by close it had fallen to $18.83, likely due to these sales.
By May 3rd, the price had fallen to $13.
It’s tough to say exactly how many shares we’re talking about here.
For the initial listing, the fund’s parent company filed to sell about 1.4 million in shares, its total share ownership at the time.
However, that same filing noted that the total number of shares was about 10.8 million – leaving about 9.4 million possibly in the hands of early investors.
If that’s correct, about 2.35 million shares were released at launch, with about another 3.5 million released on April 25th.
That would leave about 3.5 million shares still locked up. To our understanding, these will be released in 3 equal tranches over the coming months.
Notably, the next one is occurring on May 25 (which will be 60 days after listing).
DXYZ taxes and forwards
DXYZ’s premium definitely raises the biggest question marks.
But there are also other smaller oddities that investors should pay attention to.
The first is the fund’s use of controversial forward agreements.
DXYZ uses forwards to invest in Plaid, Stripe
Shares of private companies are often subject to transfer restrictions and rights of first refusal, making it difficult for holders to sell.
One way around this is to enter an agreement to sell the shares in the future (when an IPO/acquisition occurs) in exchange for cash today.
This is popularly known as a forward agreement. For investors, it’s kind of like buying an IOU for private shares, rather than the shares themselves.
The big problem with forwards is that they’re on a shaky legal basis.
When it comes time to eventually collect on the IOU, it’s not clear investors will be able to actually enforce their rights and get the shares.
Forwards form just a small part of DXYZ’s portfolio, amounting to about $1.4 million between two investments in Stripe and Plaid.
But the worry is that as DXYZ raises fresh capital, they’ll be tempted to put more money into forwards (especially if vanilla private shares are hard to come by).
Highlighting the legal risks here, Stripe has a notice on their website stating that they believe forwards are still subject to restrictions and intend to “vigorously enforce our ROFR rights with respect to all such contracts.”
Finally, I can’t resist pointing out the irony that the restrictions in DXYZ’s prospectus almost certainly ban early shareholders from entering into forward agreements on locked-up shares.
DXYZ’s tax situation is uncertain
We’re also a little worried about DXYZ’s tax situation, especially when it comes to qualifying as a regulated investment company (RIC).
Achieving RIC status is key for an investment fund since it exempts the fund from having to pay corporate taxes (21% in America). The vast majority of ETFs and mutual funds qualify as RICs.
To qualify, funds have to meet a number of different tests – including the 25% diversification test, which requires that no more than a quarter of fund assets can be held in the securities of a single issuer.
Looking at the top holdings in DXYZ’s current portfolio, you can sort of see the problem here:
In their offering documents, DXYZ has made it clear that they do intend to be treated as a RIC. But it’s hard to see how with SpaceX taking up more than 25% of the portfolio!
As a result, any earnings from underlying IPOs/exits could be seriously impacted by taxes.
The future of DXYZ
We’ve spent most of this article tracing out the story of DXYZ so far.
But where is all this headed? What does the future look like for DXYZ – and for private share funds more generally?
1) Will DXYZ investors participate in portfolio performance?
DXYZ shares trade under the assumption that shareholders will benefit from strong returns in the underlying portfolio. (Otherwise, why buy shares at all?)
But it’s not clear this is actually the case.
Let’s say SpaceX goes public at a huge valuation, and DXYZ cashes out their shares. Will DXYZ investors get a special cash distribution? Or does the money just get reinvested into the fund, increasing NAV without flowing through to shareholders?
We’ve reached out to the DXYZ team to clarify this, since it’s obviously incredibly important — but no word yet.
2) Increased competition is likely
The launch of DXYZ showcased that, at least for now, a portfolio of the right private companies is worth much more to public investors than the NAV would indicate.
After all, if each $1 of private stock you own is worth $3 when you wrap it in an exchange-listed CEF, you’d be silly not to try and start your own DXYZ copycat.
In the months to come, we expect big players like Blackrock and ARK to try and capture this revealed demand by creating their own listed CEF vehicles.
3) Will the premium persist?
In the near term, it’s very likely that DXYZ’s premium will persist.
Even once the initial hype fades and irrational exuberance becomes less of a factor, the supply/demand mismatch for retail investment in private shares remains – as does the superior liquidity of DXYZ.
But if competing funds enter the scene like we expect, this premium might even flip to a discount, reflecting both management fees and operational uncertainty.
Disclosures from Alts
- This issue was not sponsored by Destiny
- The author has no position in DXYZ
- The ALTS 1 Fund holds no interest in any companies mentioned in this issue.
- This issue contains an affiliate link to TradingView
