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1 year ago

Baron Funds

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Baron

Baron Partners Fund Dear Baron Partners Fund Shareholder: Performance Since its inception on January 31, 1992, Baron Partners Fund’s (the “Fund”) 12.23% (Institutional Shares) annualized performance for nearly 25 years has exceeded that of its benchmark, the Russell Midcap Growth Index, by an average of 3.03% per year. Baron Partners Fund is the number one performing fund in its Morningstar Mid-Cap Growth Category over that time period.* A $10,000 investment in Baron Partners Fund at its inception 25 years ago would now be worth $177,000. If an investor had instead invested $10,000 in a passive index fund that mirrored the Russell Midcap Growth Index, that investment would now be worth $90,000. Please see Table II. A graphic representation of this performance record follows the “Letter from Linda.” However, in the fourth quarter of 2016, Baron Partners Fund increased in value by only 0.03%, while the Russell Midcap Growth Index increased by 0.46%. The Morningstar Mid-Cap Growth Category, measuring the performance of all U.S. open end mid-cap growth funds, increased by 0.75% for the three months. The S&P 500 Index, which measures the performance of U.S. large- cap companies, outperformed and increased by 3.82%. For the full 2016 year, Baron Partners Fund increased in value by 4.29%, while the Russell Midcap Growth Index increased by 7.33%, the Morningstar Mid-Cap Growth Category increased by 6.03%, and the S&P 500 Index increased by 11.96%. RONALD BARON CEO AND PORTFOLIO MANAGER Retail Shares: BPTRX Institutional Shares: BPTIX R6 Shares: BPTUX Table I. Performance Annualized for periods ended December 31, 2016 Baron Partners Fund Retail Shares 1,2,3 Baron Partners Fund Institutional Shares 1,2,3,4 Russell Midcap Growth Index 2 S&P 500 Index 2 Three Months 5 (0.03)% 0.03% 0.46% 3.82% One Year 4.04% 4.29% 7.33% 11.96% Three Years 3.73% 4.00% 6.23% 8.87% Five Years 13.91% 14.21% 13.51% 14.66% Ten Years 6.11% 6.32% 7.83% 6.95% Since Conversion (April 30, 2003) 12.26% 12.43% 10.81% 8.97% Fifteen Years 9.61% 9.75% 7.96% 6.70% Twenty Years 10.17% 10.28% 8.22% 7.68% Since Inception (January 31,1992) 12.14% 12.23% 9.20% 9.26% Baron Partners Fund performed well during the five years from 2008-2013, when markets rebounded from depressed levels. The Fund nearly tripled its per share value during the five-year period and ranked in the 26 th percentile of competitive funds. Baron Partners Fund’s 22.55% annualized return from December 31, 2008 through December 31, 2013, when the Fed ended its quantitative easing program, was roughly in line with the unusually strong, and what we believe to be unsustainable, 23.37% annualized benchmark return during that period. We believe stock market prices over the long term mirror the growth of our economy. This is not the case every year, but we think the market and the economy eventually reach the same place while often taking different paths. Faster or slower growth than 6% to 7% nominal annual GDP growth over the long term for the market is, in our opinion, unsustainable. This is why we think that investing in growth companies that grow much faster than the economy offers opportunity. Baron Partners Fund’s performance during the past three years was only “average.” It ranked in the 51 st percentile of competitive funds. We hope it will soon again outperform, although we cannot guarantee that it will do so. Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail Shares as of December 31, 2015 was 1.52% (comprised of operating expenses of 1.32% and interest expense of 0.20%) and Institutional Shares was 1.26% (comprised of operating expenses of 1.06% and interest expense of 0.20%). The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. The Fund’s transfer agency expenses may be reduced by expenses offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit www.BaronFunds.com or call 1-800-99BARON. 1 Reflects the actual fees and expenses that were charged when the Fund was a partnership. The predecessor partnership charged a 20% performance fee after reaching a certain performance benchmark. If the annual returns for the Fund did not reflect the performance fees the returns would be higher. The Fund’s shareholders will not be charged a performance fee. The predecessor partnership’s performance is only for periods before the Fund’s registration statement was effective, which was April 30, 2003. During those periods, the predecessor partnership was not registered under the Investment Company Act of 1940 and was not subject to its requirements or the requirements of the Internal Revenue Code relating to registered investment companies, which, if it were, might have adversely affected its performance. 2 The indexes are unmanaged. The Russell Midcap ® Growth Index measures the performance of medium-sized U.S. companies that are classified as growth and the S&P 500 Index of 500 widely held large cap U.S. companies. The Russell Midcap Growth Index, the S&P 500 Index and the Fund are with dividends, which positively impact the performance results. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell is a trademark of Russell Investment Group. 3 The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares. 4 Performance for the Institutional Shares prior to May 29, 2009 is based on the performance of the Retail Shares, which have a distribution fee. The Institutional Shares do not have a distribution fee. If the annual returns for the Institutional Shares prior to May 29, 2009 did not reflect this fee, the returns would be higher. 5 Not annualized. 38

December 31, 2016 Baron Partners Fund Baron Partners Fund has had exceptional performance over the past 25 years even with the modest gains achieved during the past three years and, most notably, during the past six months. These disappointing results followed the gradual Fed tightening that began three years ago and has compressed growth company multiples to unusually attractive levels. Cyclical, leveraged, economically sensitive businesses outperformed during the period. The Fund’s average performance during the past six months negatively impacted absolute and relative performance over the past one-, three-, five- and ten-year periods. During the past three years, the Fund achieved a 4.00% annualized return. This compares to the Russell Midcap Growth Index’s annualized return of 6.23% during that period. We believe Baron Partners Fund’s recent average performance relative to its index and its competitors is anomalous and expect the Fund to soon again outperform. Of course, we cannot guarantee this will be the case. However, we regard recent performance as similar to the Fund’s performance during the 18-month period from October 1998 through March 2000, when it owned no internet stocks at the peak of the internet “bubble” and gained only 59.72% annualized compared to its benchmark’s gain of 110.65% annualized. The Fund ranked in the 84 th percentile for that period. During the following nine years, among one of the worst periods in U.S. financial history, Baron Partners Fund achieved positive returns that exceeded those of its index by an average of 623 basis points per year. See Table II. After ranking in the 84 th percentile during the “Internet Bubble” period, it ranked in the top 16 th percentile from 1999 through 2008. As mentioned above, although you should not rely upon past performance to predict future results, we remain hopeful that Baron Partners Fund’s performance will again achieve results similar to those that have made it the number one performing mutual fund in its category since its inception 25 years ago.* As during the “Internet Bubble” period, when the Fund didn’t own strongly performing internet stocks because they didn’t fit our investment parameters, during the past three years we haven’t owned strongly performing commodity, cyclical, and leveraged companies because they didn’t fit our investment parameters. We believe the competitively advantaged, well-managed growth companies in which we invest and whose multiples contracted during the last three years are now unusually attractively valued when compared to many stocks with less favorable prospects that have recently outperformed. We will see. 1. During the past three years, 66.8% of Baron Partners Fund’s assets were invested in 13 businesses whose stock prices significantly underperformed the growth of their businesses. Soccer club Manchester United plc’s licensing, sponsorship, and media revenues have grown significantly during the past three years, creating 34% revenue gains and 58% EBITDA growth. Its share price fell 6.7%. The book value for airplane lessor Air Lease Corp. has increased 61% since 2013 while its stock price has increased only 12.2%. Human resources software vendor Benefitfocus, Inc.’s revenues increased 125% during the past three years and its share price fell 48.6%. Gaming and Leisure Properties, Inc., the landlord to gaming tenants, has experienced an 80% increase in rents, yet the stock price has remained flat. Tesla Motors, Inc. has grown revenue and vehicle delivery by 248% over the past three years, but its stock price has been relatively range bound between $200 and $240. We think its business is likely to continue to grow strongly…as is the case for all the companies listed…and the other companies whose share prices were disconnected to their business growth in the past three years. We do not expect this disconnect to continue to be the case. 2. Virtually all the businesses in which Baron Partners Fund has invested are incurring significant expenses that penalize their current earnings, and probably their present stock prices, to become much larger businesses. Whether by hiring more sales staff, developing new products, starting up new manufacturing plants, providing additional client services, investing in new databases, integrating acquisitions or producing new products at lower gross margins than will be achieved at scale. While all businesses make such expenditures, the magnitude of these investments relative to the size of the businesses in which we have invested is unusual. Further, 83.5% of Baron Partners Fund’s investments have made strategic acquisitions in the past two years. We expect these transactions to be additive to growth, earnings, and share price over the next few years. Specialty insurance and reinsurance company Arch Capital Group Ltd. acquired mortgage insurance business United Guaranty from AIG. We regard that business as one of AIG’s “crown jewels,” believe it is a wonderful fit with the company’s existing mortgage guarantee business, and believe it was purchased at an unusually attractive price. Vail Resorts, Inc. purchased Canadian ski resort Whistler Blackcomb in what we regard as a highly synergistic and strategic transaction that will enhance results at Whistler and across the broader Vail portfolio. The acquisition will add to Vail’s customer data base, which is already the largest in the industry, and increase Vail’s annual ski pass sales. Douglas Emmett, Inc., the dominant owner of office buildings in West Los Angeles, partnered with Qatar Investment Authority to purchase 1.7 million square feet of under-occupied, underperforming assets in that submarket. This market is unusually attractive due to secular demand growth and significant limits on further construction. 3. The unexpected results of the November 8, 2016 U.S. presidential election immediately impacted domestic stock markets. Baron Partners Fund, however, did not benefit materially. Following the election, topdown investors purchased stocks in sectors they believed would benefit from Trump programs. Cyclicals such as Financials, Energy, and Industrials did well. Less economically sensitive Consumer Staples and Health Care stocks did not perform as well. Real Estate and fast growing Information Technology (IT) investments also did not fare as well. Especially noteworthy, in our opinion, was the 28.8% increase in the valuations of regional banks that would benefit from less regulation and wider net interest margins when interest rates increase. Baron Partners Fund has no investments in regional banks. Although real estate businesses’ rents and replacement values should increase if inflation increases, our real estate stocks fell 3.98% during the quarter. This is because real estate investment trusts are viewed as “yield” stocks and higher interest rates mean that yield in the short term is worth less. Although our real estate investments did not contribute to the Fund’s returns in the fourth quarter, they increased in value 21.8% in 2016. Baron Partners Fund has 5.2% of its portfolio invested in unique real estate businesses like Douglas Emmett, whose fully leased core properties in Los Angeles have been made even more valuable by recently simplified zoning regulations; and Gaming and Leisure Properties, with substantial growth opportunities for its competitively advantaged, licensed regional casinos. Services provided by competitively advantaged, growing IT businesses in which Baron Partners Fund has been a shareholder for years boost productivity of their clients. These IT companies are penalizing their rapidly growing, non-cyclical earnings to enhance long-term growth. Baron Partners Fund’s IT investments fell in price in the fourth quarter on average 4.9%. Baron Partners Fund has 18.4% of its portfolio invested in successful IT growth companies like Benefitfocus, Costar Group, Inc., Zillow Group, Inc., and Gartner, Inc. Benefitfocus’ and CoStar’s shares experienced double-digit price declines in the period. This is despite what we call their KPIs, or “key performance indicators,” continuing to increase significantly. KPIs for these businesses include measures of recurring subscription revenues, number of salespeople and analysts, and average seat revenues. 39

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