Risks and returns in pre-IPO investment

Take advantage of the potential discount by investing in fundamentally-strong companies

Over the last couple of years, ultra rich and family offices have taken differentiated paths by making direct investments across the growth spectrum, starting with early stage investing in the angel/pre-series A rounds, to mature buyout situations and late stage ‘pre-IPO’ opportunities.

The year 2017 has been touted as the year of the IPOs, with over $10 billion being raised through main board IPOs in 2017. This buoyancy in the public issuances has prompted the ultra rich/family offices to invest in so-called pre-IPO opportunities either directly or through the ‘special situations’ fund to get exposure to high-growth companies prior to their IPOs.

Pre-IPO investing is buying unlisted equity shares of the company prior to the planned IPO. These are either primary shares, issued by the company or sold by private equity investors, employee shareholders or other HNIs, who are looking at divesting some of their holdings as they have made their expected returns and don’t wish to be locked up further as certain investors are not allowed to liquidate immediately on listing.

Tapping the opportunity

In an environment of bullish capital markets and IPO success stories, every investor has been vying for that limited amount of stock available in an IPO. To capture that allocation, they are happy to go up the risk curve and take exposure at an early stage of the IPO cycle. This not only provides them with an opportunity to get significant exposure, but also enables them to come in at a potential discount to the IPO valuation.

Recently, active public market investors, including hedge funds, special situation funds, family offices and HNIs have tapped pre-IPO investing opportunities. In December 2017, Rakesh Jhunjhunwala and IIFL Special Opportunities Fund acquired ₹510 crore worth of minority stake from Westbridge Capital in the IPO-bound mobile gaming company, Nazara Technologies.

Following the interest from HNIs, the company also raised ₹50 crore primary amount from select HNIs prior to filing for the IPO. Additionally, large family offices and HNIs have shown significant interest in bidding for secondary blocks in National Stock Exchange of India.

In the recent past, BFSI sector has seen active trading in unlisted shares such as HDB Financials, Hero Fincorp, and CSB in the hope of an IPO in the near future. Even from an issuer’s perspective, getting the backing of a reputed and marquee investor before the IPO, not only improves the marketability of the IPO but also sets a pricing benchmark.

Be mindful of risks

But is this additional risk and euphoria for the IPOs justified? Our analysis shows that over 45 per cent of the IPOs in the second-half of 2017 have given negative returns after one week of listing; this has gone up from 30 per cent in the same period the previous year (considering that main board IPOs over ₹250 crore).

Investors must be mindful that, as per SEBI regulations, pre-IPO exposures come with a lock-in of one year. Recently launched pre-IPO funds have a potential benefit of size and access; however, there are issues regarding control and transparency of stock selection and adverse returns due to fee and carry structures.

Investors may need to be cognizant of the fact that companies may face delay in listing due to regulatory hurdles or change in public market sentiments. This could also impact the expected valuations of the company. Spending the requisite time to dig deep into the financials and investment potential of the company is crucial, as identifying companies that are ripe for an IPO isn’t as easy as it sounds. Analysing the growth potential of the overall industry is also important.

The writer is Head of Strategic Solutions, Sanctum Wealth Management

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