Making money in the pre-IPO market

By Morningstar |  18-03-20 | 

ADITYA KONDAWAR, an equity research analyst, narrates his experience as a young investor who was swayed by the IPO mania.  

In the capital markets ecosystem, Initial Public Offerings (IPOs) have a dynamic of their own. My fascination with them began when I was a college student. So when I received my first paycheque, I decided to take the plunge and invest my entire salary of Rs 12,000 in the Indigo IPO. That was in October 2015.

I invested continuously in IPOs for 24 months and made great returns: RBL Bank, Endurance Tech, BSE, HDFC AMC, CDSL, and Cochin Shipyard were among the 40+ IPOs I dabbled in. All along, I convinced myself that I hit upon the secret to making millions.

The IPO bull run began in 2017-18 and subscription percentages went through the roof and allotment was not a “sure thing” anymore.

So convinced was I about this route to riches, I decided to pull out all the stops. I prayed and did a naariyal offering on allotment day. I befriended an RTA agent responsible for allotments, but then realized that it is a lottery system. I got only 4 IPO allotments out of the 25 odd I applied for.

I did the next best thing – introspect honestly.

Reality began to hit. I began to see that most were overpriced. I saw the IPO mania for what it was – players inflate prices and then with a greater velocity bring them down, outliers notwithstanding.

But while the market was experiencing an IPO bull run – our IPO markets also made a tectonic shift. Years ago, IPOs indicated a pure issue of shares. More recently, it evolved to offer for sale - existing shareholders sell their shares and make a good buck. But, money doesn’t flow in to the company.

Traditionally, businesses were bootstrapped with  founder’s own money. Now they have the benefit of private equity and venture capital that enters before the listed market investors do. Consequently, PE/VCs are making money before listed market players at large do. And, as they invest in an early stage and exit the company through its IPO, the returns are manifold.

Here is how I see the beneficiaries of this new trend:

  • Promoters
  • Employees via ESOPs
  • PE/VC
  • Pre IPO investors
  • Listed market investors/ retail investors

Sadly, the retail investor is always at the end.

To make money, you have to identify opportunities/companies before the market at large does, and invest in the pre-IPO stage.

How does one do this?

By accessing the pre-IPO market wherein high-networth individuals (HNIs) and retail investors can invest in companies prior to them getting listed. Just like listed stock, the shares are sold in demat form and are reflected in one’s demat account with the corresponding ISIN number. The minimum amount could vary between Rs 50,000 and Rs 1 lakh, depending on the company and the dealer.

What about liquidity?

As per SEBI rules, all pre-IPO shares have a lock in for one year from the date of listing. But prior to listing, they are freely tradeable and can be sold by submitting a Delivery Instruction slip. But illiquidity is an issue in the pre-IPO market, and finding a buyer would not be easy.

Also, the timeline of listing may not be clear and an exit may be much delayed. For example, HDFC had always discussed and adhered to its subsidiary listing plans. This might not always be the case with every other player.

Over here I would like to make a point. Employees with ESOPs who have completed their vesting period might want to sell their shares, for whatever reason. But do note, this will be a secondary off-market deal and the company is NOT involved in this transaction.

How about the right price?

Indeed. You could very well get fooled.

One should do proper valuation to see the true value of the firm and then ascertain if the price being paid is fair. Only when a person has a good margin of safety along with good value creation seen ahead, should one proceed with pre-IPO investing.

Sometimes, pre-IPO prices get way ahead of their fundamentals, especially after IPO approval and during the week the IPO opens. One has to be careful here not to pay anything just for listing gains. You don’t want to be the individual who overpays and then faces a massive price correction.

Take the case of CSB. In the pre-IPO stage, it was at Rs 195. It listed at Rs 274 and climbed to a high of Rs 314, to scale down to Rs 163 – ALL in the span of 3 months. But just to get into the listing gains game, a lot of people were buying pre-IPO in the range of Rs 200-220. (Everyone loves listing gains but forgets that pre-IPO shares have a lock in of one year).

The IPO price itself was expensive in terms of Price to Book Value. Six months prior to its IPO, money was infused into the company by its Canadian promoter. When I had done a peer comparison during its IPO, I found it to be expensive at Rs 195; at Rs 220, the PBV went higher at 2.5x PBV and at Rs 310 it went up to 3.5x PBV. Needless to say, the price eventually caught up with fundamentals.

What is the process?

  • The buyer and seller get connected.
  • The price and brokerage is agreed upon.
  • Buyer sends money to the seller.
  • Seller transfers the shares to the buyer, and sends a screenshot of the transaction.
  • By T+1 evening, the transaction is completed.
  • Unlisted shares reflect as ISIN numbers in demat holdings
  • As soon as IPO lists, one year lock-in comes for the pre-IPO shares.

The dealer in the pre-IPO market must be someone who is recommended and has a clean record. This market works purely on trust.

Finally, besides evaluating the company, please take into account your risk appetite, capital commitment and liquidity issues.

The author is not providing any recommendations. Examples mentioned are purely for illustrative purposes. The author is a pre-IPO investor in HDB Financial Services, Bharat Hotels, KurlOn Enterprise and Fino Paytech. You can also check out his blog and Twitter handle.

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