Pre-IPO: The risks are high

By Morningstar |  26-01-21 | 
 

In Making money in the pre-IPO market, Aditya Kondawar, Founder – JST Investments, shared his personal experience. This time, he looks at the irrational exuberance in the pre-IPO market.   

If a movie was made on the global financial markets in 2020, the name that pops up in my mind is The Fast and Furious. Never before in the history of financial markets have we witnessed such a deep correction and a dramatic bounce back in such a short span of time.

The secondary market has relentlessly continued to scale new highs. But the unlisted, or the pre-IPO, market has been making significant moves of its own. In fact, the performance of listed equities pales in comparison to some of the price movements of Pre-IPO shares in the past year.

Some unlisted share rates as of January 20, 2021:

  • Care Health (previously Religare Health) Insurance: 3.7x return. Rs 38 to Rs 140.
  • CSK: 3x return. Rs 24 to Rs 70. Chennai Super Kings (CSK). In 2019, it was trading at par with its brand value of Rs 732 crore. Today, it is at 3x its brand value!
  • Nazara Technologies. 2.3x return. Rs 450 to Rs 1,050. Had an EPS of -1.78 for 6MFY21. In FY20, it had EPS of -0.77. FY19 was when it had a positive EPS. The last few years saw the market lap up platform companies and niche companies at expensive valuations, and a clear cascading effect seems to be seen here as the profits de-grew but its investor interest and share prices increased. Investor Rakesh Jhunjhunwala owning 11.38% of the company has certainly added to its allure.
  • STUDDS Accessories. 2x return. Rs 550 to Rs 1.000.
  • Lava International. 2x return. Rs 200 to Rs 400.
  • 2x return. Rs 850 (October 2019) to Rs 1,750-1,850. Its H1FY21 EPS was Rs 28, and if we annualize it to Rs 40, the PE will be around 46.25x. For perspective, NASDAQ trades at 25.9x, Intercontinental Exchange Inc. trades at 31.1x, Euronext NV (largest stock exchange in Europe) trades at 21.6x, TMX group (that owns and manages Toronto Stock Exchange) trades at 27.8x. Back home, the BSE trades at 26x PE after having doubled from 13x PE. The high PE for NSE gets justified by the fact that it has high market leadership in most of the segments Cash Market (94%), Equity Futures & Options (100%), Currency Futures (72%) and Currency Options.
  • Reliance Retail. 2.5x return. Rs 600 to Rs 1500. The retail arm of Reliance Industries, it is a behemoth in a true sense. It has more than 12,000 stores making it India’s largest retailer with no one able to match their reach and stores. As of Q2FY21, its EBITDA margins were 4.88% compared to Dmart’s 6.23% which is the most efficient. But that hasn’t stopped it from trading at more than 140 P/E (as per FY20earnings). It clearly seems as if the unlisted investors are trying to close in on the multiple of Dmart that trades at 187 P/E in the listed markets. But what is conveniently ignored is that Dmart’s margins are far superior and their operations are extremely efficient. Instead of fundamentals, it is seen that investors in Reliance Retail are bullish due to tech majors coming as investors in Reliance Industries, Reliance Retail and Jio along with the announcement of WhatsApp plus JioMart roll out and Omni channel strategy of Kirana stores conversions.

What investors must be cautious about.

The listed market has seen heavy buying in platform and niche companies, and this seems to have cascaded on to the unlisted market as well. Investors must remember that buying at exorbitant valuations is a more risky proposition since the IPO price is not known beforehand.

Pre-IPO may seem like a very easy way to arbitrage in private companies, but can be disastrous if not sufficient attention is paid to the buying price. For example, in the pre-IPO market, UTI AMC was trading at Rs 1,040 but the IPO came in at Rs 554.

It is not necessary that a listed and an unlisted comparable company are to have the same kind of a valuation multiple. In the listed market too, we see leaders at far more expensive valuations when compared to the second or third ranked in the sector. This is evident in NBFCs, banking, aviation, auto makers, FMCG and paints.

Some pre-IPO companies are trading at frightening valuations. Who is to tell if the same momentum will continue once they shift to the listed markets? Make sure you stick to the margin of safety principle when investing in such companies. Compare it with peers. Be sure of the soundness of the fundamentals of the company. Ensure that the listing timeline is provided by the company management.

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