Demystifying Pre-IPO Investments

The Indian investment landscape is witnessing a shift, with an increasing number of companies eyeing listing opportunities. As companies gear up for market debuts, investment funds are dedicating capital and capitalising on pre-listing investments, especially in high-growth sectors such as technology, consumer goods and service industry. Mutual funds, traditionally focused on public securities, are also jumping on the bandwagon to capitalise on these trends. This article explores the commercial and legal aspects of pre-listing investments, market trends, benefits and risks involved and exit strategies should a company fail to go public.

Pre-listing investments are typically made during the process leading up to a company’s initial public offering – the process begins with the filing of a draft red herring prospectus with the Securities and Exchange Board of India. It is followed by a series of correspondences with SEBI, which culminates in an updated draft red herring prospectus, until the final red herring prospectus is submitted. The RHP sets the stage for the book-building process, where the company establishes a price band and opens the IPO to public subscription. Pre-IPO investments typically occur from the start of IPO process until the submission of the UDRHP. The UDRHP usually reflects the company’s final capital structure, and SEBI generally views changes to disclosures between the UDRHP and RHP stages unfavourably.

Pre-IPO investments are soon becoming the flavour of the season as they offer early access to high-growth companies, allowing investors to enjoy substantial price appreciation when such companies go public — exclusive to institutional investors or high-net-worth individuals, pre-IPO investments also offer a unique way to diversify portfolios and gain exposure to companies that are not yet subject to the volatility and fluctuations of the public market.

Mutual funds, a key investment vehicle in India, provide their investors with a convenient and low-risk avenue to invest in a diverse range of assets such as stocks, bonds, and commodities. While mutual funds were once allowed to invest a nominal portion of their portfolio in unlisted securities, post the IL&FS crisis, SEBI restricted mutual funds’ investments in unlisted instruments, to eliminate the high risk associated with such investments. Under the SEBI (Mutual Funds) Regulations, 2019, mutual funds are now only permitted to invest in securities that are listed or set to be listed. Accordingly, mutual funds expend substantial energy in devising robust exit strategies to address eventualities where listing is delayed, cancelled, or is put on the backburner.

Pre-IPO investments hold the promise of high returns but come with certain inherent risks. Such risks can be effectively managed or mitigated with thorough analysis, professional expertise and seamless management. By carefully assessing both potential rewards and challenges, investors can make well-informed decisions, improving their chances of success while minimising exposure to risk.

The performance of a stock in its market debut is influenced by multiple factors, including company fundamentals, valuation, management quality, market sentiment and timing etc. The demand for a stock can often be gauged from investors’ interest levels — while there is inherent uncertainty in predicting market performance, experienced investors can navigate these factors to fairly assess the potential. Compared to investments in listed securities, pre-IPO investments carry a higher risk due to the limited financial information available and limited regulatory oversight. While such deals are often time sensitive, well-focused red-flags diligence can assist the investors in decision-making.

In the absence of public market forces, pre-IPO investments lack real-time valuations, making price discovery a significant challenge. Prices are often determined by private negotiations between the company and institutional investors. Without the oversight of public markets and with lack of transparency regarding the other interested parties, the risk of overvaluation or undervaluation increases. To mitigate such risk, an objective and comprehensive valuation conducted by third-party valuation firm can help instil confidence in the fairness of pricing.

Given that mutual funds are statutorily permitted to invest only in listed or to-be-listed securities, the exit strategy in case of an unsuccessful listing is key to their investment. While a host of external factors can influence the success of the IPO, such as economic downturns, unfavourable market conditions, regulatory changes, or shifts in investor sentiment, mutual funds should have a well-designed exit strategy to effectively navigate these unforeseen circumstances.

In the event of unsuccessful listing, mutual funds may explore selling their shares to other institutional investors or private equity firms in the secondary market, while ensuring that the sale price is at least equal to the acquisition price to avoid losses. An alternative exit route is buy-back of shares by the company which comes with several conditions under Indian company laws. Another highly negotiated option can be a ‘put option’ with the promoters or other shareholders, which gives the new entrant the right to sell its stake at a predetermined price. In any case, definitive documents for pre-IPO investments, especially by mutual funds, need to be tightly worded to record the company’s obligation in case of failure to list.

While there are complexities surrounding investments by mutual funds in pre-IPO rounds, there is significant potential for long-term growth in these emerging opportunities. Mutual funds can navigate such complexities with a well-planned investment strategy, careful negotiation, legal structuring, and robust exit strategies.

Tanushree Bhuwalka is partner at Khaitan & Co. Soumil Garg is principal associate and Kritika Parakh is associate at Khaitan & Co.

Disclaimer: The views expressed here are those of the author, and do not necessarily represent the views of NDTV Profit or its editorial team.