Pre-IPO investing: How does it work and is it worth the risk?

The Pre-IPO market is increasingly gaining traction with several funds and businesses tapping into private markets.

Investing in the pre-IPO market can be lucrative but comes with different risks. In this article, we speak with Access Investing’s Brett Tucker and Mark Humphery-Jenner, Associate Professor of Finance at UNSW Business School about the state of the pre-IPO investing market, factors to look when considering these investments and red flags to avoid.

Market access

So for the uninitiated, how does pre-IPO investing work and can retail investors invest in pre-IPO/ growth companies?

“The laws around private company investing were put in place nearly 20 years ago and have worked to limit these investment opportunities to a select number of wealthy and professional investors,” explains Brett Tucker, Managing Director, Access Investing.  

The company recently launched its prospectus with ASIC to raise up to up to $10 million. Its offering is designed to provide ordinary or retail investors with access to growth/pre-IPO investments.

“Retail investors make up over 90% of the investing population but are restricted in the company offers they can legally access; generally, only in companies that can afford the time and expense of preparing a lengthy public offer prospectus - such as when undertaking an IPO and ASX listing,” says Tucker.

Can retail investors legally hold these shares?

“Access Investing is able to legally provide pre-IPO shares to retail investors through a stepped process; firstly by pooling funds raised from retail investors through a public offer prospectus. These funds will be invested in pre-IPOs following due diligence by Access Investing's board and advisors. Access Investing holds the portfolio of shares until each private company prepares for listing by lodging its IPO prospectus and will then distribute those shares to its retail holders,” says Tucker. 

“The result is that retail investors hold shares purchased at pre-IPO prices in companies which are preparing to trade on the ASX. Access Investing sees itself as a market enabler, in securing generally restricted private investments and holding them until such time as they can be legally traded by retail investors,” he says.

Pre-IPO investments, while riskier generally, can have a substantial uplift in valuation (typical range is 25% - 100%) when they go public from a relatively short holding time from anywhere from three months to two plus years, says Tucker.

Factors to consider

What factors should investors consider before taking a leap with a pre-IPO company?

Mark Humphery-Jenner, Associate Professor of Finance at UNSW Business School suggests three main factors:

1. Shares purchased in a pre-IPO round will often need to be escrowed after the IPO. Investors must consider whether they want, and expect, to receive their money earlier than is possible.
2. Market conditions can change between the pre-IPO round and when the IPO is anticipated. This might delay the IPO and/or force the firm to do a bridging round before the IPO. 
3. Strong IPO returns are not guaranteed. Not all IPOs perform well. Many companies exhibit average performance after an IPO. Thus, investors must consider the risk that the shares might not perform well either at the IPO or after.

When investing, the investor must also consider what the realistic offering price for the firm would be at IPO, says Humphery-Jenner.

Potential returns look attractive, how are they likely to be made?

Generally, the returns, says Humphery-Jenner, could come from three areas:

1. The uplift between the pre-IPO round and the IPO offering price, 
2. The uplift on the first day of trade, and
3. Any post-IPO returns.

However, post-IPO returns often track the broader small cap market. Thus, investors must consider whether realistically the firm will list for more than the pre-IPO price; and thus, whether a return is likely.

“Investors should also consider the post-IPO escrow period. This could lengthen the holding period and is likely to prevent investors ‘flipping’ newly public stock on the first day of trade,” says Humphery-Jenner. Read more about the escrow regime on the ASX blog.

Red flags - companies to avoid

There are no guarantees that a company will do well, but what are some warning signs?

Red flags at a pre-IPO round are similar to those at other rounds but investors should be especially wise to whether the company has suitable governance structures and whether the company has engaged in aggressive accounting practices, says Humphery-Jenner.

“These include governance risks and whether governance structures will maximise shareholder wealth. They also include accounting related issues. At this stage, the company should have functional accounting practices. If it does not, that is a red flag.”

How to identify 'window dressing'?

“When evaluating the accounting information, investors should look for ‘window dressing’. These would be practices that make the company look artificially strong before an IPO. This was alleged to be the case with the Dick Smith IPO, for example,” he says.

Tucker reminds that investing in private companies has the extra risk that shares remain illiquid, which needs to be understood and mitigated as much as possible.

“Companies that are going public with businesses and assets tied to fad trends and sectors can have excellent short term share price performance, but may perform poorly or fail over the long term once investor interest dries up unless the underlying fundamentals are sound,” says Tucker

“The officers at ASX who are responsible for approving new listings are also closely scrutinising a company's rationale for listing on the ASX if its business doesn't have a strong connection to Australia, which could also be a red flag to investors.”

Risks vs rewards

These investments are usually offered at a discount - but do rewards outweigh the investment risks?

Managed funds and institutional investors are strengthening focus on pre-IPO investors due to the outsized return potential, says Tucker.

“Pre-IPO investments, while riskier generally, can have a substantial uplift in valuation (typical range is 25% - 100%) when they go public from a relatively short holding time from anywhere from three months to two plus years.”

While returns are not guaranteed, pre-IPO investments are an attractive preposition as they provide investors access to a relatively derisked company at a discount to the IPO offering price, says Humphery-Jenner.

Pre-IPO investing can offer longstanding shareholders a chance to buy more shares before the IPO and also allows the company to raise some more capital to accelerate growth before the IPO and ensure a competitive IPO offering price, he says.

*This article is for general information purposes only, it is not intended to provide financial/ investment advice and should not be relied on as such.