How to avoid pre-IPO traps

Investors love to talk about their winners. The stock they invested in when almost nobody had heard the name and became a ten-bagger overnight. A great Australian growth story. But far too often investors ignore their losers, and there are usually a lot of them. This doesn't change, no matter what area of the market you're in. 

In the final part of this three-part collection, three of Australia's most renowned pre-IPO fund managers warn investors of the downside of investing in the private market. Each manager shares a lesson they have learnt along the way, detailing how to avoid pre-IPO traps. 

Responses come from: 

• Andrew Smith, Perennial Value Management 
• Jessica Farr-Jones, Regal Funds Management
• Jamie Odell, Ellerston JAADE Australian Private Assets Fund 

Figuring it out early 

Andrew Smith, Perennial Value Management 

In this market, a lot can go wrong. That's why we focus on alignment with the founders of the company. You've really got to ask: "Is their motivation the same as ours?" For example, they will want a liquidity event, say, within three years. That's as far as we'll look at, because we want to allow for that two-year slippage, given our five-year fund. The biggest thing that can go wrong is a misalignment with the founders because they've ultimately got a different path than what you do. It's important to filter that out early.

We also try and make it, on our maths, look like we're investing in the last raise the company will need to become cashflow-positive. Companies running out of cash are one of the biggest risks in private markets because you don't have liquidity. If a company's not currently cashflow-positive, we want to know that the capital we're providing will allow them to become cashflow-positive and secure. If the IPO window is shut for six months, they'll be able to wait because they have that security. Sure, you don't have the growth capital, but the business doesn't need it for day-to-day. They're the things that we focus on.

It's not like regular markets 

Jessica Farr-Jones, Regal Funds Management 

There are several risks associated with pre-IPO and unlisted investments more generally, with the most obvious risk being the inherent lack of liquidity. 

If a listed business is not performing well, investors may realise this and take the opportunity to sell their shares before the share price depreciates further. Unfortunately, with unlisted companies, it is typically more difficult to “trade out” of an underperforming position.

As an extension of this liquidity risk, pre-IPO investors are also somewhat reliant on stable equity markets and the IPO “window” being open. This liquidity risk can continue post-IPO if, for example, a portion of our holding is escrowed from selling for a period of time, or if the listed stock suffers from poor liquidity and impacts the ability to sell a position.

While the lack of liquidity is undoubtedly one of the biggest risks of pre-IPO and unlisted investing, it also presents the opportunity for additional reward. Valuations for unlisted companies typically attract a discount to their listed comparables to compensate for the lack of liquidity. We often also have the opportunity to structure attractive terms through various instruments that can provide both downside protection and equity upside.

On the fund side, it’s also important to mitigate this risk by structuring terms for our investors in the funds to match the liquidity and duration profile of the assets we’re investing in. This is incredibly important to ensure we’re not forced to liquidate a position if the timeframe to IPO ends up being longer than anticipated.

Many of the pre-IPO opportunities that we invest in can be earlier-stage in nature, which presents its own set of risks - these are not unique to unlisted investing, but usually relevant to microcap investing more generally. While many of our earlier-stage investments have delivered incredible returns in the order of 5-10x our initial capital, it is inevitable that we get some decisions wrong and experience either share price declines or unlisted positions needing to be written off.

Private markets require caution 

Jamie Odell, Ellerston JAADE Australian Private Assets Fund 

Investing in private companies is a slow and labour intensive process. Unlike investing in listed equities where information is standardised, each private deal will be different and the terms of the investment may be unique. Not only is it important to understand the business model and financial information, but ensuring the terms of the investment create alignment with all investors is critical for success.

For example, let's say a company raises capital via a pre-IPO convertible note. After the note expires, if the equity market is closed, how will the company repay those notes or how will they deal with a potential redemption? Not only are investors and companies hoping the business will perform according to plan, but they are also hoping market conditions will allow for the IPO event. This can be like trying to thread a needle, and there are often variables out of anyone’s control, such as COVID. To mitigate this, we ensure we have sufficient investment horizon and confidence in the business performing, as well as taking board seats and leveraging our operating partners to help manage the performance of a business.

What happens next? 

It's easy to be swept up in the excitement of the private market, but the reality is that it is difficult for retail investors to get exposure. Pre-IPO funds are held by all of the contributors above. The easiest way for retail investors to get exposure to companies before they list on the share market is to invest in a fund similar to these. Whilst the private market is becoming increasingly available to investors, the reason it remains exclusive is for its own health: just as one doesn't overwater a growing plant, too much capital, too early, can do more harm than good for a pre-IPO company. 

If you've enjoyed this collection on investing in the pre-IPO space, be sure to keep an eye out for my colleague Angus Kennedy's wire on the current IPO landscape. You can be updated as to when that wire is released by clicking on his profile and clicking the FOLLOW button. 

If you haven't already, be sure to check out parts one and two of this collection 'Why pre-IPO investing is back in vogue' and 'From little things, big things grow'.