Investing in stocks before they hit market

The avenue can be profitable, but be mindful of the risks.

Investors like Deepak Mehta swear by this investing strategy. It sounds simple, as well. Buy an unlisted stock through wealth managers or brokers for a discount, and exit at a profit after one year.

Mehta has reasons to be happy. Last year, he invested in Oil India shares, prior to the company’s listing at Rs 700 a share. And, the stock was trading at Rs 1,433 on Thursday — over a 100 per cent profit in slightly more than a year.

“Primarily, companies look at pre-initial public offering (IPO) placements to fund their working capital requirements,” explains Hrishikesh Parandekar, CEO, Karvy Wealth Management. There are other reasons for placements as well. They may want to improve their market image by roping in big names in private equity (PE) or investors.

How to go about it?
Such deals are mostly routed through investment banks, entrusted with pre-IPO collection mandates. The banks, in turn, approach interested private equity (PE) funds or individual investors, mostly ultra high net-worth individuals (HNIs). The ticket size of this investment starts at Rs 25-50 lakh.

Individual investors can also purchase stocks held by employees of the company through their brokers. In this case, the transfer process is simplified, if the stocks are in demat form. If they are in physical form, the employee selling the stock as well as the buyer must sign the transfer form. And then, send it to the company for effecting the change of ownership. Irrespective of the form, you must check if the transaction is legitimate, according to the employee’s contract with the company.

Broker or private equity?
Investing through a PE fund is less risky than going through a broker, because a PE fund manager does the necessary background research. However, it comes at a cost. There is a flat fund management fee of two per cent annually. In addition, the profit is shared, typically in an 80:20 ratio by the investor and the fund.

The profit sharing can be applicable on the profit earned in the excess of the specified hurdle rate (usually 10-11 per cent). Or, there may be a catch-up clause. So, if the fund earns a profit in the excess of the hurdle rate, the entire profit is shared.

In the case of a broker, the investment required is much lesser at Rs 5-10 lakh. The quoted price of an unlisted stock is an all-inclusive price. It is arrived at by the broker after adding his/her commission. On average, it ranges from one-three per cent of the total price, but there is no fixed basis for determining the broker’s commission.

Risks
Unlisted stocks lack a secondary market and are an illiquid investment. Hence, if a firm does not end up listing, there may be no easy exit.

Even after the listing, the Securities and Exchange Board of India’s mandate reads that any investment at a pre-IPO stage will carry a 12-month lock-in period after the stock’s listing. So, investors must have a longer investment horizon.

All these factors, coupled with the lack of an established price, make the avenue risky for ordinary investors. Probably why, Mehta feels, “only savvy investors who have the ability to analyse stocks, their future growth and the potential should invest in unlisted stocks.”