Why make growth investments before an IPO

It’s more of a rule than an exception: a small investor is disappointed in an IPO.

Not because it would not be profitable to participate in IPOs – historically the opposite has been the case – but because a retail investor usually only gets a fraction of the shares he wants. The reason for this is the tactics used by advisers to investment bankers and listed companies. The audience should be kept hungry.

We argue that with making growth investments, it’s not always worth waiting until listing if you want to get the chance at the best possible deal. The examples presented here mainly concern the Finnish market, so there may naturally be differences with other markets.

Balanced portfolio hunting

The starting point of the argument is that we aim for a balanced investment portfolio. Old wisdom says that an investor should diversify their various investments. This is because investment values ​​are tossing; a sufficiently diversified investment portfolio means that even if one investment performs poorly, the other investment tends to succeed.

A diversified investment portfolio should have both defensive and aggressive investments. The latter are usually companies seeking rapid growth that may not yet be profitable. Growth companies can bring the biggest returns to the investor, but on the flip side, they also have the biggest risks. In many cases, a successful growth investment can even have a disproportionately large impact on portfolio returns.

When a company is listed on a stock exchange, it is often already an established player in its field at that time and is likely to be owned by professional private equity investors. At this point, much of the value has already been created and professional mutual funds have a grip on the company.

For a small investor, this, unfortunately, means that there are no more crumbs available for him at that time.

An exciting, frustrating IPO

Important reasons for listing on a stock exchange are the visibility, brand awareness, and credibility it brings to the company. There is a lot at stake in the IPO, especially in terms of image. Therefore, investment bankers and other advisors often recommend tactics to make the stock price jump in the first days of trading; it sends a strong message to the situation following. One of these tactics is to strive for oversubscription.

Oversubscription is a situation where the demand for shares exceeds the supply, ie more share subscriptions are accepted than the number of shares available. It sends a strong message to the market. One way to achieve oversubscription is to split the shares into slices (en / fr Tranche). One slice may be addressed to institutional investors such as pension funds, another to the public such as retail investors and self-investing entities.

For the retail investor, the problem is that these slices are rarely evenly distributed: according to a study by the Stock Exchange Foundation, on average, institutions receive 90 percent and retail investors 10 percent. When institutional investments are often negotiated behind closed doors, retail investors need to cope with what they have left.

This leads to IPOs, where a small investor can subscribe for shares for, say, EUR 3,000, but end up receiving only EUR 300.

Ironically, it is in their best interest for companies to keep the general public hungry because it supports course development. Unfortunately, in this equation, retail investors are disappointed because companies refuse to take their money and the investor gets the fewer shares they want. In this situation, it is difficult for a retail investor to make investments in an IPO that would generate significant absolute returns.

What to do? Distribute and invest before the IPO

One obvious factor that attracts pre-listing investments is their high return potential. For example, TELA, an interest organization for employment pension insurers, examined the investments of various Finnish employment pension insurance companies and their returns in recent years. Unlisted shares yielded higher returns than listed.

However, it is important to remember a couple of things. First of all: TELA’s example is about professional investors with a wealth of expertise and analysis to weigh the pros and cons of each investment. Thus, the results should not be considered typical, but rather an indication of how, if successful, an unlisted share can outperform its listed competitor.

Second, many early-stage startups crash completely or at least make a loss. In 2017, the Finnish business angel network FiBAN conducted a study examining 126 exit events for 40 angel investors. The exits had an impressive return factor of 3.75. However, the study also showed that more than half of the exits (54 percent) were loss-making.

A 2017 survey of 1,659 angel investors in the United States found that only 11 percent of investors ’portfolios produced positive results. Reaching the exit stage can also require a lot of patience: According to FiBAN, the average time it took for a company to develop to the point where shares could be sold was eight years.

These results show that there are opportunities for high returns among unlisted companies, but also a high risk of losing invested capital. For this reason, diversification is key: when an investment portfolio is diversified and contains carefully considered defensive and aggressive investments, it is more likely that successful stocks will neutralize the impact of failing stocks in each case.

Today, it’s simple to be a mini-angel investor: you can get started without an extensive network of contacts or a thick investment wallet. There is no strict minimum investment limit on the Invesdor platform, only the limits set by the portfolio companies – the average minimum is around EUR 500.

Unlisted shares should be considered and preserved for the investment portfolio. As long as you remember: disperse, disperse, disperse.

DISCLAIMER

The information contained herein is not meant to be, and it shall not be interpreted as investment advice or a recommendation and investors must neither accept any offer for, nor acquire, any securities unless they do so on the basis of the information contained in the applicable investment material of a target company. Investing in securities of unlisted companies is associated with high risk.

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