Investment Outlook , Published Jan 18, 2018
In the search of that ever-elusive alpha, investors have started following a direct investment or co-investment strategy in early stage ventures or pre-IPO situations as part of their alternative asset allocations, instead of only investing through private equity / venture capital funds.
“You can’t do the same things others do and expect to outperform” – Howard Marks
In the last couple of years, UHNIs and family offices have taken differentiated paths, by making direct investments across the growth spectrum, starting with early stage investing in the angel / pre-series A rounds, to mature buyout situations and late stage “pre-IPO” like situations. This momentum has been accentuated with equity capital market bullishness triggered by liquidity and the search for that meaningful allocation in Initial Public Offerings (IPOs). While not without challenges, a well-executed selective direct investment strategy could be a real differentiator in the family office / UHNI’s overall investment portfolio. Here, we look at analyzing two areas that have seen increasing focus in the private transaction space across the two ends of the spectrum – early stage direct investing and pre-IPO investing.
Early Stage Direct Investment
Startup investing has always been seen as an opportunistic investment strategy as part of one’s alternative asset portfolio, potentially delivering multi-baggers. Direct investing or club investing with like-minded investors, allows families to have a greater control and transparency over their investments, while reducing the management fee and carried
interest payable to fund managers. They also provide the ability to cherry-pick the best deals. Since a lot of these sophisticated investors either lead large enterprises or are promoters of businesses, there is a natural affinity to pick startups in industries that they understand and add strategic capital. According to Inc42 DataLabs, since H1 2015, over 1668 unique angel investors have participated in Indian tech startup funding. Starting with 257 in H1 2015, the participation of angel investors in startup funding reached 326 in H1 2017 i.e. a 27% rise . If we look at the historical data of startup funding in India, since H12015, over 127 angel investors participated in more than three deals and about 560 angel investors participated in more than one deal.
Having said that, direct investing in this asset class is not for everyone. Given the risks of investing in early stage startups with its low funding graduation rate, illiquidity and lack of return visibility, it suits only a few sophisticated investors who have the ability to write the cheque and not lose their sleep over it. Generally, only 20%-30% of the ventures can raise the next round. Additionally, finding the right types of direct investments that fit long-term wealth-generation strategies is easier said than done. The sectors where we see increasing interest are sunrise sectors such as consumer, healthcare and emerging tech like Artificial Intelligence, Internet of Things, sustainable energy along with some old favorites like BFSI and education.
2017 has been touted as the year of the IPOs, with over $10bn being raised through main board IPOs. Out of this, around $8bn has been raised since September 2017 itself, with the expectation of continuing momentum. This buoyancy in the public issuances driven by foreign and domestic institutional flows coupled with regulatory impetus has prompted UHNIs / family offices to invest in pre-IPO opportunities either directly or through a “Special Situations” Fund.
In an environment of bullish capital markets, IPO success stories and ever-increasing liquidity, every investor has been vying for that limited amount of stock available in an IPO. To capture that allocation, they are happy to go up the risk curve and take an exposure at an early stage of the IPO cycle, even 12-18 months before the planned listings at times. This not only provides them with an opportunity to get significant exposure, but also enables them to come in at a potential discount to the IPO valuation.
From a sector perspective, we have seen most of the interest coming in the BFSI space across insurance, banks and NBFCs. We believe this momentum will further continue as Mutual Funds and newer NBFCs look to list.
However, is this additional risk and euphoria for IPOs justified? Our analysis shows that, more than 45% of the IPOs in the H2CY17 have given negative returns after 1 week of listing, this has gone up from 30% levels in H1CY16*. The bullishness in the IPO market is also evident from the fact that 50% of the IPOs in CY17 have come to the market in the last 4 months (September 2017 – December 2017). This momentum is expected to continue with over 20 IPOs planned for the next 2 quarters. With increasing capital chasing these IPOs there is greed which has set in, with promotors and bankers pricing the issue to the hilt, leaving very little on the table for investors.
Additionally, investors must be mindful that as per SEBI regulations, pre-IPO exposures come with a lock-in provision for 1 year. Recently launched pre-IPO funds have a potential benefit of size and access, however there are issues regarding control and transparency on stock selection and adverse returns due to fee and carry structures.
While one needs to be cognizant of the risks involved in pre-IPO investing, if done right, through selective investments in fundamentally strong companies, with a hawk eye view on valuations, they can provide sustainable alpha.
Investment Outlook 2018