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The valuation of Paytm shares in the grey market has skyrocketed as the company moves towards an initial public offering (IPO). Various media reports suggest that other high-profile companies such as Nykaa and Urban Company are also seeking to list on the stock market. Investing in companies just before they go public can be a profitable activity. In this article, we explain how this can be done and what the potential pitfalls are.

“There are essentially three ways in which investors can buy into companies that may go public," said Munish Randev, founder, Cervin Family Office. “First is by investing in a pre-IPO fund. These are usually structured as AIFs (alternative investment funds) and have a minimum ticket size of 1 crore."

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For instance, Kotak Investment Advisors Ltd, the alternative assets arm of Kotak Group, is launching a pre-IPO fund with a target size of 2,000 crore. The fund, a Category II AIF, has been positioned as an “India-focused late-stage fund to invest in high-quality companies with a strong moat of technology".

IIFL has launched multiple such AIFs under the Special Opportunities Funds series starting May 2017.

“IIFL AMC was the first asset management company to launch a dedicated pre-IPO fund in 2017, giving investors an access to invest in pre-IPO opportunities. Today, we manage an AUM (assets under management) of over 10,000 crore across pre-IPO funds, yielding returns in the range of 10-15% (with the listed portfolio having yielded 16-30% IRR)," said Manoj Shenoy, CEO, IIFL AMC.

A few of IIFL’s marquee portfolio companies that have been listed in the past few years include Nazara Technologies Ltd, ICICI Lombard General Insurance Company Ltd, Indian Energy Exchange Ltd and Nippon Life India Asset Management Ltd.

According to Shenoy, the institutional heft of large financial services firms provides an advantage to investors in such AIFs.

“Further, investors who wish to invest in pre-IPO companies find it convenient to invest through pre-IPO funds because investors benefit from institutional access to pre-IPO deals, which have been filtered through a stringent investment process," he said.

The second route is buying shares directly through intermediaries such as brokers or wealth management firms. Large wealth managers try to leverage their corporate relationships to get deals for clients.

“Once we shortlist companies, we leverage our ecosystem of relationships across PE, VC funds, sovereign funds, financial institutions and family offices to get access to primary or secondary positions in these companies. We then use a combination of metrics to value such deals and many times valuations depend on supply-demand dynamics for the asset as well. As examples, in the last year, we did one of the largest non-institutional placement of NSE shares with our HNI (high-net-worth individual) clients. CIBIL and Policy Bazaar are some other names we transacted in," said Amrita Farmahan, MD and CEO, Wealth Management, Ambit Pvt. Ltd.

“The shares themselves either come from an early-stage investor into the company, mostly individuals wanting to exit for liquidity needs, or they come from already vested employee stock options (ESOPs) pools. Note that in case of the latter, most companies (employers) retain the first right of refusal. If you are attempting to buy from an employee, check if this has been complied as per the shareholders’ agreement," said Randev.

The third method is via small brokers and unregulated entities that periodically put out quotes for such shares. The last route is the least reliable.

“Often, the brokers in question aren’t actually able to procure the shares at the price they have quoted; these are just indicative quotes," said Randev.

Investing in unlisted shares before companies list them has certain advantages. Allotment of shares in IPOs is uncertain, particularly if the stock is strongly in demand. You may also get the stock at a lower price than the IPO offer price.

However, not all experts are optimistic about this route. “Most wealth management firms that deal in such shares buy and sell from their proprietary book and apply a 4-5% mark-up. Price discovery is difficult in this market and hence the mark-ups are steep. In this space, investors who are really interested should stick to established profitable businesses rather than PE-funded loss-making startups," said Feroze Azeez, deputy CEO, Anand Rathi Private Wealth Management.

“I do not recommend such unlisted stocks at all. I think the returns on listed stocks are sufficient to attain the financial goals of most of my clients. Some investors who have bought into such unlisted stocks look at their gains in isolation rather than comparing them with a benchmark like the Nifty or Sensex," he added.

Investors who are considering investing in such shares should also consider the different tax treatment.

Gains on unlisted shares are taxed at 20% if held for more than two years and given the benefit of indexation.

This is different from the 10% long-term capital gains tax on profits in listed shares above 1 lakh.

For shorter holding periods, gains on unlisted shares are taxed at slab rate in contrast with the 15% tax on gains in listed shares. The stamp duty on unlisted shares is also higher at 0.25% compared to 0.01% for listed shares.

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