Apr 07, 2017 04:51 PM

Opinion: Rash Investors Risk Being Snared in Pre-IPO Trap

Many investors in China are unknowingly walking into a trap as they pour huge amounts of capital into the so-called pre-IPO round of investment.

For most of the past six months, these investments were practically all that Chinese private equity investors could talk about. By our estimate, at least 70% to 80% of private equity investment funds and institutions, including banks and insurance companies, are now focused on what they call pre-IPO projects, which refers to those immediately preceding a company’s initial public offering.

If you look at those projects closely, however, you’ll realize that not all of them fit the description, and investors are blindly risking their money where the perils are hidden in plain sight.

Pre-IPO investors and other private equity investors — although both investing in unlisted companies — have different priorities when assessing whether a firm is worth investing in. Pre-IPO investors usually don’t care about the normal indicators about a company’s fundamentals that other investors would look at, such as customer retention rate. They put much more emphasis on the firm’s profit, how to avoid the risk of it falling short of its growth target with a value-adjustment mechanism, and whether they can sell purchased shares back to the founders or other investors if the firm cannot go public within a pre-agreed period of time.

These arrangements make pre-IPO investment more like debt. This deprives the business of the risk and professional skills it should have required, the implication being that the party will not last.

As it currently stands, the core competitiveness of a pre-IPO investor is not how well he can analyze a firm’s financial conditions but how cheaply he can raise funds and invest them in the company at the right moment.

Financial institutions and investment funds backed by local governments have been two of the primary sources of capital for pre-IPO fundraisings. Banks in particular have been a main provider of capital directly and indirectly through domestic and overseas channels. Some U.S. dollar funds have dabbled with yuan-denominated pre-IPO projects, probably because their Chinese investors wanted returns faster.

The notion that pre-IPO projects pay off faster, however, is more often than not a misconception.

The recent zeal in pre-IPO projects has been driven to a large extent by the fact that the China Securities Regulatory Commission (CSRC) has speeded up its IPO approval process. However, this has encouraged some companies to apply for an IPO that otherwise may have chosen not to list on a stock exchange. Taken together, it means the long line of IPO candidates is not getting shorter. If a company filed for listing in the fourth quarter of last year, for example, it would still have to wait until late 2018 or early 2019 to get the regulator’s permission to go public.

In general, it takes three to four years for investors to recover their money on a genuine pre-IPO project — much longer than many expect — not to mention that there have been many “fake” projects that may be several rounds of fundraising away from an IPO.

Also, many investors have plowed money into pre-IPO projects on the assumption that investments will reap rewards as long as the company passes the CSRC’s review and goes public. But this may not be true. In fact, as the A-share market matures, the difference in valuations between firms that perform well and mediocre companies will grow, revealing the degree to which investors have overestimated the prospect of returns.

In addition, fraud is more likely to occur when business founders think they can sell all their holdings to pre-IPO investors, allowing them to cash out early and not have to worry about what happens to the company later on.

An IPO is no guarantee of success, and many investors who believe otherwise have been burned.

It would be much wiser for venture capital and private equity investors to consider options other than IPOs such as mergers and acquisitions. For those that have invested in a pre-IPO project, it is important that they recognize it may take much longer than expected — normally three to four years — for them to receive a return, if any.

Wang Ran is a co-founder and CEO of the CEC Capital Group. This article is translated from an excerpt of his commentary published on Caixin’s Chinese-language website.

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