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Fund Investors Can Get Pre-IPO Access. But Is It Worth It?

Nick Ravo, The Wall Street Journal

Funds often have a slim investment in pre-IPOs—and it’s tough to tell what impact they have

Pre-IPO companies aren’t just for big investors anymore.

A number of mutual funds promise to let small investors get a piece of companies before they go public—something usually reserved for big-money players, like venture capitalists and major brokerage clients.

It is an idea that has boomed in recent years. Mutual funds’ investments in pre-IPO businesses hit a valuation of $8 billion in 2015, up from $16 million in 1995, according to a research paper written last year by Sungjoung Kwon and Michelle Lowry of Drexel University and Yiming Qian of the University of Iowa.

Another measure of just how widespread the idea has gotten: In 2016, the paper says, 39% of venture-capital-backed companies had received mutual-fund financing before their IPO.

But there is a lot that investors should know about these funds before taking the plunge—which is tempting to do given the fact that this has been a manic year for IPOs, especially in the high-profile tech sector. Here’s a look at some of the crucial details.

The basics

For one thing, there aren’t any exchange-traded funds devoted solely to pre-IPOs. Rather, most of the time, pre-IPO shares account for a pretty small portion of a mutual fund’s portfolio.

According to Securities and Exchange Commission rules, funds can’t have more than 15% of their holdings tied up in private companies. But no funds come close to that limit, says finance professor Jay R. Ritter at the University of Florida. In fact, private companies rarely make up more than 5% of a fund’s holdings, because funds don’t want to risk being stuck with illiquid assets, he says.

To find out how much of a fund’s assets are in pre-IPO holdings, investors can search the SEC database for the fund’s N-Q filings, which show all of its holdings.

It can be tricky to identify private companies in the listings. So, investors should look for companies with slightly different notations than other investments. For example, the entry for T. Rowe Price Mid-Cap Growth Fund(RPMGX) shows holdings in Slack Technologies with “Series H” and the acquisition date next to it. Publicly traded positions generally don’t list details about series of funding rounds.

Also note that there’s no easily available data about the performance of these funds as a group, so it can be tough for investors to find a standard for judging them. And because the funds mostly hold publicly traded stocks, it is difficult to tease out how much of their performance is due to pre-IPOs, Prof. Ritter says.

When investors are ready to choose a pre-IPO fund, there are many offerings out there, including funds from large companies such as Fidelity Investments, BlackRock, Wellington Management and T. Rowe Price. Among the better-known offerings are T. Rowe Price’s New Horizons Fund (PRNHX) and Fidelity Select Health Care Fund (FSPHX).

New Horizons invests primarily in emerging growth companies, including both pre-IPO and public companies. The fund—which had 5.9% of its portfolio in pre-IPOs at the end of 2018—has returned an average of 16.4% annually for the five years ended May 15, and posted a 94.1% cumulative return for five years ended March 31.

For comparison, the S&P 500, with dividends reinvested, has an annualized total return of 10.9% for the five years ended May 15, and a cumulative return of 73.9% for the five years ended April 30.

Fidelity Select Health Care Fund (FSPHX), which has 2.1% of its holdings in pre-IPOs, looks for health-care and biotech companies, both private and public. As of March 31, its average annual total return over the past five years was 11.7%, and its cumulative return was 70.1%.

For comparison, a benchmark index, the MSCI USA IMI Health Care 25/50, saw a total return for 67.5% for the five years ended April 30, and an 11.4% annualized return for the past five years ended on April 30.

The BDC funds

Funds aren’t the only way for small investors to get more exposure to pre-IPOs. In addition, there are a couple of business-development companies—akin to closed-end mutual funds that focus on young companies—that devote much of their portfolio to pre-IPOs. Business-development corporations must have at least 70% invested in “eligible securities,” including private companies or public companies with a market cap less than $250 million.

Firsthand Value Technology Fund SVVC -0.68% (SVCC), based in the Silicon Valley-San Francisco region, targets clean-tech and general-tech companies in various stages of pre-IPO maturity. Its cumulative return from April 28, 2011, through May 21 of this year stood at minus 31.6%, while its five-year annualized return through May 24 was minus 4.6%.

Kevin Landis, chief executive of Firsthand Technology Value, says: “The performance of SVVC stock is tied closely to the sentiment around our portfolio companies. Support for the stock fell dramatically after we sold our Facebook and Twitter positions with big realized gains in 2014, and has more recently outperformed with the IPOs of Roku, Nutanix , Pivotal and Revasum.”

GSV Capital Corp. GSVC -0.30% (GSVC), also based in the Silicon Valley region, seeks to invest in high-growth, venture-backed private companies. Its cumulative return from April 28, 2011, to May 24 of this year is minus 37%, while its five-year annualized return through May 24 was minus 5.6%.

GSV did not return messages seeking comment.

A spotty record

The big question for investors, however, might be whether it is worth trying to catch IPO lightning in the first place. Prof. Ritter says that investors are often drawn to pre-IPO investments because of highly visible, seemingly successful companies—and they don’t consider the high number of almost invisible failures.

“The IPOs of today are just as likely to be money-losing companies as were the IPOs of 1999-2000,” he says, adding that venture-capital limited partnerships ”have not earned returns much different from the general market over the last 20 years.”

ANOTHER TWIST ON IPO INVESTING: THE ‘POST-IPO’ FUND

Investors who feel uninvited to all the recent IPO debutante parties have a way to make up for it: exchange-traded funds that specialize exclusively (or almost exclusively) in “post-IPOs.”

In other words, these exchange-traded funds invest in initial public offerings after they are already trading. Evidence shows this can pay off, at least in rising markets.

The funds: Renaissance Capital’s Renaissance IPOETF (symbol: IPO) and its Renaissance International IPOETF (IPOS)—as well as First Trust US Equity Opportunities ETF (FPX) and its twins (nonidentical), IPOX Europe Equity Opportunities ETF (FPXE) and International Equity Opportunities ETF (FPXI). They’re the only game in town.

The key differences are that Renaissance’s funds specialize in companies that have just been listed and sells them two years later; FPX’s funds hold them for four years but, notably, up to a third of its funds include spinoffs.

As for performance, Renaissance IPO has climbed 38% this year. The international version is up nearly 17%, FPX is up about 29%, FPXE is up 27% and FPXI is up 24%. Don’t be too seduced, however. As IPO savant Jay Ritter at the University of Florida noted, they are likely to outperform in rising markets and underperform in declining markets.

The largest, FPX holds $1.14 billion in assets under management; IPO, by comparison, holds a mere $40 million; the smallest, FPXE, holds $1.7 million.

Other differences: At First Trust’s funds, new IPOs are often added at a quarterly rebalancing, but they can be added as soon as after the first trading day. At Renaissance’s funds, new holdings also are usually added quarterly, but the fund can buy IPOs between quarterly rebalances as soon as five trading days after its listings if the company has a market cap large enough to fall in the top 40% of the market capitalization universe of all IPOs, Indeed, this year, it added Pinterest, Zoom Video Communications, Lyft and Uber Technologies on a fast-entry basis.