Mutual Funds and Pre-IPO Companies

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Mutual Funds and Pre-IPO Companies

Pre-IPO companies
For investors, nothing can be more thrilling than investing in stocks that just recently hit the tape. Buying stock in initial public offerings (IPOs) can be a huge source of gains for a portfolio. The recent success of IPOs like GoPro (GPRO) and Alibaba (BABA) are perfect examples of how the IPO process can reap big gains for investors.
However, not all IPOs go as smoothly. Sometimes there can be major hiccups. This is why investors may want to use broad-based mutual funds that bet on pre-IPOs to get their exposure. These funds have certain nuances, but they may ultimately be a better bet on newly issued firms and can really allow investors to get in on the ground floor.

See also the 10 Biggest Mutual Fund Investing Myths Debunked

A Brief Overview

Essentially, an initial public offering (IPO) is the first sale of stock by a company to the public. Smaller and younger firms use IPOs to gain the necessary capital to expand, while large privately owned companies use IPOs to become publicly traded and allow their main owners to “cash-out” and profit from their investments. A company looking to IPO will hire an underwriting investment bank to help with the process. This firm will determine what type of stock to issue—common, restricted or preferred shares—as well as determine the best offering price and just when to bring the IPO to market.

For most investors, the day the new stock starts trading is when they can get their hands on the IPO. However, the real winners in the process are the investors that get to participate in the offering before the stock hits the tape.

See also the 30 Blogs that Mutual Fund Investors Should Read.

Normally, select brokerage account customers, private equity and other institutional players are the ones that get contacted by the underwriting firm to supply the capital for the IPO. Essentially, they get a chance to buy IPOs before they are officially traded and are the people that make the real money. Often, a firm will set their IPO price at much lower than the first initial trades that the public sees. In the case of previously mentioned BABA, that price was $68. However, the first trades in BABA stock were $92. That’s instant profits for the venture capital and other pre-IPO players.

Regular Joes do have the opportunity to get in on several of the hottest new stocks during their pre-IPO days. Many mutual funds have become major buyers of pre-IPO stocks – especially those in the tech sector. These funds allow investors to get the kind of instant gains that the venture capital firms will realize.

For example, five different mutual funds run by investment manager T. Rowe Price Group owned roughly $220 million worth of Twitter (TWTR) before it actually started trading. Likewise, T. Rowe Price, along with rivals Fidelity, BlackRock Putnam and Wellington Management, were all able to gain huge stakes in BABA during the pre-IPO process.

The Benefits for Investors

With more regular tech mutual funds getting into the pre-IPO game, the benefits for investors are pretty tremendous. They allow a broader audience of regular retail investors to potentially reap outsized gains once reserved for venture capital and the uber-wealthy. A mutual fund can get a big increase in its portfolios if the fund’s managers buy stakes in private companies months and even years ahead of a market listing. As we’ve seen with some recent IPOs, those gains can be huge for the fund’s share price.

At the same time, mutual funds’ broad nature help diminish IPO “failures.” After all, not every IPO lives up to its hype. Mutual funds help spread out the risks across many shares. In the case of the T. Rowe Price funds that owned TWTR and BABA, they were held alongside some traditional tech stalwarts. Meanwhile, some of the mutual funds that focus strictly on pre-IPOs help spread their bets as well.

Another win for mutual fund investors in pre-IPOs is on the costs front. Unlike like private equity or venture capital funds, bread-n-butter mutual funds don’t require the insane initial investment minimums. That means almost anybody can make a play for the latest tech stock. Additionally, while mutual funds vary in operating expenses, they still are substantially cheaper than the buying into a hedge fund or private equity vehicle. Over the longer haul, costs do matter.

Be sure to see the Cheapest Mutual Funds for Every Investment Objective

The true downside to mutual funds investing in pre-IPOs could come at tax time. The problem could be a hefty capital gains bill. Mutual funds are required to pass on capital gains at the end of the year. If a fund manager gets into a pre-IPO and the shares surge when they start trading, selling those shares could result in a huge liability for the mutual fund’s shareholders. Short term capital gains tax rates can be as high as 39.6%. That kind of tax bite could diminish the euphoria of the pre-IPO pop.

Two Great Pre-IPO Funds

T. Rowe Price New Horizons Fund PRNHX: This T. Rowe Price offering could be the best way to play the pre-IPO market. The fund purposely targets small, emerging growth companies, preferably early in the corporate life cycle before a company becomes widely recognized by the investment community. The focus has had the fund diving head first into the pre-IPO market with early stage investments in Twitter, Alibaba, as well as Facebook (FB). That’s helped on the performance front as PRNHX has managed to return 12.255% annually over the last 10 years. Expenses run 0.80% and the minimum investment is $2,500.

Fidelity’s Select Health Care Fund FSPHX: Investment manager Fidelity has been another big winner in the pre-IPO space. The fund manager actually has a team of analysts that will help guide the group’s mutual funds towards investments in these stocks. One of the leading funds has been FSPHX. Fund manager Edward Yoon will look at 20 or so biotech and other private healthcare stock deals each year and only choose one or two that seem like sure things. Given Fidelity’s size, that allows Yoon to get in at cheap prices and will often see 10 to 15 times returns on his investment. Those booming pre-IPOs have helped him log 25% annual returns over the last five years. Expense run 0.77% and the minimum investment is $2,500.

See also Under the Hood of the Most Popular Mutual Funds.

The Bottom Line

Investing in initial public offerings (IPO) can be a huge source of returns for investors. However, the real money-makers are the early investors in the pre-IPO process. Traditionally, this has been a world reserved for private equity, venture capital and high-net worth individuals. Yet, the game is changing for average Joes. Traditional mutual funds are now getting into the act and buying stakes in pre-IPO companies, which is wonderful news for regular investors.

Just be sure to check a fund’s prospectus and related documentation before making an allocation.


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Popular Articles

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Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next

Pre-IPO companies

Mutual Funds and Pre-IPO Companies

For investors, nothing can be more thrilling than investing in stocks that just recently hit the tape. Buying stock in initial public offerings (IPOs) can be a huge source of gains for a portfolio. The recent success of IPOs like GoPro (GPRO) and Alibaba (BABA) are perfect examples of how the IPO process can reap big gains for investors.
However, not all IPOs go as smoothly. Sometimes there can be major hiccups. This is why investors may want to use broad-based mutual funds that bet on pre-IPOs to get their exposure. These funds have certain nuances, but they may ultimately be a better bet on newly issued firms and can really allow investors to get in on the ground floor.

See also the 10 Biggest Mutual Fund Investing Myths Debunked

A Brief Overview

Essentially, an initial public offering (IPO) is the first sale of stock by a company to the public. Smaller and younger firms use IPOs to gain the necessary capital to expand, while large privately owned companies use IPOs to become publicly traded and allow their main owners to “cash-out” and profit from their investments. A company looking to IPO will hire an underwriting investment bank to help with the process. This firm will determine what type of stock to issue—common, restricted or preferred shares—as well as determine the best offering price and just when to bring the IPO to market.

For most investors, the day the new stock starts trading is when they can get their hands on the IPO. However, the real winners in the process are the investors that get to participate in the offering before the stock hits the tape.

See also the 30 Blogs that Mutual Fund Investors Should Read.

Normally, select brokerage account customers, private equity and other institutional players are the ones that get contacted by the underwriting firm to supply the capital for the IPO. Essentially, they get a chance to buy IPOs before they are officially traded and are the people that make the real money. Often, a firm will set their IPO price at much lower than the first initial trades that the public sees. In the case of previously mentioned BABA, that price was $68. However, the first trades in BABA stock were $92. That’s instant profits for the venture capital and other pre-IPO players.

Regular Joes do have the opportunity to get in on several of the hottest new stocks during their pre-IPO days. Many mutual funds have become major buyers of pre-IPO stocks – especially those in the tech sector. These funds allow investors to get the kind of instant gains that the venture capital firms will realize.

For example, five different mutual funds run by investment manager T. Rowe Price Group owned roughly $220 million worth of Twitter (TWTR) before it actually started trading. Likewise, T. Rowe Price, along with rivals Fidelity, BlackRock Putnam and Wellington Management, were all able to gain huge stakes in BABA during the pre-IPO process.

The Benefits for Investors

With more regular tech mutual funds getting into the pre-IPO game, the benefits for investors are pretty tremendous. They allow a broader audience of regular retail investors to potentially reap outsized gains once reserved for venture capital and the uber-wealthy. A mutual fund can get a big increase in its portfolios if the fund’s managers buy stakes in private companies months and even years ahead of a market listing. As we’ve seen with some recent IPOs, those gains can be huge for the fund’s share price.

At the same time, mutual funds’ broad nature help diminish IPO “failures.” After all, not every IPO lives up to its hype. Mutual funds help spread out the risks across many shares. In the case of the T. Rowe Price funds that owned TWTR and BABA, they were held alongside some traditional tech stalwarts. Meanwhile, some of the mutual funds that focus strictly on pre-IPOs help spread their bets as well.

Another win for mutual fund investors in pre-IPOs is on the costs front. Unlike like private equity or venture capital funds, bread-n-butter mutual funds don’t require the insane initial investment minimums. That means almost anybody can make a play for the latest tech stock. Additionally, while mutual funds vary in operating expenses, they still are substantially cheaper than the buying into a hedge fund or private equity vehicle. Over the longer haul, costs do matter.

Be sure to see the Cheapest Mutual Funds for Every Investment Objective

The true downside to mutual funds investing in pre-IPOs could come at tax time. The problem could be a hefty capital gains bill. Mutual funds are required to pass on capital gains at the end of the year. If a fund manager gets into a pre-IPO and the shares surge when they start trading, selling those shares could result in a huge liability for the mutual fund’s shareholders. Short term capital gains tax rates can be as high as 39.6%. That kind of tax bite could diminish the euphoria of the pre-IPO pop.

Two Great Pre-IPO Funds

T. Rowe Price New Horizons Fund PRNHX: This T. Rowe Price offering could be the best way to play the pre-IPO market. The fund purposely targets small, emerging growth companies, preferably early in the corporate life cycle before a company becomes widely recognized by the investment community. The focus has had the fund diving head first into the pre-IPO market with early stage investments in Twitter, Alibaba, as well as Facebook (FB). That’s helped on the performance front as PRNHX has managed to return 12.255% annually over the last 10 years. Expenses run 0.80% and the minimum investment is $2,500.

Fidelity’s Select Health Care Fund FSPHX: Investment manager Fidelity has been another big winner in the pre-IPO space. The fund manager actually has a team of analysts that will help guide the group’s mutual funds towards investments in these stocks. One of the leading funds has been FSPHX. Fund manager Edward Yoon will look at 20 or so biotech and other private healthcare stock deals each year and only choose one or two that seem like sure things. Given Fidelity’s size, that allows Yoon to get in at cheap prices and will often see 10 to 15 times returns on his investment. Those booming pre-IPOs have helped him log 25% annual returns over the last five years. Expense run 0.77% and the minimum investment is $2,500.

See also Under the Hood of the Most Popular Mutual Funds.

The Bottom Line

Investing in initial public offerings (IPO) can be a huge source of returns for investors. However, the real money-makers are the early investors in the pre-IPO process. Traditionally, this has been a world reserved for private equity, venture capital and high-net worth individuals. Yet, the game is changing for average Joes. Traditional mutual funds are now getting into the act and buying stakes in pre-IPO companies, which is wonderful news for regular investors.

Just be sure to check a fund’s prospectus and related documentation before making an allocation.


Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next