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