Why do mutual funds invest in IPOs? Simply Save

Investing in initial public offers (IPOs) carries inherent risks, as new companies may lack a track record of financial performance and may be more volatile than established companies.

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On the other hand, IPOs often represent young companies with significant growth potential.

Mutual funds at times seek to capture this potential at an early stage by investing in the anchor round of IPOs.

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Anchor investors are qualified institutional buyers who are offered shares in an IPO just before the IPO opens for the subscription for retail investors.
In the recently launched IPO of Mamaearth parent Honasa Consumer, seven domestic mutual funds applied through a total of 19 schemes.

Sometimes investing in the anchor round pays off, while in the past we have seen many such bets turned sour.

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So, what is the process or parameters for adding an IPO company into a scheme and are mutual funds taking extra risk to deliver better returns by investing in IPOs?

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Moneycontrol spoke to Bharat Lahoti, Co-Head- Hybrid and Solutions Funds, at Edelweiss Mutual Fund for answers. Lahoti manages Edelweiss Recently Listed IPO Fund, which is India’s only scheme dedicated to IPO investing. Here’s a summary of what Lahoti said:

• Edelweiss Recently Listed IPO Fund is a thematic fund, where 80 percent of the corpus goes into the recently listed 100 IPOs. For selecting a stock, we look if the potential for earnings growth is high. We also look at valuations very closely in such companies. Other factors include market opportunity and size, competitive advantage, and growth expectations.
• We sometimes avoid a company during the IPO period but participate post-IPO. Whenever we get comfort both in terms of valuation and in terms of earnings visibility, we tend to participate in an IPO, as long it is part of the last 100 launched IPOs.
• Startup companies are extremely fragile. We need to be extremely cautious, because if the path to profitability is too long, then chances are many of our assumptions can go wrong.
• In the case of start-ups, we look at debt-to-equity ratio, interest coverage ratio, cash conversion, Return on Equity (RoE)/ Return on Capital (RoC), questionable corporate governance practices, and promoter track record for judging a company. Also, if there is a long pathway to profitability, we typically tend to actually avoid such IPOs.
• IPO investing is all about capturing the earnings trajectory. Investing in IPOs coming from a purely valuation perspective is also not a good idea.
• IPO investing strategy is a good idea because you can find multi-baggers via this approach. If you look at the risk-reward ratio, actually, investing in IPOs can be very beneficial for the mutual fund industry.