Look before you leap from listed to unlisted equities

First, gain some experience by investing in small- and micro-cap companies for longer tenures

Investing in listed and unlisted companies requires different levels of knowledge, research capability, and risk-bearing ability. An investor who is successful in the listed domain may not necessarily succeed when he ventures into the unlisted domain, or vice versa. Therefore, if you decide to make the transition, do so very gradually and after adequate preparation. 

Pros and cons of the unlisted domain

Over the past few years, successful exits have dominated cocktail conversations, with the focus being on unicorns (companies that have produced large multiplier returns for their investors). Many, who earlier stuck to the listed domain have been tempted to move to the unlisted domain in search of unicorns. 

The main advantage of investing in this space is that you get access to new-age businesses that are high on innovation. If you wish to invest in new business ideas, and at different stages of their evolution, the unlisted domain is the right space for you.

Here, you can invest at various stages of the business, with each of them requiring different levels of financial commitment: Seed, angel, Series-A, Series-B, and Series-C. Angel investing appeals to many investors because the amount that has to be committed to a single company is small. Many investors also take a shot at angel investing because of the myth that it offers good returns. Such investors should, however, bear in mind that they will be investing in companies a the early stage of evolution. These carry the highest mortality risk. Only a few of these companies are able to transition into viable, scalable businesses. 

At the pre-Series-A or Series-A stage, the business has scaled up to a level where the proof of concept of the business model can be appreciated. From the Series-B stage, growth prospects become critical as investors look for a viable exit. From the seed to Series-C/D stage, the scale of funding that is required increases as businesses turn more mature and become larger in size. If the business has progressed well, its valuation also tends to be higher at these stages.

Nowadays, most new-age businesses started by young entrepreneurs tend to be funded by investors. The capital contributed by the promoters tends to be minuscule. Such promoters need continuous support from investors until the business reaches a state of sustainability. How well an entrepreneur tackles the softer issues between his investors and him become crucial. Often, if the business model fails to take off, differences of opinion arise on business strategy and execution. Quality of business idea, execution capability, management bandwidth, business strategy, and ability to attract and retain both talent and investors are some ingredients for a successful start-up. These are some of the qualities you should look for when investing in an early-stage business.

When you invest in the unlisted space, the outcomes can be binary, with a possibility that you earn zero return on capital. As fresh rounds of investment are made in such a company, they do give the early investor an inkling of how its valuation has improved. However, the real proof of the pudding (how much return the investor is going to give) comes only at the time of exit. Prior to that, all returns are notional and fictitious.

Investing in listed domain no cakewalk 

In the listed space, investors get to choose from a wider variety of businesses. This domain is quite different from the unlisted or private space. It is possible to alter your asset allocation to equities, since entry and exit can be at the investor’s will. Companies in the listed space generally tend to generate free cash flow. While those in the unlisted domain tend to depend on external funding for growth, most listed companies are self-sustaining.

In the case of early-stage unlisted companies, business models continue to evolve during the investor’s tenure. In the listed space, business models are already in a steady state. 

Knowledge about the traits of the promoter and the track record of the management are more readily available. However, even in this space, business models are not comprehensively researched beyond large-cap and select mid-cap companies. Diligent investors can take advantage of these inefficiencies in the market.

The most tricky part of investing in the listed space is the unpredictable change in investor sentiment towards a particular business or sector. Attractively-valued companies could remain cheap for an extended period, testing the patience and conviction of investors. Understanding market psychology, therefore, becomes a crucial part of investing in the listed space. This, however, is more easily said than mastered.

Key differences

In the listed space, investors seek multi-baggers; in the unlisted one, they hunt for unicorns. Whichever space you invest in, you need to be patient with your capital to allow unicorns and multi-baggers to develop. In the private space, patience is not an option due to the difficulties of making an exit. In the listed space, it is entirely at the discretion of the investor. This, in fact, makes it psychologically all the more difficult for the investor to stay patient. Businesses experience swings in both these spaces. Since it is easier to exit in the listed space, investors tend to make the mistake of exiting during a downtrend more often in that domain.

As evolution is significantly less in the listed space, businesses tend to be more predictable. Valuations tend to be market-determined, hence there is no need to negotiate the entry valuation with promoters and structure the transaction. A pick and choose strategy is easier to implement. In the unlisted space, information on companies is not easily available; so, cherry picking the right companies with appropriate business models requires more hard work.

If an investor in the listed space wants to transit to the unlisted space, he should begin by taking stakes in micro- and small-cap companies and holding these for long tenures. Investing in both spaces requires patience but the skill sets that make for success are different. Investors should look before they leap from one side of the fence to the other.

The writer is director and co-founder, Entrust Family Office Investment Advisors