We’re launching Lakehouse Capital for two big reasons.
The first is to better serve the many busy members who have asked us over the years to manage money for them. We’re excited to save them time and stress by delivering on that need and, hopefully, generate some very pleasing returns along the way!
The second is to provide better access to exciting opportunities that aren’t often available to everyday retail investors. IPOs.
Institutional capital raises. And, one of the most exciting twists, access to pre-IPO investments.
Most investors have never heard of pre-IPO investments, probably because they’ve never been given a seat at the table.
It’s a class of investments almost entirely exclusive to funds, institutions, and well connected wholesale investors (aka very rich people).
The fund we expect to launch in October, the Lakehouse Small Companies Fund, will be among that small group that will have access to these high-potential, off-the-grid investments. We’re so excited about the opportunity, we’re planning to invest up to 10% of the fund available to invest, in them.
How Pre-IPOs Work
A typical framework for pre-IPO investments works this way.
Let’s say a growing, private company wants to shoot two birds with one stone: Raise new growth capital while building credibility with institutional investors on the path towards an IPO in six to twelve months.
Let’s even put a name on this.
What is a Convertible Note? Startups 101 - Robert Neivert, 500 Startups
Say, Spacely Sprockets. Spacely is a cutting-edge sprockets designer and wants to acquire a highly complementary manufacturing business, Cogswell Cogs, that would accelerate growth.
Spacely’s bankers will approach some of its larger clients for potential backing, particularly the patient ones who are willing to accept less liquidity and higher risk in exchange for substantially higher potential reward.
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(And, by the way, many funds don’t even have pre-IPO investment potential chiselled into their mandates, which is yet another point of differentiation with our planned fund.)
Investors will have the chance to invest in a Spacely convertible note offering around 10% interest — a very high yield in a world where the cash rate sits at a lowly 1.5%.
But here’s the big kicker.
If all goes to plan and the company moves to IPO, the investors’ convertible notes will convert to new, publicly listed shares – and typically at a 20%discount to the IPO price.
Let’s say Spacely successfully IPOs six months later at $1 per share and, like Class on its first day of trading, pops to $1.41.
While investors entering at the IPO would’ve done very well, and certainly much better than those who had no IPO access at all, those that got in even earlier by investing pre-IPO would see their investment converted into the new shares at $1.41 — against an effective cost of only $0.80.
In other words, while IPO investors earned a 41% gain on the day of the IPO, the pre-IPO investors landed a turbocharged 76% gain — plus accrued interest.
And if it’s a strong business with bright prospects, it’s a winner that can be let run.
If it all sounds too good to be true, it’s because things can go awry.
Many pre-IPO stage companies are unprofitable, and the option of an IPO can fade away if the company stumbles or the IPO market cools off.
It is crucial that investors choose even more selectively with pre-IPO investments than with publicly listed shares.
At Lakehouse Capital, our framework for evaluating pre-IPO investments involves the following checkpoints on top of our already rigorous standard evaluation process:
- A Clear Path to A Successful IPO: A successful IPO represents the biggest payoff of all for a pre-IPO investment.
The shorter the expected time horizon until then, the greater the odds of success and the sooner investors can expect a sizable payback.
Convertible Note Terms
Consistent growth, loyal customers, a reputable board, and established profitability all grease the wheels towards a successful public exit.
- The Groucho Marx Factor. Groucho once quipped that “I don’t want to belong to any club that would have me as a member.” There’s a truth to that with pre-IPO investments, as the king of business that can’t self-fund its own growth may not have the kind of supernatural economics that we covet.
A dream situation is along the lines of WiseTech Global’spre-IPO funding in 2015, which helped to fund very logical, complementary bolt-on acquisitions to an already strong, low-risk business cruising towards an IPO.
- Few Ways to Lose. The fewer the ways to lose, and the lower the impact on those odds, the greater the chance the upside will take care of itself.
We have no interest in backing companies that haven’t already proven they can execute on an attractive strategy. Audacious bets like a new mine, drug, or far-flung acquisition come with far more execution risk than we’d ever consider. Sturdy underlying economics remain paramount, as does a reasonable valuation.
Even the most dynamic growth company in the world can prove a bust if bought at the wrong price.
- Multiple Ways to Win. Our strong bias is toward companies that would not only thrive as independent listed companies but have the resilience to stay private and successful should the IPO market run cold. One better, we prefer when the same company has established a unique proposition that makes it a logical takeout candidate, as well.
Hey, we’re very picky.
But we’re comfortable being very picky, our patience and long term focus means there’s no reason to compromise.
P.S. You can read up on our Philosophy or register your interest to receive further information.
The above article contains general investment advice only (Lakehouse Capital Pty Ltd is the Corporate Authorised Representative of The Motley Fool Australia Pty Ltd AFSL 400691).
The Motley Fool owns shares of Class and WiseTech Global.