Roughly two dozen mutual funds including Fidelity Investments and T. Rowe Price Group Inc. (TROW) bought shares of Snap Inc. (SNAP) in the private market before the company held an initial public offering (IPO), positioning them to potentially reap robust gains, according to The New York Times. As other high-profile companies—including Uber, WeWork, Airbnb, Inc. and Pinterest—gear up to hold IPOs in the coming years, these mutual funds are expected to take a similar approach. (For more, see also: An Uber IPO May Happen Sooner Than Later.)

Great Rewards

Katie Reichart, who works for Morningstar, Inc. (MORN) as associate director of equity strategies research, spoke to the great rewards that institutions can receive by harnessing this strategy when speaking with the Times. "Being early to the table can benefit fund owners. Funds can buy into a company at a much lower valuation."

Potential Risks

While purchasing stakes in companies before they go public can produce very strong returns, this approach is not without its risks, according to analysts who spoke with Investopedia. "It is difficult to value private traded equities" since they are thinly traded, said Tenpao Lee, professor and interim dean at Niagara University. Past that, the vast majority of private companies that offer securities will never go public, he added. 

 

 

Liquidity Concerns

Kevin Quigg, chief strategist for asset manager ACSI Funds, spoke to other concerns, emphasizing that privately issued securities will be far less liquid than publicly traded securities. If a financial institution purchased shares of a private company in anticipation of a successful IPO and that firm became less attractive, the institution might have a hard time selling those shares. (For more, see also: How can I sell private company stock?)

Diversification

Lee emphasized that while buying shares of a company before it goes public can produce strong returns, there are certainly times when this is not the case. As a result, investors using this strategy should diversify and hold many privately traded securities, he told Investopedia. However, over the long term, the return offered by this approach may not be greater than the return offered by other investments, added Lee. 

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