IPO Funds: Often Stellar Returns, but High Risk

ON Sept. 29, 1994, investment firm Warburg Pincus rolled out its newest financial product: the Warburg Pincus Post-Venture Capital Fund. Since then, more than $25 million has poured into the fund, which invests in innovative start-up firms that have some type of venture-capital backing. In its brief run, total returns are about 33 percent. Some similar funds have posted gains twice that big.

Welcome to the world of high-roller mutual funds!

The success of funds such as the Warburg Pincus Post-Venture Capital Fund adds momentum to what is expected to be a growing tide of mutual-fund products investing in smaller, entrepreneurial firms. The funds will invest in venture capital or in companies making initial public offerings (IPOs) of stock.

Returns from these products can be staggeringly high; but so are the risks.

Who should buy an IPO fund? "Someone young, probably in his or her 20s or 30s, with a potentially long time frame for investing," suggests Cebra Graves, who tracks IPO mutual funds for Morningstar Inc., a Chicago financial-services company. "Very few people over 50 should buy them," given the risk.

The IPO and venture-capital sector - which includes thousands of start-up companies - is one of the red-hot investment categories of the 1990s, experts say.

Early-stage firms

A venture-capital firm is a company in the pre-IPO stage, backed by wealthy sugar daddies or foundations.

Recent IPO companies include Pixar Animation Studios, which did the computer graphics for the hit film "Toy Story"; Secure Computing, which provides Internet security products; and softwaremaker Netscape Communications Corp.

IPOs and venture-capital firms are sprouting up in just about every market sector, but especially in computer technology, biotechnology, telecommunications, and health-care products. The IPO market alone has posted phenomenal growth during the '90s. Through Dec. 26, 1995 there were some 573 IPOs valued at $30.2 billion, compared with 646 issues valued at $33.8 billion in 1994, according to the Securities Data Company, a financial-services firm in Newark, N.J. The record year for IPOs was 1993, when more than $34 billion flowed into new firms.

"IPOs have done very well in 1995," reflecting "the relatively strong economy and declining interest rates," says Robert Lissmann, an analyst with Securities Data.

Ways to invest

There are two ways to buy IPOs, or firms backed by private venture-capital money, according to financial planners: (1) Buy individual shares through a broker, usually soon after the initial offering; (2) Buy into a mutual fund that invests in IPOs.

Buying directly into a brand new IPO is logistically difficult for most smaller investors, since large institutional investors - who have huge blocks of money to invest - tend to have first crack, says Mr. Graves, of Morningstar.

Moreover, studies show that IPOs often drop sharply in price during their first year of trading, as investor euphoria declines. Thus, an investor may wind up with a loss on what had seemed a shrewd buy.

The upshot: Most smaller investors who want to play in IPOs go the mutual-fund route, Graves says. "Pure" IPO funds are almost impossible to find, although there are many funds that have a hefty IPO component of up to 50 percent of their total assets, he says. Graves counts about five to 10 funds that can be identified as "IPO funds." But there are also funds linked to venture-capital start-ups, such as the Warburg Pincus fund, he notes.

Most funds that call themselves "IPO funds" are actually aggressive-growth equity funds, emerging-growth funds, or small-capitalization funds. That is, the funds specialize in companies with modest levels of market capitalization. They can be identified by finding out the companies in their portfolios, and then cross-checking the companies against recent lists of IPOs.

Popular IPO funds

IPO and venture capital funds can provide spectacular returns, Graves says. The Govett Smaller Companies Fund (an IPO fund) was the No. 1 equity fund in the diversified fund category in terms of total return in both 1993 and 1994, he says. The fund shot up 58.5 percent in 1993 and 29 percent in 1994, in both years substantially exceeding the Standard & Poor's 500 index. In 1995 the fund was up 72.65 percent through November, well exceeding the 32 percent gain in the S&P 500.

Govett is a load fund. That means it has a front-end commission charge. The minimum entry-level investment: $500. About half of the fund's portfolio is in IPO companies, Graves says.

Another example of a popular IPO fund: BT [Bankers Trust] Investment Small Cap Fund, a no-load fund with a minimum investment of $20,000. About 40 percent of the portfolio is IPO companies, Graves says. The fund was up 55 percent in 1995, through November.

Many new equity funds initially have a heavy stake in IPO companies, Graves says. Managers of some new funds deliberately buy stellar IPO companies to give a quick boost to their fund's rate of return.

Still, Graves warns of the risks. "As much as I am impressed by their returns ... they are as close to gambling as you can get" in the stock market, he says.

Graves concludes: "In bull markets, when the stock market is moving upward in value, IPOs tend to do very well. But in bear markets, they tend to drop very fast," as investors sell off IPO holdings and shift assets to high-quality stocks.