Mutual Funds and Pre-IPO Markets: Paradox of Protection and Exclusion under SEBI’s Regulatory Regime
Introduction
A historic order prohibiting mutual funds from taking part in pre-IPO share placements was released by the Securities and Exchange Board of India (SEBI) in October 2025[i]. Mutual funds are only allowed to invest in securities that are “listed or to be listed” under Clause 11 of the Seventh Schedule of the SEBI (Mutual Funds) Regulations, 1996[ii]. The clause applies to equity shares or equity-related instruments of any company which are listed or to be listed on a recognized stock exchange. Any mutual fund scheme shall not invest more than 5% of its NAV in the unlisted equity shares or equity related instruments in case of open ended scheme and 10% of its NAV in case of close ended scheme. The listed companies are the ones with ongoing trading in the stock exchange. Whereas, to be listed refer to companies whose securities are yet to be listed on a stock exchange. The space wherein the company is, “to be listed” gives rise to the concept of pre IPO market.
A pre IPO market basically allows buying shares of private companies before they are listed on the exchange. This allows investors to buy the shares at a lower price, often giving them a chance at higher return. Generally, the investors are aware of the probable risks before investing in pre IPO markets, such as capital loss, liquidity issues, and dilution of the pre IPO shares because it has not been officially released[iii]. Pre IPO investment also allows diversification of portfolio with better investment rates. Both retail and institutional investors were earlier allowed to invest in pre IPO markets. This was also used to overcome the issue of oversubscription of IPOs, ensuring the investor has shares before the IPO is launched. Typically, institutional investors investing the funds comprise of mutual funds, hedge funds, investment banks, insurance companies, and private equity and venture capital firms.
In the past, pre-IPO placements, private sales of equity to institutional investors before to public listing, have facilitated price discovery prior to IPOs and provided access to early value advantages. Up until recently, some mutual funds took part in these placements, especially large-cap or IPO-focused schemes, giving consumers capital indirect access to high-growth prospects. Nonetheless, SEBI’s prohibition aims to reduce the risks associated with holding unlisted or illiquid products in funds with retail exposure, including liquidity risk, valuation opacity, and possible regulatory non-compliance. The prohibition raises concerns about fairness, financial inclusion, and the competitive position of domestic institutional investors versus other market participants like Alternative Investment Funds (AIFs), foreign portfolio investors (FPIs), and high-net-worth individuals who are unrestricted in the pre-IPO market, even though the regulatory intent is to protect investors.
Understanding the Structure: Pre-IPO vs. Anchor Investment
The regulatory justification needs an explanation of pre-IPO investments describing what they do not constitute. The two investment types face confusion because people believe they are identical when their actual operational processes, investment periods, and investment hazards differ. Pre-IPO placements occurs in a grey zone months before an IPO filing or after the Draft Red Herring Prospectus (DRHP) is submitted. The transactions involve a private contract that the company and its original investors negotiate to produce an agreement that sells at a steep discount, which ranges between 15 percent and 30 percent of the predicted IPO valuation. The investment provides unpredictable listing dates while investors maintain complete control over their investments, which creates a situation where they can achieve both active and passive outcomes. The public markets permit anchor investors to enter their investment space one day before IPO operations begin for incoming customers. The investors purchase shares at the same price range that retail customers select, but they must lock their investment for 30 to 90 days, and they will only invest in businesses that have achieved complete regulatory approval and announced their upcoming stock exchange debut. The distinction between anchor investments and pre-IPO investments requires explicit explanation because anchor investments function as regulated public market extensions while pre-IPO investments operate as private market investments, which businesses need to convert into public assets through unspecified investors.
The major reasoning behind this decision was based on the unreliability of pre IPO market. In case of any losses faced by the fund, they would eventually be recovered from the investor. To protect the investor from any such scrutiny at a later stage, this decision was enforced.
The Risks Involved in the Pre-IPO Market
While pre-IPO deals can generate outsized returns, they expose investors, particularly pooled retail capital, to three primary dangers: illiquidity, credit risk, and information asymmetry.
1. The Liquidity Trap: Lessons from Franklin Templeton
The first danger that investors face when they invest in pre-IPO stocks arises because there exists no method for them to exit their investments. Investors should be able to redeem their investments at any time because mutual funds must provide this function. The possession of unlisted shares directly opposes this fundamental rule. The similarities between the Franklin Templeton crisis[iv] of April 2020 and this situation show a complete similarity. Franklin wound up six debt schemes holding over ₹25,000 crore, not because the bonds were technically illegal, but because they were illiquid. The fund faced difficulties during COVID-19 because it could not sell its distressed real estate assets and NBFC bonds without incurring massive losses between 20% and 40%. The mutual fund which invests in pre-IPO shares encounters the same problem when a company delays its listing or cancels it. Unlisted equity shares do not produce any cash flow which creates the same conditions as the Franklin case debt instruments for investors. The fund would have a holding which existed as a frozen asset because it had no secondary market. This situation forced the fund to choose between two options: it could either stop redemptions or it could sell its liquid assets at a loss to provide investor payouts.
2. Credit Risk: The IL&FS Lesson
The ₹90,000 crore IL&FS default in 2018 taught regulators that perceived safety can be a mirage. Multiple mutual fund schemes held IL&FS bonds rated AAA the highest safety grade. Yet, within days of the default, these schemes suffered NAV crashes of 30-60%. This crisis highlighted that complexity, illiquidity, and concentrated risk create systemic danger even when investments appear to comply with technical regulations. Pre-IPO placements combine all three factors[v]. They are complex private contracts with unlisted entities, offering no transparency on secondary market value, and are often concentrated in a single company’s fortunes.
3. Information Asymmetry: The Sophisticated Investor Advantage
When a large fund like SBI Mutual Fund invests in a pre-IPO round, it conducts extensive due diligence. However, the uncomfortable reality is that pre-IPO investors always have better information than subsequent public investors. Alternative Investment Funds (AIFs), family offices, and foreign institutional investors participating in these rounds often negotiate special rights: board observer seats, preferential liquidation terms, or anti-dilution protections. While a mutual fund could theoretically secure these rights for the fund, the retail investors pooling their money through SIPs get none of these protections. SEBI’s philosophy is clear: retail investors should not be exposed to sophisticated private equity-style investments where information is asymmetric, exit timelines are uncertain, and the risk profile is concentrated.
A Policy Critique of SEBI’s Regulatory Approach
SEBI’s prohibition on mutual funds participating in pre-IPO placements exists. The ban demonstrates legitimate concerns yet it contains essential defects which need more examination. The ban creates an uneven playing field. The pre-IPO placements remain open to Alternative Investment Funds (AIFs) and Foreign Portfolio Investors (FPIs) as well as family offices and high-net-worth individuals. The only exception to this rule applies to mutual funds, which operate as investment funds that require retail investors to contribute at least ₹500.
This distinction lacks logic. All three entities, AIFs, FPIs, and mutual funds, operate under SEBI regulations and use professional fund managers who hold fiduciary responsibilities. The investor protection concern requires differentiation between investors according to their proficiency as accredited investors and retail investors. A wealthy individual who invests directly faces no investment restrictions, while a retail investor who invests ₹500 monthly through a regulated mutual fund faces complete access restrictions.
India’s Financial Inclusion Index stands at 67% with 179 million demat accounts and mutual fund assets under management reaching ₹75 lakh crore. The pre-IPO ban creates a two-tier system that permits wealthy investors to access pre-IPO discounts and early-stage investment opportunities, while retail investors who use mutual funds to save money are excluded from this access. The system creates a divide between wealthy individuals and others who want to participate in capital markets. The system treats retail capital, which flows through SEBI-regulated professional investment funds, as inferior to capital in AIFs.[vi]
Tuhin Kanta Pandey, the SEBI Chairman, proposed to establish a controlled market for pre-IPO trading during his August 2025 proposal[vii]. The SEBI organization currently prohibits mutual funds from entering this market. Mutual funds that serve retail investors should be included in pre-IPO markets because these markets require both official recognition and regulatory oversight to prove their legitimacy. The regulator needs to provide a structured infrastructure for these markets because their existence has not been established yet, this need exists as a reason for the complete market ban.
Alternative Safeguards over Blanket Prohibition
The Securities and Exchange Board of India could have established a risk-based regulatory system that protects investors and enables them to pursue investment possibilities instead of implementing a total ban on all investment activities. Multiple options require thorough examination.
The first requirement needs regulatory approval before any time-related milestones can be established. Companies that file a DRHP demonstrate clear intent to list, though final approval remains pending. The mutual fund market should receive access only after the company has obtained the regulatory observation letter from the Securities and Exchange Board of India. The temporal filter method effectively handles the challenge of unlisted share ownership through pre-IPO opportunity access.
The second requirement establishes mandatory buyback and exit clauses. The Securities and Exchange Board of India should mandate mutual fund pre-IPO placements to include buyback contracts. The company or its existing investors must buy back shares according to a predetermined formula, which includes acquisition cost plus accrued interest or a small guaranteed return when an IPO faces a delay beyond its specified timeframe or gets cancelled completely. The solution directly solves the main problem, which forces funds into holding unlisted securities that cannot be traded.
The third requirement mandates concentration limits to be enforced through stronger governance measures. Mutual funds can invest up to 3% of their assets into pre-IPO opportunities while maintaining their existing investment allocation rules. The investment conditions require organizations to meet multiple requirements, including conducting documented due diligence, providing mandatory disclosures to trustees, preparing quarterly portfolio reports for the Securities and Exchange Board of India, and obtaining board approval before making any investment. The organization needs to establish exposure limits that will enable restricted investment in pre-IPO shares while protecting adequate safety measures.
Conclusion
India’s approach shows different results compared to developed markets which discovered workable solutions through controlled methods instead of complete market bans. On contrast, the United States allows mutual funds to make pre-IPO investments through private placements which use Rule 144A as their investment method but their funds face restrictions on liquidity needs and board decision-making. The SEC focuses on valuation practices and disclosure requirements while it does not impose any prohibitions. The FCA in the United Kingdom permits authorized funds to allocate 10% of their assets into unlisted securities when they follow stricter disclosure and governance rules for their investments. Singapore’s MAS allows retail funds to invest in pre-IPO opportunities within defined concentration limits, emphasizing prospectus disclosure and risk warnings. The jurisdictions show that professional fund managers need proper safeguards to manage unlisted investments. The blanket prohibition which India enacted operates as an unusual strategy that will most likely lead to negative effects for Indian retail investors.
SEBI’s October 2025 prohibition on mutual funds participating in pre-IPO placements constitutes a decisively protective yet structurally exclusionary intervention in India’s capital markets. By rigidly interpreting the “listed or to be listed” mandate to exclude unlisted private placements while permitting only anchor and public-issue participation the regulator has decisively insulated retail pooled capital from acute illiquidity, valuation opacity, credit concentration, and asymmetric information risks.
However, this blanket restriction entrenches a regressive two-tier market architecture between sophisticated participants who continue to engage in pre-listing discounts and governance privileges, whereas retail investors who rely on regulated mutual funds as their primary vehicle for disciplined equity exposure are categorically denied equivalent early-stage access. This weakens the competitive position of domestic institutional capital relative to less-regulated counterparts, potentially distorting price discovery and allocative efficiency in the pre-IPO ecosystem. A more calculated regime would better harmonize investor safeguarding in a more comprehensive and transparent manner.
Notes:
[i] ET Bureau, ‘Sebi Says Mutual Funds Can’t Take Part in Pre-IPO Placements’ (The Economic Times25 October 2025) <https://economictimes.indiatimes.com/mf/mf-news/sebi-says-mutual-funds-cant-take-part-in-pre-ipo-placements/articleshow/124799061.cms> accessed 22 March 2026
[ii] SEBI (Mutual Funds) Regulations, 1996, Schedule VII, Clause 11
[iii] Chang C and others, ‘Pre-Market Trading and IPO Pricing’ (2016) 30 The Review of Financial Studies 835
[iv] Neha Koppu, ‘Lessons from the Franklin Templeton Debacle’ (Centre for Business and Commercial Laws Blog (NLIU), 8 February 2022) https://cbcl.nliu.ac.in/capital-markets-and-securities-law/lessons-from-the-franklin-templeton-debacle/ accessed 22 March 2026.
[v] Riya Abraham, ‘Lessons from the IL&FS Debacle’ (The Securities Blawg, 22 June 2019) https://www.thesecuritiesblawg.in/post/lessons-from-the-il-fs-debacle/ accessed 22 March 2026.
[vi] Abhishek Sinha, ‘SEBI’s New Rule and the Disadvantage for India’s Start-up Ecosystem’ (Outlook Business, 6 November 2025) https://www.outlookbusiness.com/columns/sebis-new-rule-and-the-startup-squeeze-at-pre-ipos accessed 22 March 2026.
[vii] ‘SEBI May Launch Platform for Pre-IPO Trading’ (Business Standard, 22 August 2025) https://www.business-standard.com/markets/capital-market-news/sebi-may-launch-platform-for-pre-ipo-trading-125082100903_1.html accessed 22 March 2026.
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