Prudence or Prohibition? Deconstructing SEBI's Pre-IPO Ban

[Sansita and Smarak are B.A.LL.B and LLM students at National Law University Odisha and National Law School of India University, respectively.]

The Securities and Exchange Board of India (SEBI) introduced a significant adjustment in October 2025 to India’s capital market regulations. The central regulator definitively prohibited mutual fund (MF) schemes from investing in pre-IPO placements through a unpublished formal communication to the Association of Mutual Funds in India. Inductively, this directive limited MF’s involvement in any company’s public-listing process to two regulated channels, first is the anchor investor portion, which is initiated one day prior to the public issue and the other one is the public issue itself, as a qualified institutional buyer (QIB).

Private sales of shares taking place months before the actual IPO process to high net worth investors or institutional investors at a “discount” or “preferential price” against the expected offer price are commonly referred to as pre-IPO placements. For years, there has been this ‘grey area’ that was manipulated knowingly by the MFs that was closed by this prohibition. The ambiguity was by virtue of Clause 11 of Seventh Schedule of SEBI (Mutual Funds) Regulations 1996 which provides that MFs shall invest only in securities that are “listed or to be listed”. The broad term of “to be listed”, lacks any defined timeline and was exploited by the fund houses to justify investing in companies that have a chance to make a public issue in near future.

SEBI’s rationale though rooted in investor protection substantially diverges from global regulatory norms and carries the risk of inducing market deformities which may include regulatory arbitrage supporting less controlled vehicles such alternative investment funds (AIFs) and unequal access. Nonetheless, MF allotment within the QIB quota has dropped from 43% to 35.6% from FY 24-25 to FY25-26, for instance. 24.2 million shares of Urban Company were bought by seven mutual fund schemes through pre-IPO placement which was later listed at INR 161 per share. Further, SEBI's 2024 warning against trading in unlisted securities through unauthorized platforms displays a transfer to active regulatory intervention. SEBI particularly perceived this practice as more of a compliance violation and not an issue of debate which was crystallized by the fact that there was a direct issuance of a letter instead of a consultative paper being published.

The Regulatory Rationale: Understanding SEBI’s Investor First Doctrine

The prohibition actively addressed three intersecting issues intrinsic in pre-IPO issue within open-ended mutual funds that solidifies SEBI’s stance of fiduciary prudence rather than conservatism.

Illiquidity mismatch and fiduciary breach 

A fundamental fiduciary concern that was demonstrated by this prohibited practice was the structural incompatibility between illiquid pre-IPO securities and open ended MFs which manage INR 75.61 lakh crore primarily for retail investors providing daily liquidity. Pre-IPO shares are unlisted and subject to compulsory lock-in periods whereas open ended MF’s provided investors to redeem at a verifiable net asset value. Consequently, the worst case scenario deliberated by SEBI was what if an IPO is delayed or cancelled due to internal issues or market volatility resulting in fund houses ending up holding up unlisted equity shares for indefinite periods violating Clause 11 and the investment mandate.

Investors are exposed to systemic redemption risk as a result of this mismatch. Long-term unitholders may suffer if funds are forced to sell quality listed assets at a discount in order to satisfy withdrawals during redemption stress. The 2019 UK LF Woodford Fund collapse, which was caused by illiquidity exposure in an open-ended vehicle that resulted in huge redemptions and withdrawal suspension, is reflected in SEBI's proactive response.

Valuation subjectivity and NAV integrity

SEBI’s rationale to prohibit investing in pre-IPO placements is further based on valuation opacity. By practice unlisted shares require level 3 valuations focused on management assumptions and unverified data whereas listed shares require level 1 inputs which are transparent, market prices from a stock exchange. Potential net asset value (NAV) distortion can be a result of this risk of valuation subjectivity. The 2024 penalty imposed by SEBI on HSBC Asset Management for neglecting to record the reasoning behind its investment and valuation choices revealed the agency's limited tolerance for such ambiguity.

A very possible scenario could be that a fund overvaluing an unlisted entity shares to increase its financial standing or delay devolution of a failed investment. This is a direct violation of trust with retail investors who depend on NAV as a correct, reasonable and transparent measure of their investment’s value.

Latent conflicts of interest

Additionally, conflict of interest may arise in the pre-IPO ecosystem. The pre-public issue market is mostly surrounded by privately negotiated bargains which provides a potent area for such conflicts.

A fund house belonging to a financial conglomerate having an investment banking arm may be compelled to engage in a pre-IPO round to help the client of investment banking to build a successful book, although the valuation may not be transparent and in the best interest of MF unitholders.

A bifurcation has been brought into the market through this regulation. Liquidity and valuation transparency are prioritized through the medium of Mutual funds for retail investors whereas on the other hand AIF’s and portfolio management services (PMS) act as a medium to include illiquid, sophisticated and high-risk strategies.

It is essential thereby, to understand the impacts of this directive on MF industry, startup ecosystem and capital market in general.

Ripple Effects: Industry and Market Consequences

End of Alpha Avenue

The impact of this directive on fund houses are multifold. This directive excludes them from generating excess returns or eliminates alpha generating method. SEBI perceives this excess return as trade off against illiquidity risk, incoherent with retail mandates as pre-IPO allocation at discounted prices often provide excess returns.

As a result, the pre-IPO market is still accessible to AIFs, FPIs, and family offices but not to retail mutual funds, creating an unevenly competitive market. However, this imbalance is protective rather than punishing from SEBI's point of view. The ruling pushes funds to seek post-listing or sectoral strategies with lower prospective returns, redefining risk-bearing bounds within India's asset management sector.

For startups and issuers: A funding bridge is removed 

With nearly USD 11.5 billion raised in 2025 alone, the prohibition has been described as a "blow to the red-hot IPO market" that has experienced unprecedented capital offerings.

For late-stage, cutting-edge technological companies, the directive closed a vital link between the public and private markets. Over the past few years, domestic mutual funds have become essential pre-IPO investments. Examples include Kotak's INR 653 crore investment in Nykaa and PharmEasy, and SBI Mutual Fund's INR 100 crore investment in eyewear shop Lenskart.

These issuers are affected in two ways. There is loss of capital. As the local funding pool shrinks, startups are compelled to rely more on foreign investors, family offices, or AIFs. Additionally, participation by a credible, domestic mutual fund provided institutional confidence and credibility. It demonstrated quality to the market and was a crucial factor in determining the pre-listing price and demand. Conversely, lesser pre-listing funding and conservative pricing may be induced through the removal of this institutional validation.

Unintended beneficiaries 

The desire for pre-IPO deals and the capital will simply shift rather than disappear. The ban will probably push the pre-IPO capital flow to AIFs and PMS platforms and alter the way fund houses take private market possibilities as a result. As capital moves from the highly regulated MF wrapper to the less well-known AIF structure, this leads to regulatory arbitrage.

Furthermore, the ban significantly modifies the process of price discovery. Since MFs have been removed from the pre-IPO stage, the domestic institutional price validation prior to the public offering is now merely the anchor book. As a result, the anchor book has a great deal of power to determine the price, making it a crucial (and potentially turbulent) event for an IPO's success.

Asset management companies use this trend as a customer lure since they fear losing this portion of their business and needing to start their own AIFs. Additionally, it makes SEBI's concurrent efforts to tighten the AIF framework such as decreasing the cap on large value funds, one of the steps in that direction more than coincidental.

A Way Forward: Reconciling Prudence with Market Maturity

SEBI’s ban resolves the illiquidity issue; nevertheless, it also produces new market deformity which includes regulatory arbitrage towards AIFs, uneven playing field, and scarcity of domestic capital India’s startup ecosystem. Although ingrained in investor first stance, a more nuanced and stakeholder friendly approach would have been more sustainable rather than a complete prohibition. Such a legal structure can be formulated by transplanting the global best practices.

To start with, the MF regulations can be amended to change the “to be listed” phrase with a cap on pre-IPO investments to the extent of 15% or 10% of a scheme’s NAV aligning with foreign thresholds.

Companies that are eligible to obtain pre-IPO financing must at the very least submit a DRHP to SEBI in order to allay SEBI's main concern that the current structure allows for indefinite retention. This simple, bright-line test provides a defined "to be listed" timeline, creates a public disclosure framework, and eliminates the "someday" loophole.

Independent valuation oversight is required under the Singapore models. The most important pillar is this one. The Monetary Authority of Singapore model should be used by SEBI to reduce the risks associated with conflict of interest and subjective valuation. The regulations must mandate that all unlisted properties be valued by an impartial appraiser and, above all, that the MF Trustee approve these appraisals. This will protect unitholders from undue influence and will add another layer of protection. 

Additionally, specific risks of holding illiquid pre-IPO assets and the methodologies of valuation used must be distinctively reported in the scheme information document.

While the proposed "middle path" requires an increase in industry governance norms, the 2025 prohibition avoids this difficulty. The mutual fund sector has already positioned itself to "propose risk-mitigating ideas" in anticipation of the regulator's consideration of risk mitigation strategies. In addition to eliminating a risk, SEBI can improve the quality of the Indian capital market. Additionally, it is a balance between safeguarding investors and the development of India's rapidly expanding economy.