The Rise of Crossover Investing
What is Crossover Investing?
Crossover investing is a key trend across the capital markets and is beginning to infiltrate venture capital today. Put simply, crossover investing refers to public market investors and asset managers “crossing over” into the private markets to invest in privately held companies.
These investors tend to invest in late venture stage startups that have already achieved a certain level of maturity and validation. For this reason, crossover investment often happens between late-stage venture capital rounds and an IPO.
What is a Crossover Fund?
Similarly, a crossover fund is a fund that invests in both private and publicly traded companies.
There are two basic categories of crossover funds. The first category consists of traditional mutual funds, hedge funds and other vehicles that generally invest in public market securities but have chosen to allocate some of their capital toward private market investments. The second category consists of venture capital funds that hold onto some or all of their portfolio companies after they go public. Until recently, excluding funds in certain verticals like biotech and pharmaceuticals, venture capital funds were less active in the crossover space. We believe this is changing.
The recently announced Sequoia Fund falls into the second type of crossover funds. Sequoia made news in late 2021 by restructuring all of its holdings in the U.S. and Europe into an open-ended crossover fund. This is a departure from the traditional venture capital model. In this type of fund, a VC firm invests in high growth potential startups at various stages (often starting very early in the company life cycle), nurtures them to maturity, sees them through to a successful IPO, then exits and closes the fund in order to open another fund and start the process anew.
Under the traditional model, the fund is expected to have a lifespan of approximately 10 years. Crossover funds like the reorganized Sequoia Fund allow the VC firm to benefit from post-IPO growth, which can bring excess returns in a shorter time frame.
Crossover Investing is Experiencing Explosive Growth
The last decade has seen a sharp increase in crossover investment activity. Whereas venture capital used to be dominated by VC firms, traditional public market investors are increasingly entering the private markets in search of higher returns. This includes mutual funds, hedge funds, family offices and other large asset managers.
How much has crossover investing grown? $60 billion of venture capital allocated in 2020 had crossover investor participation. This represented 36% of total deal value for the year and a 57.7% increase over 2019. Additionally, in 2020, 74% of companies that executed an IPO in 2020 raised capital via crossover investment in pre-IPO rounds.
This stands in sharp contrast to the early 2010s when the percentage of venture capital that included crossover investor participation was barely in the double digits.
Why is Crossover Investment on the Rise?
The Sequoia Fund’s restructuring dominated venture capital news (they are Sequoia, after all), with some pundits proclaiming it a revolution in VC funding. Our view is that it is less of a revolution and more of a natural evolution. Crossover investing is predictably becoming more popular due to trends that have been in play for several years — in some cases, a decade or more. Here are a few reasons why crossover investment is becoming increasingly common.
Fewer Companies on the Public Market
In 1996, there were 8,000 companies listed on the public market. That number dropped precipitously during the great financial crisis of 2008. In each year since, there have been fewer than 4,500 publicly listed companies.
In that same time span, the amount of capital looking for investment opportunities has been growing. We believe asset managers are running out of attractive places to put their money in the public markets.
Public Market Investors Miss Out on Pre-IPO Gains
Crossover investment allows traditional public market investors to allocate capital earlier in the lifecycle of promising startups, acquiring more significant equity stakes and potentially setting themselves up for venture-level returns.
With the U.S. public equity market at or near all-time highs, this has become an increasingly attractive proposition for asset managers looking to maintain returns.
Companies are Waiting Longer to go Public
Additionally, companies often wait substantially longer to go public than they did in the past. There are several reasons for this. One is the abundance of VC capital available relative to just a couple of decades ago. An IPO is also expensive, requires a lot of extra work, and subjects the company to a whole new set of pressures (especially from shareholders) and regulatory requirements.
Thus, companies often choose to delay an IPO, using the interim to increase valuation and focus on long-term growth initiatives that set them up for sustainable success. The bottom line for investors is that more of the company’s growth happens before it goes public.
Because crossover investment occurs in private markets, the company receiving funding has a greater level of control over who can invest. So, private companies often give priority to investors willing to commit to being long-term shareholders over those looking for fast returns through a quick flip.
Long-term shareholders tend to have a stabilizing effect on share price post-IPO. In return, these investors are rewarded with the opportunity to purchase significant ownership at a discount during pre-IPO rounds.
How Crossover Investing Benefits Founders Bridging Venture & IPO
Crossover capital can offer a bridge between the venture and IPO stages. This may be especially helpful for companies that have a longer or murkier path to profitability. These companies may benefit from delaying an IPO until they have acquired a critical mass of users, built out complex infrastructure, scaled operations or cleared other significant roadblocks.
Increasing Valuation Before IPO
Crossover funding can also help private companies gain credibility and validation (along with additional working capital), potentially raising valuation going into an IPO. Participation by traditional public market investors can also increase the comfort level of other public market investors who may be sitting on the fence.
Networks & Expertise
Public market investor partnerships can often expose founders to new networks, business expertise and other resources that can be valuable to post-IPO growth. Investors are often awarded seats on the company’s board or appointed as strategic advisors, potentially amplifying the benefit.
Crossover funds may engender better alignment between VC firms and their portfolio companies. Under the traditional venture model, the VC firm typically divests its stake in the company soon after IPO. So, while both the VC firm and the company have an obvious interest in maximizing growth through the IPO, the company may have more of an interest in optimizing its business model for sustainable growth far beyond the IPO.
With a crossover fund, the firm intends to hold its portfolio companies after they have gone public, fully aligning the two parties’ interest in long-term, sustainable growth.
Crossover Investing is Here to Stay
When viewed in the context of current markets, the state of the broader economy, and the changing landscape of high-growth startups, crossover investing seems like a very natural evolution in the venture capital model.
DCA fully expects crossover investing to be a long-term trend that will play a prominent role in shaping the future of venture capital. Crossover funds have the potential to be mutually beneficial for startups, venture capital firms and public market investors alike. For this reason, expect to see the inception of more crossover funds in the coming years.