Crossover Funds: A Win-Win Scenario?
A crossover fund is an investment fund that invests in both publicly-traded and privately-held companies. Crossover funds are designed to give investors the ability to invest in private companies without having to be a “qualified” investor or an investor in a venture capital fund. Mutual and hedge funds that invest in private companies do so in order to potentially increase their return, but this potential return comes with higher risk. Investments in privately-held companies by crossover funds are typically made in “IPO-ready” companies before entering the public markets, giving these funds a foothold into a potential IPO at a discounted price.
On the surface, selling shares at a pre-IPO discount does not make sense for a private company, but this late-stage crossover round can serve many purposes. The most obvious of these is that crossover funds provide capital to run the business. Many late-stage private companies are burning through cash and need to raise more capital in order to grow. Selling a portion of equity to crossover investors provides additional capital to the private company, potentially giving it more time to reach a stage that public company investors will find more intriguing.
A subtler benefit of a crossover fund investment in a private company is the perception of quality. Having a strong group of venture capital funds and a solid list of blue chip crossover funds invested in a private company can be a signal to public investors that the private company is potentially a good investment.
Research on Crossover Funds
In November 2014, Bruce Booth, a partner at Atlas Venture, ran a study comparing pre-money IPO valuations and post-IPO stock performance for 94 therapeutically-focused IPOs, of which 24 had crossover led financing rounds. Based on the data, which came from an investment bank active in therapeutically-focused IPOs and spanned from January 2013 through late 2014, the median pre-money valuation at IPO for the companies with a crossover led pre-IPO financing was over 128% higher than companies without. When adjusting for the additional capital from the crossover funding, the median pre-money valuation at IPO was still over 80%.
For funds that cannot participate in private company financings, post-IPO stock appreciation matters most. For the 24 companies with crossover financings in the study, the median stock appreciation was 83% from pricing to September 30, 2014, despite having a higher IPO valuation due to the crossover round. This median return compares very favorably to the negative 10% median return for those companies without a crossover round. While this study only included 94 companies, and stock price fluctuations occur for many reasons, the results of this study are quite remarkable.
Traditionally, crossover investments occurred at least six months prior to an IPO and were generally initiated by an investment bank, giving private companies extra time to become more appealing to potential public investors. Over the past several years, the number of crossover financings and the timing of financings have changed. As mutual and hedge funds look to increase their returns, they are becoming more willing to invest in crossover financings. These days, some private companies receive crossover investment requests from investors during “test the water” pre-IPO roadshows despite having enough capital. Crossover requests are becoming more frequent, which in turn is compressing the time between a crossover round and IPO. If the trend continues, we could see the average time between these two events be less than 100 days.
Crossover financings were developed to provide private companies more time and capital prior to an IPO. This type of financing also gave traditional mutual and hedge funds an opportunity to potentially increase their return by investing in a private company at a perceived discount to an upcoming IPO. As these financings have become more popular, the timing has contracted. We expect crossover investing will become even more popular in the foreseeable future, and we believe a larger percentage of private companies will request crossover funding prior to going public.
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Greg Chodaczek, Managing Director