What’s Old Feels New Again with Crossover Funds

Finance industry participants and observers have recently been using the term crossover funds to describe investment vehicles that traffic in both public and private securities. The phenomenon it describes is not that recent or new, though.

Roughly 10 years ago, when I was a vice president of manager research at an investment consultant, I learned that a well-known firm’s small-cap equity fund had held companies like Facebook before they had gone public, taking advantage of Securities and Exchange Commission rules allowing mutual funds to hold up to 15% of their assets in illiquid securities. (This is an oversimplification, but readers can read the technical rules here.)

The fund manager explained that the number of US public companies had halved in the previous 20 years, putting the highest-growth companies out of the reach of public market investors. To catch the early growth of such companies and maximize potential returns for his shareholders, the manager argued he had to invest in them before they matured enough to go public.

Formerly, if you wanted to invest in multi-billion-dollar companies such as Lime LIME, Discord, or Chime Financial well before their IPOs, you needed large amounts of personal or institutional assets to meet the account minimums of venture capital or private equity funds.

A shift is happening, however, and the number of funds providing access to public and nonpublic companies—so-called crossover funds—is increasing. Previously, highly regulated mutual funds or exchange-traded funds were seen as the vehicles to use for exposure to public markets, while unregulated private equity or VC funds were for private investments. Crossover funds allow investors to access both in one package. (However, note that Morningstar research on the efficacy of this approach indicates that “the results are not encouraging.”)

Why Are Liquidity Terms So Important to Understand?

The limit on illiquid holdings in mutual funds is designed to protect investors.

Mutual fund shares trade daily, but finding a market for nonpublicly traded holdings could take more time and incur higher trading costs than public stock trades. In a normal market environment, funds can typically sell a portion of their more liquid holdings to meet redemptions. In times of stress, however, if too many investors decide to sell at once, the overall portfolio could quickly become much less liquid as the proportion of illiquid holdings rises as the size of the fund shrinks.

One way to avoid this reweighting of the portfolio would be to sell down the illiquid investments, but it might have to be done at fire-sale prices and high transaction costs, locking in low valuations and harming the investors who stayed put.

For institutional investors, hedge funds, the largely unregulated investment vehicles that now encompass a wide variety of strategies, branched into holding private companies long ago.

They are not exempt from the liquidity problem, though. In exchange for only allowing in large investors, they can have higher private company exposures than mutual funds. Hedge fund investors can typically only redeem their shares quarterly, which provides some relief to the managers of the fund when investors want out.

During the global financial crisis, however, many hedge funds had to get creative, often creating sidecars for their private company holdings in which investors asking to redeem their stakes had to stay invested until the funds’ managers chose more advantageous times to exit.

Thus, liquidity is a very important consideration for investors as they mull offerings that claim to provide more liquidity than the vehicles’ underlying holdings. The more exposure to companies without a ready market, the more important it is to closely examine the fund’s liquidity provisions.

How Are the Traditional Private Asset Managers Crossing Over?

Even private equity and VC fund managers have been getting more active in public markets.

In 2018, one well-established private equity fund manager strongly suggested to the foundation that I represented that, to be allowed to invest in their flagship fund, we would also have to agree to a staple transaction that required that we invest in their new fund that held public companies the firm had owned when they were private.

In another example, in 2021, Sequoia Capital restructured its active funds into a single one that amalgamated everything from early-stage venture to publicly traded companies, removing the artificial time limitations that come with the traditional 10-year life of private equity and VC funds.

Private equity funds will sometimes also invest in public companies via private investments into public companies.

Berkshire Hathaway BRK.B, a public conglomerate, notably made several PIPE investments in distressed firms like Goldman Sachs GS, Bank of America BAC, and GE GE during the 2008 financial crisis.

PIPEs typically let a large investor, often a private equity firm, supply capital directly to a company—rather than to other investors selling their shares—at a price often lower than what it would require to accumulate the stake on the open market. The investment may also include a board seat if the capital infusion is large enough, providing some level of control to the investor hoping to influence the investment outcome.

Private equity funds will sometimes use PIPEs to make large investments in public companies they feel are undervalued but can’t or don’t want to control. PitchBook’s database shows a handful of PIPEs before the 1980s, but from 1983 on, the numbers expanded significantly.

Among the early examples were the 1984 restructuring of Mattel MAT with capital from Hellman & Friedman and Warburg Pincus. Private equity investors in those firms’ funds would thus have had public company exposure in their private equity portfolios.

Final Considerations

The rise of mixed public/private investing is thus not new, but by creating funds with more intentionality around the mixed offerings, it is taking a new form in the rapidly expanding semiliquid universe.

For fund managers who identify opportunities outside their usual public or private scope, these funds offer mandates that allow for both. It is important to note, though, that many of the funds mixing public and private investments do so not necessarily because their managers have skill in both worlds but because the funds need to hold some liquid securities alongside their illiquid holdings to make the semiliquid structure work.

Few managers will be equally adept at picking private and public investments, however.

Crossover funds thus demand careful review. Investors must determine if private equity managers have the skill to make money with public stock holdings if they can’t dictate how they’re run. They also must ask if the public holdings, held for liquidity reasons, are likely to water down the private market portion of the portfolios. For traditionally public market managers, the question is whether they have the capabilities to buy and operate private companies like a private equity or VC investor. The two worlds are converging, but investors should be cautious: Just because they can access private markets doesn’t mean that they should.