Monday, August 13, 2001
Crossover Investment: A Neccesary Evil?
Caroline Braunschweig , Private Equity Week
A company is drowning, desperately grasping for a buoy of cash. But its venture backers don't have enough lifeboats to go around. What choices can a venture capitalist make?
Sure, a fund can round up a party of new investors to bail out the struggling company - and risk diluting the value of its own equity position.
Or it can reach into the coffers of one of its family of funds still flush with cash to rescue a struggling company.
The practice, known as crossover investment, may sound better than "bailout", but the two often are interchangeable. While industry observers see little or no good in the practice, in rare circumstances it can add more mass to a firm's firepower.
"The biggest concern is in the new fund bailing out the old fund's crappy investment," said Mark Selinger, a partner in McDermott, Will & Emery's corporate department and member of the firm's private equity and emerging companies group in New York. "Whatever the conflict rules are within the partnership, you're playing with fire. Whatever the reason is, it's probably not a good reason to be hoisted on the second fund."
Rare are the potentials for gain so high a firm wants to spread its equity stakes in a single portfolio across its family of funds so that all its limited partners are rewarded equally.
In fact, a prohibition against crossover investment is often structured into a fund's charter. Following the high-profile burn out of David Silver's Santa Fe Private Equity Group in the 1980s and the lawsuits that followed, sophisticated LPs, like CalPERS, began to demand it. CalSTRS, on the other hand, has no formal policy regarding the issue, but when a partnership returns to the pension fund for additional capital, the request is put through the same review and due diligence process as the original request.
"The perception is that you're digging into your other pocket." Selinger says. "In a new fund, if the prior fund is tapped out, or close to tapped out, you think about it for just a day. At the end of the day you really don't want to do that. If it's a good deal, you could have found other investors. If you can't find another avenue or you're not willing to, that's probably telling you not to go into the second fund."
Venture firms, if they are to represent the best interests of their LPs, must demand the stringent guidenlines that preserve their capital investment: higher liquidations preferences, full-ratchet anti-dilution rights and participating convertible preferred stock. When investors don't make these demands in follow-on rounds of financing, they are not representing the best interest of the partnership - especially when the round is led by the firm's other pocket.
Some big-name venture capital firms prohibit crossover investing, while others use it sparingly. In Accel Partners' 18-year history there are only three examples of crossover investment. New Enterprise Associates, for its part, also avoids the practice, citing only a handful of examples in its history.
In a few circumstances, however, crossover investment can be justified. For small venture firms, those young early-stage investors with less than $50 million under management, a strategy driven by crossover investment translates into more firepower in a competitive market for early-stage deals.
Tech Capital Partners Inc., based in the Toronto suburb of Waterloo, for example, recently closed a CA $30 million venture fund, a successor to its 1999 investment vehicle, the CA $5 million Waterloo Ventures.
The new fund, Waterloo Tech Capital, will pro rate any investment opportunity available to either fund at a nine-to-one ratio. "The reality is that a small fund like the one we had made it difficult to provide the capital resources that an early-stage company needs," says Andrew Abouchar, a partner with the firm. "Maybe it would get them six months down the road and they'd need money again. So we thought, and our investors agreed, with more firepower, we could do a better job."
Tech Capital Partners' second fund is like an attachment to the first: both will scout seed and early-stage opportunities in the information technology and communications sectors with equity investments totaling between CA $1 million and CA $2 million; and both funds are co-managed by Abouchar and Partner Tim Jackson.
Still, the two funds have unique sets of limited partners. The sole LP in Tech Capital's first fund did not invest in the second, while LPs in the second fund include the Business Development Bank of Canada, the Ontario Municipal Employees Retirement System and Cranston, Gaskin, O'Reilly & Vernon Investment Counsel of Toronto.
Round size and geographic reach are also limiting factors in the first fund's investment strategy. So, when the firm is interested in a deal that does not fall under the mandate of both funds, the partners circulate the investment to its corporate governance committee - made up of LPs - to approve or reject the investment.
"Tech Capital Partners is going to source the deal, and instead of one line, there are two lines for us to sign in the shareholder's agreement," Abouchar says. "This allows a larger fund to get a larger share of the portfolio and diversify some of the risk. The strategy is not only to do seed investment, the strategy is to pick our spots, start with them and try to keep running with the winners. Our focus is to have fewer relationships and run longer with them."
Still, there are caveats. No more than 15% of the first fund's capital pool may be committed to any one deal, and no more than 20% can be taken from the second fund. Also, 40% of the first fund must be committed, and 70% of the second fund must be committed, before the firm begins another round of fund raising.
Though it's still too early to tell, the strategy may add more muscle to the likes of Tech Capital Partners. But for those long-established players in the market already retrenching and reevaluating a portfolio of struggling companies, crossover investment may do little but send smoke alarm blazing in the direction of LPs.