New Kids on the Block: Nontraditional Investors in Venture Capital

There were not many winners of the pandemic. In the past few years, we have seen hundreds of millions of people lose their jobs, hundreds of thousands of businesses shut their doors, and trillions of dollars of debt accumulated to curb the negative impacts of a shuttered global economy. A notable exception from the pattern of struggle and loss was the venture capital (VC) industry, which consistently shattered funding records after the onset of the pandemic. Low interest rates and a shift in preference toward digital goods and services encouraged capital to pour into venture-backed companies at unprecedented rates and also activated a red-hot IPO market. One of the main drivers behind the frothy VC market was the proliferation of nontraditional VC investors – NTIs – as participants in deals. NTIs, which are all investors that do not fall under the category of traditional VC funds, angel investors, or start-up accelerators, have been players in the VC market since the dot-com bubble era, but grew to be especially prominent during the pandemic. These private equity firms, hedge funds, mutual funds, sovereign wealth funds, and corporate venture capitalists participated in $130B worth of US deal value in 2020 and $254B worth of deal value in 2021. 

NTIs have earned themselves the title of “Tourist Investors” by traditional VC firms, as in the past they’ve been known to emerge when times are good and retreat when times are bad. However, in recent years, various factors have made VC an attractive investment class for NTIs, beyond just favourable returns. One such factor is that startup companies are staying in the private markets for longer. As a result, they are demanding bigger cheques to fuel growth, which means that deals are large enough to move the needle for NTIs, who tend to have much larger assets under management than traditional VCs. Additionally, due to the increasing maturity of late-stage companies, their risk profiles are more moderate and thus attractive to NTIs that cannot afford to take too risky of a bet. In general, late-stage deals have come to look less like traditional VC deals and more like private equity deals – fundraising companies have proven track records and (up until recently) a clear path to exit. As such, it makes sense that private equity firms and other large money managers have stepped in to lead late-stage deals, as they are no longer suited to the average VC. 

VC investing has also allowed NTIs to buy access to winning companies before they go public. NTIs can secure an allocation of IPO shares while reaping the benefits of the significant growth that occurs in the private markets. Access can be a scarce resource in Silicon Valley, so the exposure that VC investing provides to NTIs is incredibly valuable.

The investing strategy pursued by NTIs in VC differs depending on the firm, but they can be grouped into two major categories: private equity (PE) firms and Crossover investors (firms that invest in the private and public markets), as well as corporate venture capitalists. PE firms and Crossovers share similar characteristics in that they have deep pockets, and thus invest more dollars. They also tend to be more sector-agnostic due to the breadth of the overarching firms’ portfolios. Corporate venture capitalists, on the other hand, make up the venture arms of corporations and typically invest smaller dollar amounts and focus their investments on the sector in which their parent company operates. Within these two broader groups, investment strategy and style can vary in terms of stage, geography, and velocity, among other things.

The general strategy for PE firms and crossover investors is to knock out competition in venture deals by offering deal terms that traditional VCs cannot match. Major players in this sphere include Tiger Global, Coatue Investment Management, General Atlantic, and Insight Partners. In addition to writing abnormally large cheques, PEs and Crossovers are incredibly quick to deploy funds. For instance, there have been anecdotes of Tiger Global issuing a term sheet for a company in less than 48 hours. Another abnormality of this group is that they rarely demand a board or observer seat. They are not interested in helping guide companies through their growing pains and have no desire to assist in assembling the perfect C-suite;  they are solely focused on their financial interest. Founders like to work with these types of investors, as they offer more money, tend to invest with less due diligence, do not care to have a say in company decisions, and are flexible on deal terms and valuations.

Corporate VC is quite different from PE firms and Crossover investors. While they were initially notorious for being fair-weather investors, post-2008, corporate VCs have re-emerged as sophisticated organizations which conduct themselves very similarly to traditional VCs. They operate out of evergreen funds created by their parent companies, in which a certain dollar amount is allocated to VC investing based on budgetary needs, so they do not answer to Limited Partners like other VC investors. They favour seed and early-stage rounds with smaller capital commitments to help them stay current and understand what the next frontier of their respective industry is. Corporate VCs are unique from all other types of VC investors because they can reap non-financial benefits from investing through increasing technical know-how and forging relationships with high-tech companies that can be potential business partners. 

The impact of NTIs in VC is undeniable, as can be observed by the way late-stage valuations and deal sizes boomed in 2020, 2021, and the beginning of 2022. 265 late-stage mega deals (funding rounds raising $100M+) closed in 2020, and that number jumped to 659 in 2021. The proliferation of mega deals had a trickle-down effect on earlier stages, causing early-stage financings to look more like the late-stage financings of the past, and seed financings to look more like early-stage financings. Notably, there was and still is a large discrepancy in median pre-money valuations and deal sizes for fundings that are completed with and without NTI participation. In H1 2022, the median pre-money valuation for early-stage companies that raised with an NTI in their syndicate was $75M whereas the median pre-money valuation for early-stage companies across the board was $67M. The faster deal pace pushed by NTIs also gives founders more leverage when negotiating with traditional VCs. In fact, the combination of deal velocity and high prices has pushed many traditional VCs out of deals altogether. 

Although once a class of investors who liked to ‘crowd in’ when VC markets were hot, and disappear when markets were not-so-hot, NTIs have become a seismic force within the VC ecosystem. It will be critical to track the continued activity of these firms as the VC market deals with increased uncertainty brought upon by public market volatility. Only then we can be certain of the role that NTIs play in the VC ecosystem, and if they are here to stay.