Family offices should partner with emerging managers when considering early-stage investments
Family offices should consider investing alongside venture funds to get access to verified deal flow and improve their overall return profiles. Typically, families that have accrued generational wealth aren’t afraid of locking up their capital for long periods of time in an effort to generate outsized returns. Focusing on private market investments has the same effect, reducing liquidity to improve returns for the overall portfolio.
There are a number of reasons that a family office should consider partnering with emerging venture capital managers, namely: instilling a sense of hard work and risk management in a subsequent generation through connections with portfolio companies; gaining insights into the skills and processes needed to construct a diversified venture portfolio while avoiding adverse selection risk; and positioning the portfolio to take advantage of the power law inherent in venture, which is difficult to find in other asset classes.
Altruism and Returns
Firstly, it gives the family a chance to give back to a country or region that has enabled them to get to a certain level of success. Giving back to up-and-coming entrepreneurs doesn’t necessarily need to have a completely altruistic rationale. Helping the next generation of entrepreneurs will also give the next generation of the family exposure to and insight into the drive that’s required to build a successful business from day one. It’s hard to pass down the same attributes and characteristics that made a family business successful to begin with. A lot of people will be familiar with the adage “shirtsleeves to shirtsleeves in three generations.” This describes the concept that grandchildren will likely be unable to manage wealth accumulated by their grandparents.
Stewardship of wealth requires communication, education, and having a strong strategy that can traverse generations. Having exposure to a portfolio of highly entrepreneurial ventures will not only help to improve the potential return profile of a family office’s portfolio but it could also help to communicate the strong work ethic that’s required to make a dent in the world and educate the next generation about the various nuances of different business lines.
The strategies that were used to accumulate wealth are seldom the same that are required to maintain that wealth (especially if we’re talking about the real purchasing power of that wealth). One way to take advantage of the longer-term time horizon that family offices naturally have is to look at more illiquid investments. Yale did this to a reasonable effect in the 90s, increasing portfolio exposure to private investments and reducing the public equity portfolio. Family offices and endowments can further improve their probabilities of success with this approach if they align themselves with the General Partners of up-and-coming funds. They could provide cornerstone investments, providing guidance and governance for the fund manager, while also benefitting from more favourable economics (such as a portion of the carry) if they make their bets prudently. This means that they aren’t just paying an external fund manager for a strategy that they don’t believe in but they are becoming actively involved with a partner that has values and processes aligned to that of the family office.
Portfolio Construction and Investment Selection
Secondly, I’ve had a number of conversations with family offices that have been thinking about getting involved in venture investing. Depending on the stage that a family office is considering investing in, there are several different skills that are required. Early-stage requires a thorough knowledge of networks and incumbent solutions as well as an adept touch-and-feel for people. Later-stage venture capital begins to resemble private equity around series B to C. At the later stages, there are sufficient numbers and supporting information to make an informed decision. There are also a number of financial mechanics that can be put in place to skew the risk/reward proposition favourably (e.g. liquidity preferences >1, ratchet clauses, and other factors seldom seen in early-stage funding rounds).
Instead of starting to try to master a broad range of skills or hire a team that can support these functions, it can make more sense to partner with investors who have been specializing in this space. Family offices would do well to learn about the processes and heuristics that are important by working with established managers.
Further, another topic that often comes up is “We already have a lot of start-up deal flow, why would we need to invest in an external fund?” This approach fails to consider the selection process that comes from being fully immersed in an ecosystem for years. Two out of the last three investments that we made were never pitch decks that were circulated. We make it our job to be one of the first people that founders contact when they are building a fintech business in Southeast Asia. I know that there are other venture funds in Singapore that make it their job to meet with every founder that is raising regardless of whether they will invest or not. We will look at >300 potential investments each year. Previously, as a generalist, I would have looked at >3,000 potential investments each year.
What I’m saying is that if a family office is seeing random pitch decks flood into their inbox, then there’s a relatively good chance that those pitch decks have been passed over by the sector specialists. So, if a family office is going to begin building an early-stage investment practice independently, then they need to be able to deal with the adverse selection bias that it will entail.
Improve the potential distribution of returns
Venture is a power law game, whereby a few hits will account for a majority of the value that’s created by companies generally. AngelList has written about this extensively here and it has also been discussed here. The main concept is that an investor should aim to have more than 150 investments in their start-up portfolio and probably something more like 300 investments.
领英推荐
It can be quite difficult to amass 300 start-up investments for anyone let alone a family office that has a myriad of other tasks that they will be dealing with at any given time. That’s why, it could be suitable to partner with a handful of specialist managers to get the overall portfolio exposure to dozens of companies as opposed to trying to get some limited exposure independently.
To make matters more complicated, family offices will tend to lump their private investments into one bucket. This means, they could be treating venture and private equity as effectively the same risk exposure when they couldn’t be more different.
Private equity portfolios are generally composed of (and this is a gross generalization) going concerns with some operating cash flow. The manager will then perform some financial wizardry (increasing leverage to juice returns to equity and “focus” management) and then make operational improvements to the business (reducing costs and focusing on performing markets). While the left hand-side of the outcomes are still bounded at 0, the upside is far more constrained because the exit price will usually be dictated by an earnings or cash flow metrics (assuming we aren’t in the throes of a bull market mania).
The exit could be low double digit multiple of the earnings for a business that now has improved margins and potentially a more disciplined approach. Depending on the amount of leverage deployed, there could also be some upside as some of the debt could have been repaid, improving the multiple of cash invested.
Venture returns are a completely different beast all together. While the left-side of the tail is bound at a complete and utter failure, the right-side of the tail of returns could be multiples. Our general partners have been lucky enough to have one venture investment (Coinbase) that returned 2,500x the initial amount invested. This isn’t the typical result for venture, but it does represent the presence of power laws in a venture portfolio. Every small cheque could return multiples of the original investment and even the fund. The large positive outcomes change the skew of the investment return profiles for venture investments (see the image below).
Private equity returns are more likely to follow a normal distribution, with a majority of outcomes clustered around the mean. Venture returns are more likely to follow the power law return distribution, where there are a lot of relatively small returns with some exceptional outcomes.
Overall, this means that family offices need to change their mindset around venture. One trend that we’ve noticed when operating in the early-stage space in Southeast Asia is the desire for yield, which has been sorely lacking over the past few years. We have seen situations where family offices have preferred to structure an investment with a convertible note at a higher valuation than a preferred equity investment because “there is a yield associated with it.” This mindset is misplaced when you are looking for exceptional results in a highly fractured field. Partnering with venture capital funds can give family offices the exposure to outsized returns without necessarily taking on outsized risks.
Conclusion
There are a handful of reasons that family offices should partner with venture capital funds, including:
Venture investing can be difficult but there are a number of risk mitigation strategies that family offices can put in place to ensure a more reasonable outcome.
If this is something that you’re considering, we’d love to talk to you about it – even if we’re not a great fit for your current purposes.