The State of Family Offices 2019

UBS publishes an informative report that surveys family offices (“FOs”) from around the world on a variety of topics including investments, governance, succession, cost structure, and philanthropy.  I’m slow to write about the contents of the report, but better late than never.  I’m sticking to areas where I can pretend to know what I’m talking about, so we’ll highlight investments topics.  Most of this will be a recap with some of my opinions and perspectives thrown in relating to topics of interest.  The whole report is worth a look if you aspire to better understand how FOs invest, how they are structured, and how FOs work to meet the needs of their principals.  There are even staff compensation data points for people considering a career path working for FOs.  All charts are from the 2019 UBS Family Office Report unless noted otherwise.

Most Family Offices Are Relatively Young Organizations

About 2/3s of FOs were founded in the last two decades in a roughly even split.  Almost 1/3 of FOs haven’t been through a full economic cycle.  What will be interesting in the future is to see how many of these younger organizations react to market turbulence greater than what was experienced in 2016 and the end of 2018.  Will these young FOs be positioned to capitalize on opportunities if/when we have sharp decline in asset prices, or will groups get too aggressive as the cycle continues onward and find themselves overextended in a time of potential opportunity. The experience of the investment professionals on the team isn’t the only factor at play here. Principal’s attitudes can change quickly when they see their net worth going in a negative direction and younger teams may have less trust with end decision makers relative to their more established counterparts when things get tough. 

Another implication of the relative freshness of many FOs is these young groups are often evolving as investors looking for what aligns with their strengths and the objectives of their principals while generating results.  I’ll save a deeper exploration of this topic for a later post because there is plenty of meat on that bone.  Let’s just say strategy whiplash is very real. And it sucks.

Second and third generations are serviced in the same or greater quantity than the first generation.  For those of you that don’t have as much experience interacting with a variety of FOs, teams founded by first generation wealth can have a very different character and mindset relative to FOs primarily serving subsequent generations.  As always all FOs are their own snowflake, but my experience is G1 driven FOs tend to have a stronger entrepreneurial spirit than the average G2 or G3 lead organization with more engaged principals (not always a good thing). Serving younger generations is also a key driver of ESG investing becoming more prevalent in FO investment strategies.  A quote from the allocation section expresses the view that generational changes are increasing the risk appetite of some FOs.

“A lot of money has been changing over to younger hands – and the next generation has a longer investment horizon and also a bit more risk appetite than the older generation.” – Portfolio Analyst, Multi-Family Office

Where Did You Get All That Money?

The breakdown of industries where families originally generated their wealth is interesting.  At first I was surprised by finance and insurance being the source of wealth for ~1/5 of survey participants (~1/3 if you include real estate), but this is less of a shock considering families with deeper experience in financial services are more likely to build out an investing FO compared to families who generated their wealth elsewhere. The composition of survey respondents could be swinging the results with 360 2019 survey participants vs 311 in 2018. Or maybe finance and insurance jumping to the top is a result of all those hedge funds shutting down and turning into FOs? 2018 data is the second chart below. 

Strategery

FOs most commonly pursue a balanced investment approach while growth strategies are more prevalent than a focus on wealth preservation.  AUM had relatively little impact on the type of strategy used by a FO, but different regions have notable discrepancies in strategy.  North American FOs are more likely to focus on growth and invest more in equities because ‘Merica. 

Where Are You Putting Money to Work?  Alternatives ….. Duh

Alternatives account for over 40% of the average FO portfolio.  Hedge fund allocations keep coming down.  High fees, doubts about downside production, and junky performance (the real culprit) were cited as reasons for waning interest in hedge fund strategies. 

Direct private equity investments made up a larger portion of portfolios than investments in private equity funds.  This result was out of line with most of my personal experiences, but I also wouldn’t be surprised if some survey respondents included some family run businesses in this number.  I could also just be ignorant and wrong. 

Real estate was the most added to investment category at +2.1% vs 2018.  Have to make sure your principals have that mailbox money.  I wouldn’t be surprised if this continues to increase over time.  Principals can wrap their minds around real estate faster than a variety of other strategies, tax efficiency in certain real estate investments can be material, and the labor lift needed for some FO approaches to real estate by the investment team can be relatively low.  Real estate was a much smaller portion of portfolios for $1B+ FOs at 12% vs 20% of portfolios for FOs under $250M.  The $1B+ FO crowd was generally in more liquid assets than their smaller peers.

The Family Office Magic 8 Ball

Survey respondents expect to increase allocations to alternatives in the future.  Good news for sponsors raising those dollars.  Direct private equity, private equity funds, developing market equities, and direct real estate were strategies most likely to see increased allocations in 2020 with more than a third of all respondents expected to deploy more capital into these strategies.  None of these strategies are a monolith, but the projected allocation changes of FOs are interesting considering their concerns about risk. 

55% of FOs believe a recession is coming in 2020, thought I feel like the we’re 12-18 months from a recession song has been playing since 2013.  42% of FOs indicated they were increasing cash reserves, but only 26% indicated they were increasing cash or cash equivalent holdings for their portfolios in 2020.  45% of respondents claim to be re-aligning investment strategy to mitigate risk.  My experience in conversations with other FOs is the prospect of a recession is weighing heavily on decision makers with the length of the current economic cycle cited as the number one reason as to why a recession is near.  I doubt these conversations with FOs are different than the ones any of the readers here might have had in the last several years. 

What I find most interesting about these answers is 46% of FOs expect to increase allocations to direct private equity investments while a majority of FOs believe a recession is around the corner. Given the relatively young age of most organizations, roughly a third haven’t been through a full economic cycle. I hope organizations hired people with ample direct deal experience to help manage through an economic downturn because a recession could be a painful learning environment for many teams. There could be bifurcation in views and responses in the survey, but I imagine there is cognitive dissonance present in some respondents answers.   

Below are some quick hitter observations on FOs views of private equity and real estate. 

Private Equity

  • FOs like direct private deals because of greater control and a reduction in fees.  Below is a chart from the 2018 edition of the UBS Family Office report.
  • Passive direct investments were the most disappointing portion of private equity portfolios.
  • Growth investments were the most common type of private equity investment employed by FOs.  Can say this lines up with personal experience and from comments out of groups that are trying to create opportunities tailored for FOs. 
  • Technology companies were the most popular for direct investments.
  • Club deals were the least likely to disappoint, though return expectations were lower than buyout or growth deals. 
  • Below is a quote that I would call the FO investment direct dream.  This will be a topic explored over time.  I’m curious to see which FOs commit the resources necessary to execute on the dream and which ones will get disillusioned about the work necessary to execute direct strategies at a high level with in-house staff. 

“I encourage families to get closer to the assets they own.  The best way is to align yourself with other families interested in avoiding agency risk, pool your capital within the appropriate governance framework, and create collaborative vehicles. Families should spend more time focusing on how they can disintermediate financial institutions – such as private equity and venture managers.  There is plenty of talent out there to bring this work in-house.  I think we are going to see a lot more of this.” – Chief Investment Officer, Single Family Office, North America

Real Estate

  • FOs have a strong local bias with their real estate investing.  My experience is FOs can feel content with the opportunities in their back yards cutting down on the drive for teams to explore other markets.  Staying on top of your local market is much easier when you know what’s coming down the pike because of the country club crew. 
  • Office was the most prevalent type of FO real estate investing followed by multifamily. 

Please check out the report if you want to see additional details or commentary on topics that interest you.

Part Time Venture Capital: What Could Go Wrong?

This year I found myself having more discussions with teams at other family offices (“FOs”) about venture capital and how to best invest in the space.  My experience in these conversations is there is strong interest by FO teams, or the principals themselves, to begin investing directly in venture capital opportunities.  Venture is still a hot topic, despite the negative headlines associated with SoftBank’s misadventures, and we have lots of money.  We should do it direct, right?

The typical logic for FOs considering a direct venture strategy is if we commit resources in-house, we can cut out the fees and get similar, or better, outcomes yielding higher net returns.  The assumption tends to be we have a smart staff and we can figure this out.  We’ve got a big-name family behind us, a large check book, a flexible mandate, and a differentiated time horizon, so it should be easy to get access to the best deals.  I wish the playbook were that easy to execute. 

Let’s look at expectations FOs might have and dive into what is often the reality of the situation.  I’m going to use general assumptions about FOs here, but note that every FO is its own snowflake and generalized circumstances might not apply to that organization.  FOs have a long history with venture investing and some have great success with the asset class.    

Expectation:  We can have one or two people on staff committed part time and succeed.

Reality:  A staff member needs to be doing this full time if you want to have a shot at sustainable success.  The time commitment can come in conflict with the resources the FO is willing to invest in a venture strategy.

Finding good opportunities, managing deal flow sources, connecting with entrepreneurs, developing relationships with service providers, helping solve problems for your portfolio companies, and being a part of the early-stage community is a full-time job.  If the goal is to do true venture style investing, you need to have a good answer about why you can get allocation in a deal that also includes a top tier venture firm operating in the area or sector.  Lacking a solid answer should prompt introspection about a viable path to success with the resources allocated to the task.  FO principals should put real thought into what assets they’re willing to commit to early stage investing and if the commitment is aligned with the time from staff necessary for a fair shot at success.

Image result for ron swanson whole ass
Wisdom from Ron Swanson

Expectation:  We will get access to quality deals with our limited efforts.

Reality:  Adverse deal selection is a betch.  You’ll fund companies you shouldn’t be funding.  Building a pipeline of quality partners and ideas takes effort.  Decisions will be made based on the relative quality of the deals you do see. 

I lived the consequences of having your view about a venture opportunity being anchored to the quality of your pipeline.  You wake up a few years later realizing you were an idiot and your standards were too low in part because the team wasn’t seeing enough quality deals, if any.  Too bad your team already made a bunch of investments because the team was ‘killing it’ with their proprietary deal flow and now you realize your venture portfolio is more likely to be steaming pile of toxic waste ready to meltdown at any moment than it would be a group of companies comparable to top tier venture portfolios.  Managing this type of scenario could entail helping existing companies in non-financial ways while being careful about which businesses are worthy of additional capital and having the team go back to the drawing board with lessons learned to build a true sustainable venture strategy or outsource all venture dollars to funds. 

Expectation:  We have good taste in businesses and will know a good deal when we see one.

Reality:  The mid-level or junior person you have working on venture deals has a PE/public markets/consulting/worked in the business/golf buddy background and doesn’t have a compass that points north in the land of venture capital.  Below are two charts, one from Correlation Ventures and one from VC: An American History that give context for what to expect for venture investment outcomes. 

I’m surprised about how few conversations FOs have with venture capitalists to help FOs understand diligence, term sheets, returns, etc. for venture opportunities.  Some FO teams are more than willing to dive right in.  I used to believe underwriting to a 50% IRR was going to be a home run for our team when I first started doing direct early stage deals.  Conversations with full-time venture investors made me realize my hurdle of what was expected from a quality venture deal was too low given the failure rate of these businesses.  Throw a former PE associate at this problem without any context and they’ll probably think a 50-60% IRR target return will lead to success.  Outcomes will likely fall short of expectations. 

Understanding what drives failure in venture investments is important when thinking about how you conduct due diligence. My experience is most FOs explore this issue on the surface at best, along with other basic challenges, before deploying capital directly into venture deals.  Talking to the person managing capital relationships for an incubator to source deals isn’t enough.  Stepping on avoidable land mines is a great way for principals to become disillusioned with the strategy and a huge drag on the team’s time.  Not understanding the problems, value creation expectations, and ways the team can help young portfolio companies can be a source of friction, stress, and disappointment. 

Expectation:  We will be patient and use our resources to connect with good partners to help us ramp up the curve and succeed.

Reality:  The team will invest in too many deals too quickly.  These investments will face challenges, introspection and learning won’t be applied, and the strategy will likely be abandoned. 

The Kauffman Foundation has a great report on venture investing examining the outcomes of investing in 88 venture funds over a period of ~20 years.  Twenty-three funds were ten to fifteen years old and eight funds were fifteen years or older.  That’s a long hold period. PitchBook 2019 Q3 NVCA Venture monitor data puts the average time to exit from first VC investment for 2019 exits at 6.4 years with a median of 5.5 years.  PwC / CBInsights MoneyTree reports estimate the average time to exit around 6.5-7.5 years.  If a FO’s venture experience is similar to this data, the feedback loop can be very long when assessing the final success or failure of the opportunity. 

Your principals can become distracted or have their determination waiver without a couple of prospective winners in the early stages of building out the portfolio.  Dealing with disillusionment is real when the first investment was made 4-5 years ago, there hasn’t been an exit, and maybe a couple of companies are exhibiting traction while the other investments are struggling and taking up resources from the team.  New FOs can start out with a capital gains mandate only to have their principals start asking about liquidity, cash generation, etc. 2-3 years into the life of the team.  I can promise your principals can find creative ways to burn money that will give them more joy with a lower level of stress and take less of the team’s energy. 

Source: PitchBook 2019 Q3 NVCA Venture Monitor

Expectation:  We have a great network that will help send us proprietary deals.

Reality:  Most the people you know are even worse at venture investing than you are.  Relying on their ideas can go poorly for everyone involved. 

Great venture deals flowing through your network (unless you’re in a major venture hub connected with the right people) are more uncommon than FO principals and staff likely realize.  Much of your high-powered network sees fewer opportunities than your team.  The team would be well served to put effort into building out new networks that are integrated into the entrepreneurial ecosystem(s) where the FO aims to invest.  Going to the accelerator up the street and attending a few demo days is a good start but won’t cut it in the long run. 

Expectation:  We’re not in one of the major venture hubs.  We will be the go-to source of capital in our backyard, helping build an entrepreneurial ecosystem providing us with a reputation for future deals and solid returns.

Reality:  Your backyard doesn’t have enough talent at this time to merit only investing in the HQ city of the staff and family.  Deals won’t be attractive or there won’t be enough activity to merit the investment of staff’s time.  Let’s take a look at the PWC/CB Insights MoneyTree Report from 2019 Q1 for some context (I like the visual of the maps so I’m using older data, please check out the latest report for up to date information).  Deal volume and dollars (skewed by late stage growth rounds) are still heavily weighted to the major venture hubs on the coast. 

The home base for the family might not have the breadth and depth of deal volume for a staff resource to spend the majority of their time looking for ideas to deploy a relatively small amount of capital annually.  The southeast region had 65 deals averaging just over $6.5M in capital per funding in the quarter in 2019 Q1.  That’s a lot more work to cover relative to say the LA/Orange County region, but LA will have more known venture investors our there competing for quality deals.  Maybe having a manager in town who can do the legwork for you while providing broader portfolio diversification and still helping grow your area’s ecosystem is a better way to go.  

Venture investing is a topic I’m sure we’ll explore more in the future.  If your team is considering a venture capital strategy, I encourage them to spend some time understanding the proposed strategy before putting significant capital to work.