Venture Capital and the Retail Investor

There is a segment of the technology and venture capital communities that believe a lack of access to the venture capital asset class is a major disadvantage to the individual investor. The story tends to go something along the lines that venture capital has tremendous returns and the barriers to investment are limiting the wealth building capabilities of individuals while favoring wealth accumulation for the very rich. An example comes from Fred Wilson’s blog post on May 5th, 2021 titled Half of All VCs Beat The Stock Market. Fred closed his post with the following:

“The VC market remains largely out of reach of many “main street” investors as the SEC limits these fund investments to qualified and accredited investors. That has never made sense to me and is yet another example of the “well meaning” rules resulting in the wealthy getting wealthier and everyone else missing out.”

– Fred Wilson

Alex Rampell and Marc Andreessen communicated a similar narrative during their interviews with Patrick O’Shaughnessy on Invest Like the Best. Each person mentioned is a better investor than myself and I would be thrilled if my career success was a fraction of their own, but I disagree with their view on this topic. There are also far less reputable individuals who are more aggressive about championing open access to venture investing and alternative assets in general.

I’m going to present a case that the story of accessing venture will improve the lives of retail investors is overblown as average venture returns aren’t clearly better than public market alternatives and illiquid assets often don’t address the challenges of the retail investor. Many of the considerations will apply to other private markets asset classes including private equity and real estate, so venture isn’t alone in my critiques, for those that believe access to these illiquid assets with make a meaningful change to the wealth generating ability of non-accredited investors.

Is The Performance Story Real?

Let’s start by looking at the investing outcomes of venture relative to more accessible liquid alternatives. My belief is the paper reference by Fred in his blog post from Harris, Jenkinson, Kaplan, an Stucke (“HJKS Paper”) dated November 2020 overstates the relative returns of the venture industry compared to public markets due to data biases and the existence of a more appropriate liquid investment benchmark than what is used in the piece. Please check out the paper if you want to dive deeper into the methodology and for interesting information on persistence of returns (along with conclusions favorable to emerging fund managers).

While the HJKS Paper uses the S&P 500 and Russell 2000 benchmarks to compare returns, the Nasdaq 100 (or QQQs) are a better proxy as a public market alternative given the underlying industry exposure. The S&P 500 and Russell 2000 have technology sector exposure well below that of the venture asset class at this time. Data below doesn’t account for historical differences (both potentially closer to or further diverging from the index). A more appropriate benchmark comparison will remove some of the delta in performance associated with the beta exposure to the underlying industries. Using Cambridge Associates data on the industry composition of the venture asset class, below is a table detailing the industry composition of the Cambridge Venture Index (“CVI”), S&P 500, Russell 2000, and Nasdaq 100.  Also below is a table showing the delta between the CVI and the three public indexes. The Nasdaq 100 is likely the best proxy to the CVI out of the three options based on industry exposure.

How much of the difference in performance can be explained by sector exposure?

Returns data from Cambridge through June 2021 presents a mixed picture of performance relative to a more appropriate benchmark to account for industry betas. Cambridge’s Nasdaq Modified Public Market Equivalent (“mPME”) is a composite of the whole Nasdaq index, which should be roughly in-line with the Nasdaq 100’s performance given the disproportionate weighting of the largest 100 stocks on the overall performance. The 25-year window has spectacular returns for venture capital, which happens to include the tech bubble. The 20-year window has material underperformance relative to the Nasdaq mPME with roughly flat relative performance in the five, ten, and fifteen year windows. Venture outperformed in the one and three year time frames. The mixed record for the whole asset class calls into question how much benefit a retail investor would realize with venture exposure in their portfolios.

One could argue recent history entered a period where venture can continue to outperform given the scale and scope of businesses being created at this time. Relative to the twenty-year window, there would need to be a persistent shift in return outcomes going forward and not just a small window of venture excelling. I’m assuming the tech bubble window was a unique period and not something that would occur with enough frequency that those return outcomes are consistent enough to impact long run returns for investors. Twenty years is a long time to lag public alternatives. Carlota Perez’s work on technological revolutions could imply that if tech bubble level events do occur with some repeatable frequency, the cadence could be every fifty to sixty years. Near term outperformance by venture, the results of investments made years ago, may not continue unless the breadth and scope of the opportunity set is greater than the market’s drive to elevate valuations at all levels of growth investing. In my view, continued levels of excessive performance would attract more competition at higher prices as seen by the behavior of firms like Tiger Global that would drive down future prospective returns for the asset class.

Another consideration that weakens the case for venture’s outperformance is that the HJKS data set likely overstates average venture returns. Burgiss returns data used in the HJKS Paper is based off of investment returns from LPs using the Burgiss platform. Over 1,000 LPs use the platform including pensions, endowments, family offices, and other institutional investors. The professionalism implied by LPs paying for the service most likely means a venture firm of a minimum quality is partnering with the LPs in the sample. The average AUM of venture funds in the sample is $226M ($300B over 1,329 funds) also implying a certain level of quality in GP given the amount of funds raised. Removing, what is likely, a material number of underperforming managers would positively skew the returns reported in the sample. Given the difficulty tracking private markets returns, Cambridge’s venture index data also likely has some degree of performance inflation given the selection biases of the types of GPs and LPs contributing to their data set.

While almost a decade old, the Kauffman Foundation’s 2012 We Have Met the Enemy and He is Us report paints a less optimistic picture about outcomes from a large venture portfolio.

“The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with six-nine funds (78 percent) that did not achieve returns sufficient to rewards us for patient, expensive, long-term investing”.

-Kauffman Foundation, We Have Met the Enemy and He is Us

Venture can be a game worth playing, but you need to be in the winners. The hope of excess returns with average outcomes is most likely overrepresented in the HJKS Paper given the selection bias of the data used.

Low Hanging Fruit

I find the narrative that being unable to access venture capital, or alternative investments generally, has a meaningful impact to financial outcomes of individuals to be disconnected from the challenges of median retail investors. Below is a chart from the October 2021 JPMorgan Guide to the Markets. The chart shows that the average investor’s return outcomes aren’t exceptional and there are liquid investment options that would materially improve the financial outcomes for the average investor before even considering adding alternatives to the portfolio.

The Average Investor has a long way to go.

Getting individual investors to achieve the returns of a 40/60 portfolio of stocks and bonds, let alone 60/40 equities and bonds or the S&P 500, would double their annual realized returns. The HJKS paper notes the venture asset class underperformed public markets for the 1980s and from 1999 to 2006 meaning that venture outperformance may not happen for a decade despite the liquidity difference. Given existing behavior by retail investors, creating products or companies that can effectively address the challenges of achieving market outcomes with easily accessible liquid investments would be more relevant and impactful for the average investor than changing regulations to allow people access to venture capital or alternatives with a nominal allocation.

I imagine some will present the case that robust secondary markets are a solution to solve for liquidity and risk management issues allowing more practical investment by retail investors into the venture asset class. Cost effective and liquid secondary markets would certainly be a benefit. Potential cash drag issues and forced selling in secondary markets to meet potential redemptions raises questions if there is a structure to invest in alternatives that would allow the retail investor to outperform public market alternatives. Given the precarious savings position of many households, redemptions would likely come in times of economic stress with negative impacts on liquidation prices of illiquid assets in forced sale environments. Maybe there is a potential product similar to a lifecycle fund that has a broad allocation with a piece of the portfolio being allocated to alternatives that reduces the potential liquidity stress in times of market stress with high redemptions. A single product focused on venture or alternatives would have potential challenges relative to more liquid alternatives in times of heavy redemptions.

The Adverse Selection Problem

Based on the returns data presented earlier, the real case for venture investing helping materially change the wealth creation ability of retail investors is for the average investor getting access to the RIGHT venture funds or a structural change in asset class returns going forward. I’ve expressed my skepticism of venture asset class level returns being structurally different in the future relative to the past. Data on performance persistence of high performing funds is meaningful, but how likely are these select organizations to open access to their platforms when they already have a group of institutions willing to provide the GPs with as much capital as the GP desires?

As a hypothetical, let’s say some vehicle existed allowing retail investors to participate in venture and a there is a robust secondary market for shares allowing the fund to have liquidity to meet potential redemption needs. What businesses that has a variety of capital options would choose a term sheet from this type of vehicle relative to a more traditional fund structure? The cap table of the business could be less stable due to the potential of liquidations needed to meet fund redemptions. All things equal, you imagine a top tier entrepreneur would avoid taking capital from this type of structure unless the amount was of no true consequence to influence the business relative to other options. Access to the best entrepreneurs is part of the underlying magic to create enviable returns for the exceptional venture organizations. One could say this type of fund could pay the entrepreneur more for access, but we already have Tiger Global out there vacuuming up deals with more aggressive pricing and they, along with similar types of strategies, lack the uncertainty that comes with a fund that would likely have to meet redemptions.

The best venture firms are more than capable of raising additional capital as seen by the expansion of the franchises over recent years. They don’t need the money. The groups that have the need for capital are often GPs with middling or poor investment track records and emerging managers. Not exactly ideal hunting grounds for individuals that, on average, have trouble committing to index funds. Top tier venture firms could potentially carve out a piece of their allocations or create more retail friendly vehicles like a closed end fund, but their existing investors are more attractive partners than retail investors. I would be remiss to mention, that there are some non-accredited investors that do have access to some top tier venture funds through pension benefits for those that are lucky enough to have that kind of retirement plan.

Dispersion doesn’t help people that think investing in stocks is complicated and risky.

We have yet to address to issue of scale. The reality is even with the increase in size of the venture industry, there are only so many exceptional outcomes available for investors. 2021 will likely be the first year the venture capital industry will raise over $100B based on Pitchbook data. For simplicities sake, lets assume top quartile returns tie to the amount of capital raised and $100B is raised in 2021 which would have $25B of committed capital from the year achieving top marks. That’s ~$75 per person of top quartile venture investing commitments available for 330 million people on an annualized basis.

“There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.”

Kauffman Foundation, We Have Met the Enemy and He is Us

Having Your Cake and Eating it Too

While not explicitly stated, I believe those that trumpet retail needing access to alternative investments are making the case that their companies are positioned to play by a different set of rules relative to publicly traded businesses. The creation of liquid secondary markets and access to retail investors sure looks a lot like being a publicly traded company without some of the costs required to be listed. One future that would allow retail to share in the wealth creation of some of the exceptional venture funded businesses would be to go public earlier than has been the case for many of the most exceptional companies built over the last decade. A couple of considerations here could be changes in the requirements or costs to go public, changes in preferences by entrepreneurs, or changes in fund structures that allow early stage investors to hold public shares longer that might adjust the calculous of when a company would choose to go public.

The Grift is Out There

I don’t sense that very successful venture investors appreciate the shenanigans that happen in the less reputable portions of early stage capital markets they are likely lucky enough to avoid. The Grift is always out there and there will always be people willing to sell their integrity for the option to make a few dollars. You can argue regulations might be too onerous, but there is a storied history of people willing to take advantage of others ignorance to make money and lower information disclosure requirements increases the opportunity set for these shady characters. Just because you’re smart enough to see the fraudsters coming, doesn’t mean everyday people will be.

Let me tell you about the opportunity of a lifetime……

Returns data shows retail investors struggle to get outcomes in-line with basic index strategies. Financial outcomes don’t inspire a great deal of confidence that retail investors will have the ability or interest to invest the time to effectively research which fund managers (that would even take their money) would succeed, identify attractive markets for a company’s product, or have a sense of who might become a great founder. Lacking these skills would put normal people at high risk of being swindled, potentially with their life’s savings. They can’t afford to lose $10K unlike others that are have more wealth.

The Yale Model Wasn’t Designed for the Everyman

Let’s assume realized venture returns for retail investors would be in excess of what can be accessed through public markets to consider the ability of a retail investor to capitalize on venture outcomes. The reality is the financial situation for most people doesn’t align well with the prospect of locking up capital for 10 years outside of a nominal allocation. Information sources from Charles Schwab, Fidelity, and JPMorgan Chase are used to paint the best picture I could of the median household’s finances to discuss the practically of long-lived illiquid investments. Financial returns realized by individuals also show there is substantial room for improvement in investment outcomes for the average household before even considering the need to use illiquid alternative investment to potentially enhance returns.

According to Charles Schwab’s 2019 Modern Wealth survey, 59% of Americans live paycheck to paycheck, 44% typically carry a credit card balance, and only 38% have an emergency fund. Not exactly a position of strength to tie up capital for extended periods of time. The same Schwab survey asked people what they would do if they received $1 million. 54% would buy a house first. Additionally, respondents would use funds to reduce debt (28%), invest (23%), and save (21%). Liquid assets are best served to address many of these goals given most individuals probably don’t want to wait around for a decade to pay down their debt or attempt to purchase a home for their families.

Investment strategies should be informed by their personal goals. Venture is unlikely to be a strong solution for these goals consideration the financial position of most people. Decade and longer lock ups would need to be handled in retirement accounts for the majority of people given their financial situations.

“Many VC funds last longer than ten years – up to fifteen years or more. We have eight VC funds in our portfolio that are more than fifteen years old.”

Kauffman Foundation, We Have Met the Enemy and He is Us

Data for retirement savings also puts into question the impact of illiquid investment strategies for median households. The chart below shows the average 401(k) savings balance for individuals based on data from Fidelity Investments. Savings accumulators in the early phases of the life have balances that wouldn’t allow for material contributions towards venture or other alternative investments, either via individual companies or funds. Those with larger balances have more leeway to manage the investment duration typically seen in early-stage investing based on the amount of capital they have, but they are closer to retirement and likely have upcoming needs to help fund their lives from those assets. Having ~$200K in your 60s to last you the rest of your days doesn’t afford the luxury of keeping a meaningful portion of your savings in illiquid securities.

That’s not to say higher returns don’t matter and can’t make a difference. Below is a table showing the amount of money a $1,000 investment would turn into over extended periods of time based on different constant rates of compounding. $20K-$50K more in assets can be a big deal for many savers, but that wouldn’t make people in this situation wealthy. As discussed previously, I’m skeptical of the venture’s asset class as a whole to outperform liquid tech focused indexes and believe the structure of funding in alternatives creates adverse selection problems for the retail investor that increase the barrier to outperforming over time.

Individual’s after-tax savings has even less practical application to venture investing. Below is a chart of weekly checking account balances from JPMorgan data. The 75th percentile doesn’t even clear $6K. One might argue retail savers would have more assets in brokerage accounts. While fair, I wasn’t able to find good data on the average balance of these types of accounts and believe the checking data aligns with the picture that most American’s are living paycheck to paycheck. Who can commit to locking up taxable capital for a decade when their savings are in such a fragile state?

The Case for Choice & The Series 65

In my view, the strongest case for access to venture capital and alternative investments by everyone is the argument from choice. If you are ideologically consistent about prioritizing freedom of decision making in your views, this perspective is tough to argue against. This case is less common in the web spaces where advocates for broader access to alternatives share their views. Alternatives champions tend to emphasize other arguments like higher returns or democratizing investing (I view this as different than the case for choice), which I believe are missing the bigger picture.

Expanding the accreditation rules would most likely benefit younger high earners that are below accreditation standards. They are likely more motivated to learn about early stage investing and have extra capital to invest. This cohort has a path forward under the current rules. They can afford to take their Series 65 to gain access to investments requiring accreditation. A nominal barrier of entry like a test is probably a good thing given the amount of Grift happens at the lower end of private markets. The Series 65 isn’t hard, it just takes a little time and money.

Closing Thoughts

Attempting to put a bow on everything, the reality is many people struggle to get comfortable with even an S&P 500 index fund. They aren’t interest, procrastinate, get scared, or just don’t care about investing decisions that much or they would be closer to balanced portfolio returns. There is room for improvement using existing liquid assets before even needing to explore alternatives. Tech forward indexes provide an opportunity for retail investors to achieve returns roughly in-line with the venture asset class. The venture industry’s best performers lack the scale to move the needle for the bulk of savers. The lock up aspect of illiquid assets tends to only fit retirement savings goals for normal people. And finally, there is a path to accreditation that has a limited financial and time commitment. Let’s help the retail investor get the most out of liquid, low cost, off the shelf, investment options before we worry about further complicating their financial lives.

The State of Family Offices 2020

This post is long overdue and was sitting mostly finished for several months. Life upheaval and burnout were impediments to delivering timely commentary on the UBS 2020 Global Family Office Report. We will cover the contents of the 2020 report, which I recommend reading if you are interested in family offices (“FOs”). All charts are from the 2020 UBS Report with one exception. This post will review structural changes between the 2019 and 2020 surveys, private investments, asset allocation, ESG/Impact/Sustainable investing, and some random data points and thoughts. For reference, my post on the 2019 report can be found here.

I aspire to be more active over the coming months as life is more settled compared to the summer.

 What Changed in the 2020 Survey

Data points, perspectives, and trends relative to the two previous iterations of the UBS report may not be as applicable for the 2020 survey which had 121 participants compared to 2018 and 2019’s 311 and 260 participants, respectively. The report appears to be focused on single family offices (“SFO”) while previous incarnations included multi-family office contributors, which made up about 20% of prior survey respondents. 2020 participants averaged a reported net worth of $1.6B, which is higher than 2019 FO respondents average net worth of $1.2B and average SFO net worth of $1.3B. ~21% of 2020 survey participants declined to disclose the FO net worth. Overall the 2020 vintage provides readers with less information across the board, but we’ll make due with what is available. UBS appears to have made changes in staffing for their team covering FOs (no connections to the organization in a work capacity), which could be driving changes to the format.

Private Equity – The Hero Family Office Investors Want

48% of FOs invest in private equity (“PE”) to access a broader range of opportunities. 69% of responding FOs view PE as a key driver of returns with 34% of FOs describing PE as a passion for the owner. 73% of FOs expect PE to deliver higher returns compared to public markets. 52% of FOs state they invest in PE for diversification purposes and the ever-important benefit of not having assets priced daily.

There are interesting nuggets on survey respondents approach to PE investing. Direct investing FOs actively investing in PE had five deals under review in the months ahead of the crisis. Depending on your interpretation of ‘under review in the months ahead’, this number could be relatively respectable or a data point highlighting deal flow challenges faced by many FOs attempting to execute direct investing strategies. The language in the report is squishy enough that I am assuming more of a negative connotation on the amount of and quality of opportunities seen by most FOs attempting to invested directly into businesses, but I have strong biases on the subject. Unsurprisingly FO owners (68%) prefer to invest in sectors with higher levels of familiarity to the office. As a practical matter, those who want to raise capital from FOs are more likely to find success pitching ideas to families with ties to that industry. Professionals considering a working for an investing FO should keep this reality top of mind when considering any potential career opportunity with a FO.

Greater control of PE investments was seen as a positive by 35% of FOs vs 27% in 2019’s survey. The perception of control provides comfort whether or not that control can be and is used to create better outcomes. I hope they’re right in assessing their abilities if FOs choose to get more involved with their investments, a journey that can burn considerable amounts of time and resources.

A striking data point for your author was 38% of FOs investing in PE had the family as the main source of new deals, which I view to be a negative for investing outcomes over the long-run in most circumstances. The family providing the majority of deal flow is likely to anchor expectations for the organization regarding the quality and filter types of ideas seen by the organization. Principals lacking meaningful deal experience driving the opportunity set for the team is likely to create challenges due to a lack of understanding of what constitutes a quality deal by the individual(s) controlling the deal funnel. Many principals believe they have a stronger network for sourcing investment ideas than the reality of the situation. At the end of the day the capital belongs to the principals and they have final say over what happens, but a narrow approach on partners and deal sources can produce negative outcomes for the organization over time.

The two charts below aren’t apples to apples because the 2019 information refers specifically to direct investments while 2020 refers to private equity sectors generally, but technology, healthcare, and real estate remain popular sectors for FO investment activity. Assuming the data sets correlate, 2020 survey participants saw a material increase in the desire to invest in healthcare focused investments with health care being the second most popular sector for FO PE investments. Healthcare was the fourth most popular direct investment sector for 2019 FO survey responders. Consumer discretionary is also a sector potentially generating more interest between the two surveys. The survey notes that FO usually diversify across four or five sectors for their PE investments.

2019 UBS Global Family Office Survey

Private Investments – Other Items of Note

  • Both cohorts preferred to make growth equity investments with 70% and 71% of 2019 and 2020 respondents making growth investments.
  • Ventures was marginally less popular in 2020 with 53% of FOs investing compared to 57% in 2019.
  • LBO investments weren’t as common in the 2020 cohort with 40% of FOs investing in LBOs compared to 55% in 2019. Surprising to me considering the 2020 group had larger AUM and buyout funds seem to get more traction with larger groups relative to smaller FOs in my experience.

Asset Allocation

Given the timing of this post lagging the source material, I’ll keep the asset allocation observations high level and quick.

  • 76% of FOs reported their portfolios performed in-line with or above their respective target benchmarks over the year to May.
    • 13% max drawdown on average of survey respondents.
  • 2/3s were trading up to 15% of their portfolios tactically during the early stages of COVID. 55% rebalanced.
  • Respondents had relatively more exposure to developing markets in their fixed income allocations when compared to their equity allocations.
  • Private equity allocations were ~56% direct investments and ~44% funds.
  • Principals are the main driver of strategic asset allocation for 28% of respondents and another 28% of respondents have principals that share the asset allocation responsibilities with investment staff.
  • Responding FOs expect to invest from elevated cash positions over the next two to three years with real estate as the asset class expected to see the most new investment followed by direct private equity.  
    • 45% of respondents expect to raise allocations to real estate in the coming years. Based on my experiences, real estate is the asset class that has the most success and lowest level of difficulty in raising capital from FOs.
  • Not meeting investment goals was the number one risk to manage.

ESG/Sustainability/Impact – Wave of the Future?  

Sustainable, ESG, or Impact investing continues to be a space of interest for global FOs. Personal experience and comments in various iterations of the USB surveys reinforce the idea that measuring or defining impact remains a challenge for FO investors. Exclusion style investing was the most popular expression of sustainable investing for 2020 survey participants while a smaller subset are actively making ESG and impact styled investments. The general expectation was for increased activity in all three styles over the next five years. Groups that are successful at framing or defining impact could find some FOs welcoming them as new partners.  

Follow through about Sustainable/Impact/ESG by FOs remains a question mark. Survey responses lay out barriers or concerns for adopting sustainable investing. Maximizing returns and being more involved philanthropically was seen as more attractive to 38% of responding FOs.

Finally, a different kind of green continues to be the biggest driver of any potential green investments. I remain skeptical about the staying power of ESG/Impact investing as structured today unless there are businesses that can deliver impact and high levels of return.

Additional Thoughts

  • ~1/3 of FOs had no plans for a change in control despite most beneficial owners being in their 60s and 70s. Might be time for some organizations to be putting a plan in place.
  • ~56% of families remain closely involved in strategic asset allocation. People are always looking to get direct access to the family with a belief that talking to a family member will improve the chances of that individual or team getting a desired outcome with the FO (mostly raising money). Those that are lucky enough to have a conversation or email exchange with a principal about their investment opportunity are likely to find the family’s level of interest disappointing.
  • 70% of FOs have their own research team to evaluate investment opportunities. Couldn’t give any context on how representative the data point is of reality, but found the number interesting.
  • Good chart below showing the difference in interests by generation. The generation of the principals can be a key insight into how a particular FO might handle their business.

Why an Investing Family Office?

Today’s post is inspired by interactions on twitter over a period of several months. Given the opaque nature of many Family Offices (“FOs”), there are questions by some about why principals bother to build investment teams compared to outsourced solutions. The question has merit.

We will be getting into a few of the potential reasons driving principals to build an investing FO. This list is by no means comprehensive and I don’t claim to be an expert with all of the possibilities presented. Some topics are touched on, but could merit further exploration in the future. From an investment professional perspective, I think an important point to internalize is your opinions of why a FO investment team should or shouldn’t exist really don’t matter or have to align with your view of reality. Principals build investment teams because they want to and they have a variety of motivations for undertaking the venture. Empathy and understanding is something I encourage of people who question the raison d’être of these organizations, not agreement. Investment professionals that understand the drivers of why specific FOs exist could have more success in their interactions with these organizations.

Trust

People with large amounts of wealth face an issue that can be hard to appreciate for normal folk; the feeling that most people look at you like a money piñata they want to bust open. There are so many people trying to get a piece of someone who has more that it can hurt your view on humanity. Sorting out the grifters is one of the worst parts of the job, but has high value to the principals. Even financial advisors, private bankers, whatever you want to call them, at large name institutions can be wolves in sheep’s clothing (discussed more later). Principals may feel more comfortable with the relationship dynamic where the employee is solely reliant on the principals for a paycheck. Deeper trust can be forged through the more frequent touch points that come with staff compared to service providers and the comfort knowing the whims of other masters aren’t as prevalent in the relationship.

Conflicts of interests can, and do, exist between principals and FO investment professionals. Compensation structures and forms of aligning incentives such as co-investment can be created to minimize the conflict based on the investment strategy of the FO. Many can have difficulty imagining people who are willing to invest millions each year for trust, but people that are so fabulously wealthy are price insensitive to something they could value so dearly. You also probably don’t have the experience of anyone with PowerPoint and a lust for money trying to get a piece 24/7. 50 BPS of costs for a $1B AUM FO is $5M in annual expenses, a cost many families won’t think twice about paying for the peace of mind that comes with trusting those responsible for stewarding their assets.

Alignment

Alignment is tied at the hip with control and trust. Conflicts exist to varying degrees with those working with the principals as providers, investment managers, or employees. This topic alone could merit a singular post, but I’ll just use a couple of quick examples to illustrate friction points that can drive principals to prefer their own investing team relative to other options.

Advisors are a tricky bunch to size up. Some are high character individuals trying to do right by their clients. Others are polished, highly educated, and smooth-talking leeches. Anecdotally, I know of stories of theft, fraud, and of trading clients into the ground to make commissions. These terrible outcomes happen. The sad reality is principals can take years to figure out what is happening before the extent of an abusive, or incompetent, advisor relationship is revealed. To be fair, FO investment professionals can be guilty of the same sad conduct. Some advisors treat the assets of clients as a resource of the advisor and make recommendation that can conflict with the client’s best interests. As an example, I know of some advisors that won’t make certain types of investments with their clients because that AUM isn’t easily portable to their likely next firm. Hired guns exist and the reality is some of these clients grow distrustful of the institutions that claim to put the client first.

Here’s shocking news. Not all investment managers make decisions in the best interests of their clients. This reality is part of why FOs with enough resources consider bringing some strategies in house. Here is a generic situation that generates frustration as a family office investor (I know this applies to endowments, foundations, and pensions too). Let’s say a FO invests as a limited partner in a fund with a GP claiming they are long-term focused investors aspiring to compound capital for the long run, a familiar story to all I’m sure. Two or three years into the strategy, the GP comes knocking for the next iteration of the fund. Curiously, the top performers in the portfolio of the prior fund all happen to be for sale at once. A ten-year fund, longer when you consider the GP’s right for extensions, and the GP wants to conveniently blow out of the best holding right around fundraising time. I wonder what is happening here. A principal with enough resources and confidence (or over confidence) could say to hell with it and believe they are better off attempting similar investments in house with a team more aligned with the principal’s investment objectives.  

Control

I had the experience of helping a family member allocate some cash in a retirement account to a S&P 500 index fund. The process took almost an hour because they wanted to supervise every step of the process. Now take the personalities of some very wealthy people, especially wealth creators, and imagine how they might feel about controlling their assets. Finding principals that built a FO investing team who didn’t value control would be a rare citing based on my experiences. The desire to be in charge seems pretty straightforward.

Principals can still exert a significant amount of control over their investments working with outside advisors, but having a team in house opens up the options further for those who choose to make the investment in building a team. There is freedom not being tied to a platform or a research team designed to service a broader set of clients. G1 wealth creators can have a certain confidence that they will succeed in other ventures due to their history of generating life changing wealth. There are some who believe their skills as an operator will translate into skills as the head of an investment operation, a transition tougher than many expect. They still want to be in charge of something and a FO can be an outlet for that type of individual.

Objectives & Strategy

Another topic with enough depth to shine in a singular post so what is discussed could seem brief. FO mandates are all over the place. Principals can have a vision for what they would like to accomplish that they believe isn’t appropriately addressed by traditional service providers even when trying to coordinate between outsourced groups (accounting, investments, legal, philanthropy, etc.). From the outside looking in (I have no connections to the organization), Laurene Powell Jobs’ Emerson Collective is an example of a FO with a wide scope of objectives that integrates investments into the organization’s larger mandate. I also know of organizations that seek to impact their local communities through a combination of philanthropic giving and investments with intent to help their local economies. The collaboration, idea sharing, and information flow across different arms of an organization can be difficult to replicate by outsourcing to more traditional organizations.

Major financial institutions have their own set of investment products and relationships that are available to clients. Institutions are generally pretty good at creating products to meet their customer’s needs or make money for the firm. Principals that want to have the flexibility of working with a broader set of firms start to get into issues of coordination, research, and portfolio management creating challenges large enough to start putting people on the payroll.

FOs that desire to make direct investments (not advocating here) will get access to a more diverse set of partners in opportunities not available through a singular platform by building a team. I’ll pick on the big banks for a moment, who love to hype up the opportunities available to their clients through their alts platforms. Casper’s Series-D financing? Here is a deck and an hour call with the executive team where you might be able to ask one question if you’re lucky. Thanks, but no thanks. And that could be one of the more interesting direct opportunities presented to clients. I know the organizations like to make these opportunities sound exciting. They’re generally not.

All In The Game Yo

Indeed

I imagine most of my audience is directly in, or adjacent to, the world of investing. Let’s admit making investments and feeling like you’re out in the world getting things done is addicting. Principals get the same rush. Don’t underestimate how much a family member might like walking downtown and pointing out what buildings they own part of, bragging to their friends about how a startup they funded just raised a Series B with brand name venture capitalists, or discussing on the golf course how one of their portfolio companies is expanding by doing M&A deals. Investments gone wrong are quietly swept under the rug. The pull of the action is real, and principals impacted by the gravity of the game love being in the mix.

There is a subset of principals who seek to be involved with the investments made by the FO beyond just boasting to their social circles. The experience of the principal often frames how they view what is the appropriate level of engagement. Some want to show up for board meetings and pontificate. Other principals get intimately involved with operations and advising management teams in ways that can add value. The builders out there have a switch they just can’t turn ‘off’. They want to get out there and do s***.

Bill Gates Has a Family Office, I Should Too!

Really rich people have conversations with other really rich people that would seem strange to almost anyone else. How do you decide to spend your time between your five homes, security issues, yacht maintenance costs, the harvest for the winery, etc. One might feel left out if their social circles are building investment teams with smart people that are getting all these deals done and making heaps of money. At least that’s what principal’s will tell people. Once the FOMO bug for all these great deals bites, calls to recruiters will be made and teams will be built. For some, the reality is having a FO can be status symbol for separating the fabulously wealthy from people worth mere tens of millions. For those that remember the author’s distant previous post, about 2/3s of FOs were created in the last 20 years. Getting in on the investing action in this form is a relatively new phenomena.

We Gonna Make That Money

Finally we get to the possibility of making bigger piles of cash. The potential for FO structures to achieve superior investing outcomes was an initial appeal for your author to enter the world of FO investing. At this stage in my professional journey, I’m fairly ambivalent about the prospect of fantastic investment returns being why someone would build a FO investment team. Returns wouldn’t even make my top five reasons for myself to build a FO if I somehow found myself possessing a sizable fortune, though I would still hope for that outcome.

The dream of achieving exceptional investment outcomes is evergreen with principals believing their resources, ‘brand name’, decision making, and maybe a little chutzpah will yield a greater fortune. The usual ideas can be bantered around as to how FO’s will do better than alternatives. Longer time horizons, flexible structures, the ability to go anywhere, being better partners, their network, ‘proprietary deal flow’, etc. There is truth to each of these ideas. The execution often leaves much to be desired. Candidly, I rarely talk organizational investment performance with other FOs. My sense is there are few FOs that realize exception investment returns. The dream lives on.

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.