By STEVEN I. WEISS
Given the recent volatility in the stock market, family offices are increasingly turning to startups or small businesses with the potential for high growth and stronger returns.
Family offices have long made direct investments in private companies. Today, however, 85% say they’re likely to invest at earlier stages of a business’s life cycle — up from 74% in 2021, according to UBS’ 2022 Global Family Office Report.
Of the 221 single-family offices surveyed by UBS, 63% said they usually invest in venture capital, up from 61 percent in 2021 and 53 percent in 2020.
According to a new Citi report that surveyed 126 family offices around the world, the surge in venture capital investing is “fueled in part by family offices not finding sufficient attractive opportunities in operating businesses and real estate.”
The interest in companies at the earliest stage of their life cycles comes amid continued inflationary pressure and low expected returns from more traditional investment vehicles.
“For sure, the trend of direct investment over the years has increased,” said Kent Swig, president of Fulcrum Equities, a family office in New York that makes many direct investments.
Swig views the growth in direct investments, including venture funding, as an indication of the maturity of family offices as a field. “Twenty-five years ago, you didn’t have the communication, the infrastructure, the networks and the services that you do today,” he said. As a result, family offices are better able to identify, discuss, perform due diligence on and manage direct investments.
To be sure, there are risks. It remains to be seen, for example, whether family offices will be successful in generating the same returns as traditional VC funds when making direct venture investments.
One fund manager at a family office who would only speak on the condition of anonymity emphasized that family offices “are more PE type of investors versus VC,” in large part because of risk aversion and an emphasis on cash flow.
“They tend to prefer revenue-generating ideas versus seed or Series-A-type of deals. … There is a higher aversion to risk in these family environments where your direct stakeholders are your brothers, uncles, sisters, cousins, etc.”
Another reason for family offices to be cautious as they approach VC is how well they can perform on one of the most discussed aspects of VC investing: “deal flow.” The best companies want to raise from the best VC funds, and getting access to the best companies and the best VCs can require a mix of existing relationships and a willingness to continue backing a given entity.
“Venture capital is a small community; it’s very relationship-driven,” said Jordan Stein, director of private capital at Cresset Capital Management, a wealth management firm with a significant focus on family offices in Chicago. To Stein, that means focusing on venture funds rather than direct investments can be a better approach. But even there, identifying and working with the right investors can be its own challenge.
“If you look at quartile returns, the spread is widest in VC,” Stein said. He noted that the top VC funds formed since 2000 have generated an internal rate of return of 33%, according to recent research out of the University of Chicago, while the bottom quartile of such funds actually generated negative returns.
THE BEST STAY THE BEST
Stein drew special attention to persistence in VC, where fund managers who have previously generated big returns are far more likely than most to remain top performers: 45% of the top quartile of VC funds are those that were also in the top quartile in their last fund. Compare that with 35% for buyout funds.
This strongly suggests that whom you choose to manage your VC investments matters more than in other asset classes, Stein said, and “it can be really hard to access these very good funds.”
Despite those challenges, Stein said investing in venture capital, alongside other direct investments, can be a major driver of growth for family offices.
“If you look at what allows families to maintain and grow their wealth, it all happens in the private markets,” Stein said, adding that his firm advises clients to have between 40% and 70% of their funds allocated to private markets.
And among all the options in private markets, Stein suggests that venture capital investments, when done correctly, can have the greatest returns for family offices, if they're willing to deal with the trade-off of locking up their capital for substantially longer than is typically required in private equity and other investments.
Venture capital typically means “return of capital in year seven or so,” Stein said, with a “full harvest in year nine to 13.”
Because general partners in VC often raise new funds every couple of years, Stein imagined that a $100 million VC allocation could involve 10 or more funds, with a key component being an ability and willingness to allocate a million or so every couple of years to each of those general partners as they raise new funds over 10 years.
THE WEALTH OF RELATIONSHIPS
For those who do want to make their family office more like its own VC fund, building relationships can also be a matter of getting out in the world and meeting with individual companies for direct investments. That’s a model that Steven Hirth of the Hirth Family Office said he has been following ever since his investments in funds disappointed him during the Great Recession of 2008-09.
Hirth has set up his family office to be “like the international merchant bank that the families in Europe used to do years and years ago.” He said he travels an average of 200 days a year and believes that his relationship-building is what allows him to allocate what he described as “the bulk” of his funds toward direct investments in companies.
And whereas venture capital firms tout their relationships within the tech industry as a competitive edge, Swig said family offices could actually have a greater advantage there. “A fund is typically for 10 years, and there are people going in and out of it,” he said, whereas a family office is “multigenerational.”
The typical timeline for VC funds is another reason for family offices to consider direct investments, Swig said. “They have multiple funds, and they have to churn money after 10 years,” he said. That means a VC investor has to deal with investment details, taxes and more on that schedule.
With the freedom to choose their own schedule for exits thanks to a longer-term investment horizon, family offices can choose to have taxable events and other aspects of venture investing line up with their own goals. They can also generate greater profits with lesser returns, if they’re racking up fewer fees from funds and others along the way.