The immediate uncertainty ignited by the collapse of the Silicon Valley Bank (SVB) subsided as the FDIC stepped in to guarantee all deposits and took steps to secure funds for other mid-sized banks. Questions about oversight, capital requirements, and moral hazard came to the fore in the United State. Potential weaknesses in the banking sector spread to Europe, which saw UBS purchase its longtime rival Credit Suisse. For many of us who lived through the 2008 global financial crisis, this brought up vivid memories of that difficult period.
For startups and VC investors, the trouble at SVB highlighted the role of venture debt and the immediate banking needs of startups to meet payroll and pay vendors so they can continue to operate and grow. As examined in this review, VC is a high-risk asset class and these events draw that out in sharper relief. But if SVB’s collapse is indeed chilling start-up funding, then perhaps this is a time of opportunity for family offices in this space.
2. The Venture Capital Landscape
The talented entrepreneurs bringing their innovations to market are at the centre of the venture capital world. Startups need access to the capital, of course, and that’s the raison d’etre of VC investing, but most startups also need mentoring and support in areas such as business development that family offices are ideally positioned to provide either through their own internal capacity or through their networks.
Investors accept the risks inherent in venture capital investments because they seek returns greater or uncorrelated to listed equities or other asset classes. Many VC investors are also driven by their desire to fund innovative solutions to societal problems. The nature of investing in early funding rounds of a startup attempting to bring an innovative new solution to market requires understanding the technology and service landscape of the industry in addition to the business prospects of the new firm. The world is not static and an extended product development cycle brings technological and market changes, increasing uncertainty. It is often repeated that 90% of startups fail. This statistic serves as a caution by highlighting the significant risk of investments being complete losses in this asset class. However, VC investing is not just about avoiding risk but identifying opportunities that many seasoned VC investors miss.
Venture investment is a competitive landscape where major VC funds with deep connections and technical expertise dominate in terms of total capital raised and deal flows. Tiger Global and Sequoia Capital stand out in this regard as does the SoftBank Vision Fund.
The factors in favour of the large VC firms maintaining their position are their brand, track record, a strong pipeline of potential new deals, significant non-monetary resources such as connections and advising, and, lastly, interest from entrepreneurs themselves.
The funding cycle bookended by the 2008 economic crisis and the covid era was marked by the incredible amount of money poured into VC. These two era-defining events unevenly impacted the VC landscape. Recent challenging macroeconomic conditions have focused attention on the potential headwinds faced in the VC space, though differentiated across business and technology sectors.
In recent decades the focus of much VC funding has been on potentially disruptive innovations. However, there are focused critiques on the limitations of VC, especially of institutional VC investors, to “advance substantial technological change” across society because of the “narrow band” of potential technology they choose to invest in. Additionally, as noted above, identifying the most disruptive firms at an early stage that will succeed is a difficult task.
Of the large VC funds, Tiger Global made waves over the past few years for the amount of capital it invested around the world and the speed at which it did so. It reportedly outsourced due diligence and inked deals in a matter of days. It is debatable if Tiger Global Management truly ate the VC world, but the difference in approach from family office VC investing is striking. Most family offices choose to allocate their resources differently than these super-funds, which brings us a discussion about what family offices bring to the VC table, what function VC investments have in a family office portfolio, and what paths family offices take to achieve their desired exposure to the asset class.
3. Family Offices and Venture Capital
Venture capital is one of the most demanding asset classes for investors. Deal sourcing and due diligence require deep networks and experienced team members or trusted external capacity. The extended time horizon of illiquidity needs to be accounted for and managed. VC sits squarely on the high-risk/high-potential returns side of possible investments. VC is a highly specialised area where it takes time to develop expertise. Family offices, of course, function to both protect and grow wealth, which leads them to follow comprehensive wealth management strategies that may tolerate significant risk in part of their portfolio.
Simple’s six family office archetypes differ significantly in operating capacity and orientation, which influence how they chart their paths to VC investing. The demands of VC require an interest in the asset class and team members to source, do diligence, and manage the investments at a minimum. Providing continuing business support takes an even larger staff commitment. A startup family office may have deep connections to the VC space, while a legacy family office may be more comfortable delegating this part of their portfolio to a trusted investment fund. Across the archetypes, rationales for investing in the asset class, or avoiding it altogether, hinge on risk/reward calculations and the toleration of illiquidity. Average allocations flatten these different journeys, but they do evidence the significant interest of family offices in VC.
Most family offices believe in diversifying factor exposure for their direct investments
Family offices average about 6% of their total wealth in VC investments
Family offices seem intent on increasing or maintaining their exposure to the asset class in the current turbulence
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Clearly, family offices are significant players in venture investing within their geographical spheres and globally with this level of committed capital in their portfolios. Family offices have the capacity to be ideal VC partners with startup firms through their ability to manage the long time horizon of their investment and to leverage their other intangible assets to assist growth in the startups they invest in. If we flip this view to think about what VC looks like from the perspective of a startup, it might be tempting for a startup to want a blank check, but experienced hands know that this does not bring as much value as the fleet of resources that best-in-class VC investors provide.
Family offices are increasing their influence in the VC space by shifting the ecosystem because:
“Family offices possess several key ingredients for venture capital success: capital, patience and commercial history”
– Kjartan Rist, Founding Partner, Concentric
The Function of Venture Capital in Family Office Portfolios
From a purely financial perspective, family offices are attracted to venture investments for similar reasons to other investors: they seek returns not readily available in other asset classes and are willing to accept the risk for this portion of their portfolio. The goal is to make investments uncorrelated with equities markets over the near term and that provide greater returns over the long term. However, venture capital for many family offices is more than purely financial. Many family offices invest in areas in which they have particular expertise and interest or in sectors where they want to drive innovation. The opportunity to move the needle in important business areas is a strong motivation.
Family offices commonly view VC as part of their illiquid alternatives portfolio allocation and a mechanism to play certain investment themes. Across the board, family offices design this portion of their portfolio for the long term by managing its liquidity–often through laddering–while remaining mindful of the high failure rate. Venture capital is about managing risk and portfolio construction. One family office principal noted:
“Venture investing can be binary, so one should only invest money one can afford to kiss goodbye to.”
Family offices have the option of making direct VC investments, going through funds, and funds of funds. VC investments can also provide exposure to new technologies that have yet to reach maturity in listed firms. One example might be investing in a fund of funds to tap into the potential of a broad suite of blockchain startups, recognising the high attrition rate of technology startups, but still potentially capturing some of the gains of the surviving firms. The downsides of this approach are the high fees and that large funds of funds rarely offer the opportunity for close relationships with fund managers.
Family offices have clear distinctions from large funds, but they also face specific challenges. Many family offices are highly opportunistic when it comes to investing. The downside of being opportunistic is that family offices might not take a structured approach to their venture capital investments. Some lack the internal resources and time to fully diligence each investment. Additionally, family offices often gravitate to investing in sectors in which their wealth originated, which can economise their knowledge resources, but lead to a lack of diversification.
4. Paths to VC Exposure
Direct? Funds? Funds of funds? What model is best for family offices?
The answer to that question lies in the family office itself influenced by its interest, knowledge, capacity, available capital, and other factors. When Simple spoke with family office principals and fund managers, one often repeated observation was that opportunities and risk management come through your internal capacity and network. Family offices lacking in either might be best served, at least initially, by investing through VC funds, before making co-investments and eventually investing in a fund’s general partnership to gain experience, expand their network, and gain a presence in their targeted VC ecosystem. Drawing on years of experience in the highly competitive technology sector in Silicon Valley, California, one well-placed VC investor put it simply:
“Access is the key”
What they were stressing is just how strong the competition is among investors for the best investments, the startups that they believed had the greatest potential for success.
The freedom of family offices to take advantage of opportunistic investments should not substitute for a well-defined VC strategy. All but the best-connected family offices will find that access is the first hurdle to clear when making direct venture investments. Another way of putting this is to question why each investment opportunity is being presented to your family office. Competition is high for firms to carve out space in existing markets or create entirely new markets for their goods and services, but that competition also extends to VC investors in well-developed VC ecosystems. There are a limited number of startups and over the prior decade or so VC funds invested an enormous amount of capital. Why did the startup decide to pitch your family office, rather than a fund or a different family office? Of course, there are many good answers to this question: your geographic location, personal connections, and probably most important, the startup may value your family office’s ability to help them grow their business in additional, non-financial ways.
Globally, the family offices we spoke to tend to have geographical areas of expertise with concomitant networks and long histories where they concentrate their direct VC investments. One way they leverage these advantages is by connecting with other family offices both informally and formally by creating investing syndicates. This can raise family office profiles in a local VC ecosystem, increase deal flow pipelines, and spread out the costs and time of doing diligence on potential opportunities across multiple investment partners. Another advantage of joining syndicates is that they can be a way to extend the reach of family offices into new VC markets. Globally, a common economic development strategy is attempting to bring the IP created on university campuses to market through dedicated startup support infrastructure. Adjoining VC syndicates near world-leading universities may offer value for family offices looking to increase their VC opportunities.
Another aspect of direct VC investing by family offices looks beyond financial resources. Principals can look past the strategic and diligence requirements of funds to invest in companies and ideas in which they believe in. One of the strengths of family offices in this sense is having the freedom and the financial flexibility to back innovative, yet overlooked ideas. This can also blend into impact investing by putting money into causes they care about. Of course, these startups may still fail.
Family offices understand the complexity and challenges of direct investing. This is their response when asked about what they view as the biggest challenge of making direct investments (including PE):
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Funds offer the easiest and quickest way to achieve desired VC portfolio allocations. Best-of-class VC funds have distinct advantages in their professional management, deal flows, financial, and technical expertise. They also spread risk (netting) across a large pool of investments. VC funds often target specific sectors or themes though, so this should not be confused with proper diversification.
After completing a diligence process on the fund, family offices can allocate the capital and account for the expected time horizon without further involvement. Funds, of course, charge handsomely for these services. Many family offices want to nurture relationships with the managers of the funds they chose to invest in. The availability of managers and their chemistry with them can also factor into the evaluation process.
Funds themselves vary considerably in the services and support that they provide to the startups they invest in. Given the high failure rate of startups, this should factor strongly into evaluations of VC funds by family offices. If the startups invested in fail, you will be writing off your investment and VC funds are still high-risk investments.
Funds present additional opportunities for family office investors than buying into the main investment pool. First, family offices can inform fund managers that they are interested in co-investments. There is some evidence of fund LPs earning higher returns on their co-investments than their fund investments. The family offices we spoke to are active in pursuing these opportunities, viewing it as a way to increase their venture capital allocation through pre-vetted opportunities with funds with which they have existing relationships. Co-investments are typically only offered to existing LPs so the initial investment is key to gaining access. Second, family offices can invest in a fund’s general partnership, gaining a seat at the management table. This can be advantageous to increase total VC allocation, target specific sectors, and raise profiles in the VC community.
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Funds of Funds
Investing in funds of funds is the aggregate of venture investments. The family offices we spoke with view funds of funds as a way to gain exposure and spread risk in emerging market sectors such as blockchain and biotechnology. The downsides are high fees and less potential gain. Ease and time of entry are similar to funds, but unpacking the risk across a fund of funds’ portfolio does present distinct diligence challenges. Advantages include diversification, potentially balanced returns, access to exclusive VC funds, and additional management expertise.
5. Managing Liquidity and Valuation
There is no way to ignore the illiquidity of VC investments. The length of time is influenced by the seed stage of investments and the ultimate success of the startup. A late-stage investment made before a quick high-value buyout is a rare occurrence. One common strategy for managing liquidity in VC investments (and other assets with long time horizons like bonds) is to take a laddered approach. This may help add a measure of predictability to this part of a portfolio, but it does not factor in risk. Direct VC investors, especially ones that are not involved in the development of the startup, may only have solid accounting data for the amount they invested and the percentage of the company that they own. As the startup matures, its revenue can be tracked and factored into its valuation through standard accounting norms. As a startup goes through additional funding rounds, the value of the initial investment can be estimated by comparing it to the new investments, especially by large funds, in subsequent rounds. This is all to say that before earnings, early-stage investments are very incredibly difficult to value and what’s more, any value is difficult to realise because there is limited ability to sell an early-stage VC investment. The common theme that emerged when Simple spoke with active family office VC investors is that timely communication by startups varied as did their success rate. Accepting the risk and waiting brought both surprising successes and failures.
6. Venture Capital and Private Equity
The family offices we spoke with commonly viewed their venture capital and private equity investments as a continuum in their portfolio allocation of alternative assets. Considerations of the amount invested, timeframe, and potential returns skewed toward the long term reveal a spectrum and the considerations at each stage of a company’s growth. Nonetheless, VC and PE are distinct asset classes in their structure and financing. For example, PE investments are often leveraged, which increases their sensitivity to macroeconomic conditions and interest rates.
In aggregate VC returns have been greater than PE returns in recent years despite their higher risk, though the data below reflects a funding cycle that saw strong economic growth. Timing is crucial in VC investments.
7. Market Insights: Promising Sectors in Turbulent Times
Venture capital went through an incredible spending cycle between the 2008 economic crisis and the current period. One well-placed VC investor views the present period as one for reflection and to double down on the need for a clear understanding of the purpose of VC investments in a family office portfolio today.
“Think through what family office direct VC investments look like in an up cycle and a down cycle. Are you searching for yield? What about your need for liquidity over the long and near term? What are the ramifications for putting money in private tech now at this point in the cycle?”
Currently, family offices are focusing their VC investments on core growth industries:
- Climate Tech
If we look briefly at healthcare, core forward-looking sectors are attracting the most interest from family office venture capital investments. The interest in healthcare and IT hold true for PE investments as well.
In spite of the recent collapses of key crypto firms, blockchain startups continue to raise funds.
Often the simplest advice is the best advice. Across our interviews with family offices and VC funds, we heard guidance about the risks and the extended period of illiquidity inherent in this asset class. The surprising success that came from the buyout of a company that the investor had nearly written off was matched with stories of failed investments. Even the best minds with patient capital get it wrong. Family offices looking to move into venture investing have options to move slowly and build networks, capacity, and experience as part of an extended learning process to maximise the potential for returns.
Simple would like to thank Kjartan Rist, co-founder of Concentric, for sharing his invaluable insight in assisting with this review.