Kjartan Rist for Forbes

When it comes to venture capital, one could argue that wealthy families created the whole industry. Some of the oldest venture firms were developed as the investment arms of wealthy families – from the Phipps family (Bessemer Ventures) to the Rockefellers (Venrock). In Europe, prominent banking and investment families such as the Warburgs, Rothschilds, and Wallenbergs have had direct and indirect exposure to venture investments for centuries.

And yet, while the venture capital industry continues to mature, many family offices remain unsure about how to approach it. Venture capital is certainly on their agenda, particularly in the technology space. Over the last decade, tech has moved from being a vertical to a horizontal offering, addressing real problems across every sector of the economy. At the same time, venture capital is increasingly recognized as the best and most efficient way of locating and developing technology companies and nurturing talent. The challenge is to determine the right strategy for each family office.

Family offices struggle with VC as an asset class

By the end of Q2 2019, there were 7,300 family offices worldwide, including 2,300 in Europe, with the average office managing assets of around $917 million. These offices – comprising single and multi-family operations – are highly professional, employing large teams and taking an increasingly sophisticated approach to investment decisions. Despite the turmoil caused by Covid-19, 76% of single family offices claim that their portfolios have performed in line with or above expectations during the year to date.

Both family offices and activist VCs share a passion for ‘building’ companies and supporting entrepreneurialism. One of the founders of modern venture capitalism, Georges Doriot, even referred to his investee companies as his ‘children’, treating them with according care and attention.

John Moore, Managing Partner at boutique consultancy Moore & Moore Investments, explains the attraction of VC amongst certain family offices. “We are increasingly seeing a diversification of appetite to risk from family offices who balance prudence with higher risk placements alongside VC-backed or even pre-VC opportunities. Such investments are typically in the technology space and focus on scalable SAAS solutions and high return opportunities that offer the prospect of the classic unicorn return of 2-50x in some cases. There is often a social as well as economic impact in these investments.”

But although UBS data shows that just over half of family offices are involved in venture investment, typically these offices account for just 4% of investment into initial VC funds, and just 8% of investment into follow on VC funds.

Why, despite this clear alignment – and given the financial strength of these offices – have a significant number of families yet to find an approach to VC investment that works for them?

Alan Merriman, Executive Chairman at multi-family office Elkstone Partners, feels that “First-generation family offices sometimes tend to be curtailed by the entrepreneur who created the wealth in the first place and who consequently feels more comfortable in investing in his or her own core business or specialism. By contrast, for generational family offices it is more about judging the right asset allocation as a whole for venture, and then getting access to the right managers. This access, combined with the ability to develop long term relationships, is the key barrier to solve.”

Direct vs fund investment

Put off by the management fees charged by some fund managers, and concerned by the level of transparency into the performance of the underlying investments, many family offices show a preference for direct involvement with tech startups over fund-based investment.

In fact, two-thirds of newer family offices (created post-2015) now make direct investments in private companies, compared with only just over 50% of those founded between 2006 and 2010, with, 61% of direct investments made in technology companies.

Patrick Aisher, serial entrepreneur and Chairman of family office, Kinled Holding, explains the attraction. “My family has always been entrepreneurial in nature, and as a fifth-generation entrepreneur, my background is much more aligned with VC investment. What families appreciate about direct investment is the ability to back people as well as ideas. We have a portfolio of over 50 companies we’ve supported in this way, so in a sense, our office serves as a VC organization in its own right.”

For a family office looking to manage venture capital investment entirely in-house, a plethora of skills is required – many of which may prove difficult and/or expensive to develop internally.

Ha Duong, investment principal at Ocean Investment, points out that, “Early-stage venture is a high-risk environment. Specialist VCs with a native understanding of the technology, the business model and the industry should have a much stronger ability to price both risk and upside.”

This can be a major problem for family offices. The Covid crisis is creating a raft of opportunities for startups to solve urgent real-world problems using technology, but there are hundreds of thousands of young tech businesses battling it out for investment. Family offices don’t always have the networks or resources to sift through the detail and make the right investment calls.

In contrast, investing via a fund enables an office to hand over vetting responsibilities to a dedicated and trusted third-party, as well as allowing the family to support a wider range of businesses than they might via direct investment.

Building a balanced portfolio is difficult

Committing funds to one successful pooled capital vehicle is economically more attractive than investing deal-by-deal, on average offering the same level of returns for half the portfolio carry.

As Francois Botha, founder of international strategy consultancy Simple, highlights, “Defining a solid, clear portfolio strategy not only takes time but also requires the input and buy-in of multiple parties to make direct investments work… In many instances, family offices do not have this type of clarity within their portfolio strategies, or they may lose sight of these as internal changes or opportunistic events arise that shift their focus.”

In contrast, the best VCs build portfolios around well-defined processes and strategies, informed by years of in-market experience and the ability to tap into extensive on-the-ground networks. This makes them better suited to picking the right early-stage companies at the right time, building out a balanced portfolio, and assigning dedicated personnel to focus on managing deal flow. The stronger the investor’s reputation, the more likely they are to access the best deals – again to the disadvantage of family offices with no prior record in VC investment.

“Combining direct investment with a third-party fund-based strategy helps to diversify our risk,” notes Aisher. “Our VC partner won’t necessarily like the same deals that I like, but I trust them to make the right judgment calls. Further, if I really like the look of a business that the fund has invested in, our fund manager is always happy to set up an introduction and allow me to get involved directly.”

The VC lifestyle requires total focus

Venture portfolio companies require an active management approach, given that they are constrained in terms of resources and skill set, and thus require constant assistance and support across numerous areas, from business development, product positioning, and fundraising to HR, operational setup, and more.

Crucially, the most prolific venture investors also provide significant added value on top of pure capital. The job of managing venture assets in post-seed stages becomes a ‘lifestyle’ requiring total active focus, with little room for other activities. It’s often a step too far for a family office, particularly if venture capital is not core to the office’s overall asset allocation.

Choosing the right VC investment partner

Of course, opting for a fully outsourced approach to VC investment can also pose issues. Selecting funds is not always straightforward as the established funds are often closed to new investors, and many funds prefer an institutional investor base.

It’s a complex landscape to navigate. Cambridge Associates notes that “Many families assume there is less risk in the “famous” funds and lament the inability to gain access. However, new and developing funds actually are perennial top performers.”

According to Aisher, “The key for a family office is to identify a VC with a modest fund and a small, focused team of people, so you can have a personal relationship – no bureaucracy and direct access to the fund partners. That way, you’re still investing in people, as well as great ideas.”

Making the ‘wrong’ venture fund selection will be detrimental to portfolio returns, particularly if the fund manager operates a hands-off, passive approach to investment.

The advantages of a hybrid approach

For many family offices, a hybrid investment model may be the best way forward. This approach involves deeper relationships with two to three complimentary venture fund teams, outsourcing deal flow generation, vetting and investment management as well as creating balanced diversification.

In parallel, this approach allows a family office to maintain a small number of direct investments and to build their own investing brand within their preferred sector or vertical of expertise. There is even the potential for family offices to invest into venture funds as well as co-investing into selected portfolio companies. The office can gain exposure to different strategies, investment stages, and risk levels in a proactively managed manner, but without the need to hire a full-fledged operating venture team.

As with all VC relationships, the hybrid model requires genuine alignment between LP and GP, with the GP able to demonstrate its willingness and ability to support the portfolio companies and keep the family office firmly in the loop on fund developments.

Merriman suggests that the VC industry could also do more to improve the scope for more co-investment opportunities. “If VC funds found a way to provide more optionality for family offices around each individual portfolio investment, this could be a real win-win. This would deepen and increase the pool of money being allocated by offices.”

Whatever strategy is adopted, it is important to remember that venture investing is very much a hands-on activity, not unlike building a business. It can be a very rewarding activity for family offices, but it also requires a diligent and considered approach to structuring – to the benefit of GP, LP, and the portfolio companies themselves.

Fuelling the tech ecosystem

Writing about current structural challenges in the European VC landscape, Duong argues that, “A major problem of the European tech ecosystem is the lack of funding for emerging managers. In order to enable long-term economic prosperity and independence from international investors, more private capital needs to be mobilized in this region.”

Right now we see a clear funding gap within the European market for mid-stage tech businesses that have achieved product-market fit and represent a significantly lower risk for investors. If family offices get their venture capital approach right, their financial strength and extensive relationship networks can enable them to play a significant and crucial role in closing the gap and driving the European tech ecosystem forwards in the years ahead.

Original Forbes Article