What are the biggest challenges family offices face when venture investing?

Opinion 02.06.2021

What are the biggest challenges family offices face when venture investing?

Kjartan Rist for &Simple

Family offices are often involved in venture investments and this interest is only increasing as new generations take the helm. Healthy returns, the opportunity to diversify and support young entrepreneurs are just some of the benefits of venture investments. Inversely, there can be some challenges to navigating these investments, but what are they? And how can family offices overcome them?

  • Venture investing is increasingly popular amongst family offices. This is due to the promise of large returns, a diversified portfolio and the ability to support entrepreneurial spirits that resonate with them.
  • However, large failure rates among startups, coupled with hesitation about reinvesting can lead to added stress for the family office.
  • Other challenges can stem from the family office themselves and the way they’ve previously done business. These can include a vague process, a lack of time to focus on specific investments, lack of diversification and choosing the wrong investment partner.
  • These challenges are not insurmountable, however, and require some careful planning to move past them. Going forward, the majority of firms will look to a hybrid approach; a combination of partnering with venture funds along with co-investment, or some direct deals.

Family offices are increasingly involved in venture investing, with research showing that the average firm will now allocate 10% of its capital to funding innovative startups. Not only does venture offer the promise of outsized returns – around 25% to 35% on average – alongside the diversification of a family office portfolio, but many firms are passionate about supporting founders, often coming from an entrepreneurial background themselves. And this interest is only growing, as new generations come to the fore, with an eye for the latest tech and innovations.

But despite this natural synergy, venture investing can still cause headaches for family offices. Many have also been burnt by bad experiences in the past, making them reluctant or nervous about reinvesting. With the failure rate amongst startups standing at around 90%, and a tiny percentage even making it big, the risks of getting it wrong are significant. And, given they usually operate with small teams and have a broad investing remit, offices frequently struggle to make it work, without leaning on the support of external expertise.

So, what are the common issues that family offices face when venture investing and what can they do to ensure success?

Unstructured venture investing process

When making venture deals, many family offices tend to take an opportunistic approach. This is often based on who they know, or the sectors that they’re already familiar with, as opposed to putting any kind of strategy or structure in place. The result is often a somewhat scattergun approach, involving higher risk, poor companies, or bad deals, which fail to achieve the returns that firms were hoping for. Family offices can also find themselves with a serious case of FOMO (fear of missing out) as they see their peers achieving big returns through their own venture deals.

Instead, family offices should be thinking strategically about the best way to access the asset class and formalise their decision-making around investments. For example, do they have the skills and resources to manage their venture investments directly? Or would it be better to follow a managed or hybrid model with the help of a VC firm? And if they do want to work directly, what areas will they focus on, and how will they ensure they’re able to access the best deals? This usually requires investing in skills, processes and brand building, to ensure they’re in the running when the most promising founders are fundraising.

Lack of time

Family offices vary greatly in how they are managed, ranging from multi-family offices, to 100% internally run, or those with both internal and external managers. But whatever the set up, they often find quite quickly that they simply don’t have the time and skills that successful venture investing demands.

Unlike other asset classes, venture requires a hands-on approach, whereby managers take an active role in supporting the growth of portfolio companies, utilising their networks and past experience to help overcome challenges. The risk and uncertainty involved mean that venture rarely works if investors are hands-off. And with just a small team and a range of assets to oversee, family offices often underestimate the amount of work required in managing a selection of direct investments, and the myriad issues that can crop up along the way.

It isn’t impossible for FOs to actively manage investments directly, but it requires planning and investment in dedicated venture skills, which are expensive to hire. Usually, it means focusing on a very small number of deals, or alternatively pooling capital as part of a multi-family office.

Paying too much for venture assets

As Warren Buffet famously said: “Price is what you pay, and value is what you get,” and the job of the venture investor is to identify which deals offer the best value for the best price. Of course, that isn’t always easy with early-stage businesses, requiring detailed analysis of the addressable market, competition, and a good understanding of the underlying technology. For many of the reasons already outlined, family offices are often unable to do that work thoroughly in-house, and without significant investment in skills, processes and networking, they often overpay for assets, leaving them little room for growth and manoeuvre going forward. There is also a tendency for FOs to invest too much in a small number of deals, again greatly increasing their exposure to risk.

Lack of diversification

Many family offices naturally gravitate towards certain sectors when investing, where they already have good knowledge and useful contacts. But in the high-risk venture world, focusing all your funds in one sector can leave a family office dangerously exposed in the event of economic or regulatory shifts. Bear in mind that VC funds often make the majority of their returns from just 20% of their deals, which highlights the chance of getting it wrong, even for experts. That’s why the safer strategy is to diversify your startup bets across a range of sectors, ideally by working with a selection of venture funds in the process.

Choosing the wrong VC partner

Working with one, or a selection of VC firms can solve many of the aforementioned issues – but choose your partners carefully. It is common for family offices to be attracted to the big brand VCs, because they have the impressive reputation, and the promise of greater security and returns. But opting only for the big players doesn’t always guarantee a positive experience, or better performance. For example, it can mean that firms find themselves as a small fish in a big pond, where fund managers are more worried about keeping their institutional investors happy.

Family offices will often have a more positive, and profitable experience through identifying and working with emerging managers who are able to offer a personal approach, along with greater transparency on deals and performance. Smaller firms are also more likely to offer the opportunity to co-invest on certain deals, so family offices can effectively build a ‘portfolio within a portfolio’.

But with any VC partner, the most important thing is to understand the thesis and ambition of the fund manager, find out how hands on they are with their portfolio companies, and whether you have the personal chemistry to create a successful long-term partnership. Also be aware that family offices can offer a lot to their VC partners in terms of network and skills, so look for a firm that has the outlook and processes to extract and maximise these for your mutual benefit.

Implications and the way forward

Poor or failed venture investments can have disastrous consequences for family offices, as a loss of capital and the stress involved leads to family tension, reduced confidence, and a loss of trust in the asset class for many years to come. In extreme cases, poor investment decisions can even bring unwanted media attention and other reputational challenges, due to lack of due diligence, overexposure to a single asset or, even involvement with fraud or unsavoury characters. These can be extremely hard to recover from.

But with venture investing hitting a record high in the first quarter of this year, there is little doubt that it will continue to offer huge opportunities to family offices, and become an even more integral part of their focus going forward. Consequently, we will also see knowledge and expertise increase across the sector and strategies start to crystallise. Most likely with the majority of firms taking some kind of hybrid approach; a combination of partnering with venture funds along with co-investment, or some direct deals. And as that happens, family offices will not only see their venture returns improve, they will also have fewer venture headaches.

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