The 3 Most Common Mistakes Family Offices make when Investing in Venture Capital
“We don’t do venture capital” is something that most people who have tried to raise money from a family office have probably heard before, and it only seems like the number of family offices reluctant to engage with venture capital is ever increasing. But why? Venture capital is, after all, one of the best-performing asset classes, and it would just make sense for families who built most of their wealth through entrepreneurship to also invest in it.
In talking to numerous family offices over the past years, we made an interesting observation: their reluctance towards venture capital is often not rooted in a disregard for the asset class, but rather in previously failed attempts to invest in VC, which have led to their current apprehension to (re-)enter the market.
We have noticed three common mistakes that many family offices have made, which could have significantly improved their experience with VC had they been avoided.
Not Understanding The Power Law
Family Offices have the mission to preserve and grow the wealth of one or multiple families over several generations, which often comes with a risk-averse mindset. It is this mindset that leads to the common misconception that investors should focus on somehow lowering the risk associated with venture capital by doing things such as only investing in later-stage companies, avoiding certain industries or technologies that are deemed too risky or insisting on onerous terms and control rights. However, this should never be their goal.
Venture capital outcomes do not follow a normal distribution; they are governed by exceptionalism. This means that outliers will be responsible for most of the returns and offset the losses from other investments. Even top-tier VC funds, which are often considered to be a “safe bet” by family offices, have to write off a majority of their investments, relying on their biggest outliers for returns.
Understanding this power law is integral to venture investing and managing expectations of the potential returns from the asset class. Since a majority of any portfolio will not generate significant or any returns at all, investors should not try to minimize the downside risks (write-offs) but rather focus on maximizing the upside potential i.e. increasing the chances of finding outliers.
The only means of achieving this is sufficient diversification. Time after time, family offices invest in only a handful of startups or one or two VC funds, thinking that it will suffice as their venture allocation, although such a concentrated portfolio has significantly lower chances of returning their investment.
Mitigating risk is possible through diversification, but attempting to entirely eliminate it is counterproductive and will lead to family offices losing out on high-return investments.
Being a Tourist
The venture capital market is cyclical, and especially in up-markets when investment activity is already high, many family offices are anxious to miss out and start deploying capital. However, as investments mature and some inevitably fail, they are also quick to leave the market (and never return).
This so-called “tourist capital” is a recurring phenomenon in venture capital. Intrigued by the promise of high returns, new investors who don’t have the same level of experience and expertise as other VCs enter the market. The increased overall competition and the willingness of “tourists” to pay more then contribute to overvaluation and bubbles.
Ultimately, these tourists exit the market once either the excitement around VC investments dies down or when they are discouraged by high losses, wrongly attributing their poor performance to the asset class rather than their own investment practices.
Since it‘s impossible to know the ideal time to enter a market, regardless of the asset class, the best course of action for family offices is to moderate their deployment over a longer period and to make sure that they participate in every vintage.
Venture capital is, after all, a long-term asset class that should not be approached like a short-term opportunity. It requires a deep understanding of the industry and, most importantly, patience.
Overestimating Their Abilities
Simply increasing diversification and moderating deployment alone will not suffice. In the end, access is key. Family offices must have access to the best investment opportunities on the market.
Unfortunately, many drastically overestimate their sourcing abilities and access due to a limited understanding of the industry, unrealistic expectations or inexperience with early-stage investing.
Adverse selection is one of the main obstacles family offices face when pursuing direct investments. Even if they can identify a good investment opportunity, in most cases, they will not be able to secure an allocation due to the highly competitive nature of the market.
Founders, especially at an early stage, will generally prioritize investors who can provide value beyond just capital (smart money vs. dumb money). As a result, family offices have only limited access to startups and are far more likely to invest in companies that have previously failed to raise money from other sources.
In addition, finding the right people to spearhead VC initiatives within a family office and ensuring that their interests align is a massive challenge. Investment professionals with the necessary knowledge and network are far more likely to join or create a VC fund, as it provides them with more independence and the possibility of significantly better compensation. Thus, family offices are usually better off investing indirectly into startups through VC funds, although this has its challenges too.
Identifying great VC funds is difficult and getting access to them is even more so. It is crucial to have a team with the right network and experience in making fund investments, despite there only being a very limited number of investment professionals who meet these criteria.
Most family offices not only lack people with relevant investment experience in these positions, but they don’t have a team at all. Instead, they often rely on a single person to manage all their VC investments, usually alongside several other asset classes. As a result, they have a rather limited expertise and network in VC, which ultimately leads to poor access and an underwhelming financial performance.
Based on the limitations above most family offices would be better off investing in venture capital through fund of funds that have a dedicated team that has the necessary network, resources and experience in making fund investments.
Final Thoughts
Most family offices are not well-suited to invest in venture capital, particularly at an early stage, but this should not discourage them from investing in the asset class. Instead, they should develop a long-term strategy that is specifically tailored to their size, resources, and abilities.
For many, this could be to gain access and insights into the venture capital industry by investing indirectly through one or multiple fund of funds, developing the required knowledge and network over time to then start making investments in individual VC funds, and lastly, to start investing in startups through SPVs of their portfolio funds or directly.
For more information about Multiple Capital, please visit our website or reach out to our team directly.