Family offices (FO) and venture capital (VC) investments have not traditionally made good bedfellows, says Stephen Scott, managing director, Ince Corporate Finance. 

However, since 2010, when FOs accounted for only 156, or 1.7% of the total number of venture deals, the number of family office led venture deals grew at a compound annual growth rate of 24.9% to 1,805 in 2021, according to research by Silicon Valley Bank (SVB). That is a 4.7% share of today's total number of venture deals, a 2.8X increase. 

The reason for this is obvious; venture funding internal rates of return (IRR) averaged a measly 2.8% from 2001 to 2006, following the dot.com crash of 2000. In contrast, achieved returns from 2007 to 2016 for venture funding IRRs averaged a dramatic increase to 18.1%. A recent survey by SVB estimated average returns of 14% and 24% in 2019 and 2021 respectively.

This performance has led to an increased allocation of funds by FOs to venture funding. SVB estimates that the figure rose from 10% in 2019 to 12% in 2021, a sizeable 20% increase.

Direct vs. intermediated VC

The key concept here is "direct". This term applies to investments made directly into a venture without the intermediation of a fund or other fiduciaries. In other words, the FO is responsible for sourcing, performing due diligence and negotiating investments. This does not rule out investments with trusted co-investors, who may share some of these responsibilities. 

VC investments often involve co-investors as a means of diversifying risk and the validation implied by a second or third opinion. Competent professional advice in all phases of the investment process is an important asset.

SVB's survey estimates that in 2021, FOs invested 36.4% of their VC allocation to direct investing, up from 30.4% in 2020, a material factor of 1.2X in the space of just one year. In the next two years, FOs, on average, expect to make 12 direct investments versus six fund investments. Historically, the average FO direct investment was US$4.4m versus US$4.6m for funds, implying that direct investment will account for about two-thirds of new commitments.

Direct investors can outperform fiduciaries

From the point of view of the FO, the incremental professional infrastructure may be comfortably balanced by the absence of fees and carry that are earned by VC funds. Many FOs are themselves run by their founders, who generated the family wealth. They have a proven eye for value and negotiating nous.

SVB estimates that returns on direct investments have consistently exceeded those for fiduciary investments. In 2019, direct investing earned 17% v. the average of 14%. In 2021, the figures were 26% and 24%, respectively.

Advantages of direct investing 

FOs have several inherent advantages in managing venture funds. This is important because there is a lot of money chasing quality investments making it is a highly competitive market.

Firstly, they can move much more quickly because they are investing their own money and not subject to the constraints often imposed on fiduciaries. This flexibility can be instrumental in building relationships with entrepreneurs, and in responding to problems which inevitably emerge from time to time.

Secondly, they can focus on sectors that they know well or have a strong interest. Sector expertise can be a valuable marketing tool and can be determinant in accessing new innovations and the entrepreneurs that are driving the value creation. With emerging technologies, this edge may be provided by advisers who have relevant experience.

Thirdly, they can bring to bear ambitions other than purely maximising financial returns. Many wealthy investors are focusing on impact investments; where they can make a difference tackling issues, such as climate change, natural resource preservation, health and wellness, corporate governance and inclusion, environmental degradation, and social opportunities. On average, FOs allocate 20% of their VC allocation to environmental, social and governance (ESG) issues.

Fourthly, they can afford to adopt a long-term investment horizon. Many promising VC investments struggle to gain market acceptance and they require patient investors. VC funds typically focus on three to five year exit horizons because they are under pressure to monetise their investments and to return cash to their investors.

Finally, they are often led by entrepreneurs, who understand the challenges faced by start-ups and early stage growth companies.

They may become directors or be less hands on, but they will remain close to the issues investees are facing, providing sound, strategic advice. 

Direct investment strategy

Direct investment in venture funding, while on the increase, still has much untapped potential to grow. FOs offer entrepreneurs advantages to help them win investment mandates, and there is every reason to believe that they can continue to outperform fiduciaries.

Equity markets are currently roiled for a number of reasons, one of them being the decline in tech valuations, which have led the market fall. In many respects, the fall has been inevitable. Companies that were losing money and trading at over 50X annual recurring revenues (ARR) are now trading at less than 10X. Variances in the private market are even more pronounced. Herd mentality won over common sense.

A direct consequence is that new money can be invested at more attractive valuations. Markets in distress create good opportunities. Multiples and sentiment may not recover quickly, so one should be prepared to invest for the long term. This plays into a sweet spot for FOs.

Additional rules of engagement that should always be borne in mind are: 

(i)    Understand the sector or the technology, preferably based on personal experience; 

(ii)    Stress test the management team and ensure a balance between vision and effective control of cash generation/preservation; and 

(iii)    Be alert to the ESG considerations that the FO cares about.

At the same time, FOs must make themselves more visible to attract quality deal flow. Self-sourced deals which leverage sector expertise and relationships are likely to be more productive and more profitable. Financial and legal professionals should be encouraged to assist in achieving these objectives by sharing deal flow and encouraging the gradual trend toward disintermediating VC investing.

By Stephen Scott, managing director, Ince Corporate Finance and  co-authored by Norman Ebner, analyst at Ince Corporate Finance; Linda Tipping, director at Ince Corporate Finance; and Matthew Biles, partner & head of private client at Ince.