Venture Capital Asset Allocation: Common Family Office Pitfalls in Finding Alpha
Family Offices have been around for centuries, but with the fast changing pace of technology innovation, low interest rate environment and the general growth startup ecosystem in the last decade, they are taking a closer look at venture capital as a way to diversify their investment portfolios. But how can family offices approach venture capital in a way that aligns with their goals, values, and risk tolerance?
First and foremost, it’s important to understand that venture capital is a high-risk, high-reward investment strategy. Unlike traditional investments in stocks, bonds, or real estate, venture capital is about investing in early-stage companies with the potential for ‘alpha’ growth. Family offices need to be prepared for a level of uncertainty and volatility that is not typically seen in other types of investments. With that in mind, we have seen a pattern of missteps made by family offices, when deciding how to allocate exposure.
1. Random introductions to someone who knows someone ‘doing’ VC
Often times when family offices make commitments to funds it is because of a personal relationship with the fund manager (i.e. someone met someone at a conference or knows someone raising a fund). Even though validating the bona fides of a manager are great, the chances of being that person being a top performing manager in venture capital are slim. In venture a small group of venture capital firms have consistently created the majority of the returns, know as a power law distribution:
2. Understanding a VC investment thesis and what makes a great VC requires specialist skills and experience
Let’s face it. Most family offices don’t have, and shouldn’t have the requisite skills on staff to critique a VC deck/team/strategy. The risky part is believing they do have the skills — the information asymmetries can be painful.
3. Venture Capital as a side job
Given that venture is arguably even less transparent than private equity is it takes time and dedication to build relationships with managers, learn and find access to the best managers. Many family offices do not have the capacity to allocate millions to venture capital on an annual basis and therefore do not have in house professional teams that are dedicated to venture capital. VC also differs a lot from other asset classes FOs typically invest in, such as private equity (buy-out), real estate and public equities. This makes it virtually impossible to create a well-balanced venture portfolio without dedication.
4. Underestimating Venture Capital performance
Venture is the best asset class, but only if you select well. The top quartile venture capital performance over the past 30 years, based on IRR, has been exceptional. According to data from the National Venture Capital Association, the top 25% of venture capital funds have delivered average IRRs of around 30% or higher. The overall performance of the VC industry can be measured by indices such as the Cambridge Associates US Venture Capital Index (CAVCI) or the NVCA Venture Capital Index (NVCA VC). Over the last 20 years, the average annual return for the S&P 500 was 7.96%, while the average annual return for the CAVCI was 9.24%. The NVCA VC had an average annual return of 8.22%.
5. Small cheque sizes, less influence and oversight
Typical ‘cheque sizes’ are too small for the best of the best managers, often there is a minimum of €5m and below that it is not worth the time of the manager to be in conversations. Typically, the pool of funds accepting small cheque sizes are increasingly not top decile or top quartile. They can be but selection capability is even more critical as the pool becomes increasingly less transparant.
6. Overestimating VC insights and knowledge
To “get into” $1b+ deals, a VC must have a strong network, ability to identify and act on market opportunities, and a track record of successful investments. Being well-established and having a strong brand can help, but it’s not the only factor (and for family offices the brand can be the wrong indicator!). Founders will choose a VC based on their trust, alignment of values, and ability to add value. Assessing these qualities of managers can be quite tricky and requires expertise. Even larger, experienced, LPs can miss the finesse of the art of ‘doing a deal’.vLacking the expertise required to build a balanced VC portfolio many family offices invest opportunistically and underestimate venture capital power law. Its only very few that win in venture and to win a combination of strategy, niche expertise, and unique selling points is required.
