If you are a founder talking to a VC investing their first fund, or a VC with a fund that is $50 million in size or smaller, it’s highly likely that the VC is getting the majority of their fund’s commitments from family offices. Family offices are quite opaque, and understanding a bit about this capital source can help you figure out a bit about the venture capitalist’s motivations.
What is a family office?
Family offices are private wealth management advisory organizations serving ultra-high-net-worth investors. They can be organized in many different ways, which can make it difficult to spot one. Some are set up to invest a single individual’s wealth. Others are organized around a family’s money - think of a person who made billions, and now they have a team that invests their adult children’s wealth. Sometimes different families get together to pool their assets.
Their main function is to centralize the management of a significant family fortune. Services provided by a family office can go beyond just investment management, often including tax planning, estate planning, charitable giving guidance, and even managing day-to-day accounting tasks like payroll and bill payments. Some may be actively run by a member of the family; others may be completely outsourced to professionals, with anything in between possible.
Challenges family offices have investing in venture capital
It can be difficult for family offices to get into the VC game. Well, actually, there are plenty of venture funds that will take money from high networth individuals, but the smart families understand that they have certain challenges if they want to start investing some of their wealth into the venture landscape. Here are some of those challenges:
1. Risk-Return Trade-off: VC investments are high-risk, high-return in nature. While they can offer substantial returns, they also entail significant risk, including the total loss of investment. Family offices must consider their risk tolerance and long-term financial goals when deciding to invest in VC funds. Many funds will not produce acceptable returns, even if their return expectations at the start of the fund are strong.
2. Illiquidity: VC investments are illiquid, meaning they can’t be quickly sold or exchanged for cash without a substantial loss in value. The long lock-up periods (typically 10 years) can be problematic for family offices that require liquidity. How VCs make money is slow. This makes it very hard to tell if a family office’s VC investment strategy is working; if it takes 10 years to get returns, you will have committed to several funds before you know if the 1st fund commitment was a good one! And seed and pre-seed funds may have an even longer path to liquidy.
3. Due Diligence: As a specialized investment product, venture funds are not easy to diligence, and many high networth individuals don’t have the expertise to do quality due diligence. New investors into the space must scrutinize the VC fund’s management team, investment thesis, historical performance, sector focus, stage of investment (early vs. late stage), and portfolio companies.
4. Access to Top-tier Funds: Early-stage funds are typically small - they don’t raise a lot of capital. And the best funds, the clearly top-tier ones, are usually not adding new LPs to their list, so many family offices new to investing in this asset class are boxed out of the top funds. So, this means they have to pick between repeat funds (i.e. Fund 3 in a VC firm that has been around for a while) or new funds that don’t have a track record. Both require serious expertise at due diligence that family offices may not have. Additionally, the investment sizes are large, so many funds also often prioritize institutional investors or existing investors, making it challenging for family offices to gain access.
5. Alignment of Interests: Family investment teams must ensure that their objectives align with those of the VC fund. For instance, the time horizon for return on investment, the exit strategy, the level of involvement in portfolio companies, and the fund’s fee structure are all key considerations.
6. Diversification: Investing in a single VC fund can expose the family office to significant risk. Therefore, it’s crucial to diversify not only among different VC funds but also across different industries, stages of investment, vintages, and possibly geographies. Doing this correctly can take a lot of capital.
Once a group has decided that they want to get into this asset class, they will still face some serious headwinds. Some other problems that they’ll have to deal with include:
1. Lack of Expertise: VC investing requires deep understanding of the startup ecosystem, deal structuring, and risk management. High networth groups may lack this expertise, leading to potential suboptimal investment decisions.
2. Scalability: The high minimum investments required by top-tier early-stage funds may limit the number of funds a single family can invest in, reducing their ability to diversify their portfolio.
3. Opportunity Cost: The long lock-up periods and high risk associated with VC investing mean that family offices may miss out on other, potentially more lucrative or safer investment opportunities. High networth individuals often have a large number of great looking investment options, so tying up capital into a new fund for a long time can seem risky.
4. High Fees: Funds often charge substantial management fees and carried interest, which can eat into the returns for the family’s investment. This is definitely not a cheap asset.
5. Lack of Control: Unlike direct investments, investing in a VC fund gives the family investment team limited control over the investment decisions. Buy an apartment complex? You can decide to make renovations, refinance, sell when you want. But invest in a fund? You are locked up with that manager for a long time.
6. Industry specific metrics: Tracking performance of a VC fund investment requires knowledge of specific metrics like DPI. Some of these metrics include numbers that can be manipulated by the VC (may not nefariously, but there are a lot of judgment calls). Examples include the valuation metrics; what is a private company worth?
To navigate these challenges, family offices often seek advice from financial advisors, conduct extensive due diligence, and collaborate with other family offices to pool resources and share expertise. Some also invest in fund-of-funds, which provide diversification across multiple VC funds, although this comes at the cost of additional layers of fees.
Challenges for VCs looking to get family offices as investors
It’s really hard for venture capitalists to find the family offices that will entertain investments in new VCs. One joke is “if you’ve met one family office you’ve met one family office.” Basically, each family is going to have its own investment philosophy, decision making process, etc; none are really alike at all. These are hundred millionaires if not billionaires, they are going to be quirky!
Additionally, after a few years, a family’s ‘dance ticket’ may get filled up with returning managers. Imagine a billionaire decides to invest $15 million a year in VC. In the first year, they put money into groups that they’ve never worked with before; same in the second. But by the third or fourth year, the first VCs they committed to are coming back to the table for their next funds. Pretty soon, all of the capital that that billionaire wants to commit to this asset class is taken up by managers who they already are working with! This makes it hard to break in if you are a new manager.
Challenges VC face related to finding interested family offices
Selling your new, emerging fund to high networths is hard! Here are some of the problems emerging managers face when trying to woo investments from very right households.
1. Identification of Prospects: Identifying family investment groups that have an interest in venture capital can be a significant challenge. These investors tend to be very quiet and often take aggressive steps to stay under the radar. The lack of a centralized directory or database can make the search process a daunting task for emerging VC managers.
2. Lack of Established Relationships: The venture capital space heavily relies on networks and personal relationships. For emerging managers, the lack of established relationships with families can be a barrier to even initiating the sales process. And many family groups rely on relationships as part of their diligence, so it takes time to get these relationships going and strong.
3. Long Sales Cycle: The process of courting a family office to become an LP can take a considerable amount of time. And from a potential LP’s perspective, it’s OK to say no and to wait for the next fund. If you are managing intergenerational wealth, why not wait 3 years to make a decision?
4. Trust Building: Convincing a family investment team to invest in a fund managed by a relatively unknown entity can be difficult. Building trust and demonstrating credibility without an established track record is a big challenge.
5. Tailored Approach: Unlike institutional investors, family offices are unique and require a more tailored approach. They have different investment criteria, preferences, and decision-making processes. Understanding their individual needs and preferences requires extensive research and customization of the sales pitch.
6. Education: Some families may be less familiar with venture capital as an asset class or may have preconceived notions about the risk involved. The VC manager may need to spend significant time educating potential investors about the value proposition, the risk/return profile, and the role venture capital can play in a diversified portfolio.
To navigate these challenges, emerging VC managers need to focus on building strong networks, investing in relationship-building, and demonstrating their industry expertise and value proposition. Being patient and persistent throughout the long sales cycle, while also providing educational resources about VC investing, can help attract family offices to their fund.
Other challenges emerging VCs face when trying to find families to invest in their funds
Emerging VC managers often face a multitude of challenges when trying to attract family offices as limited partners into their funds. Here are some key obstacles:
1. Track Record: New VC managers often lack a long-term track record demonstrating their ability to generate substantial returns. Family asset management teams typically prioritize funds that have consistently high performance, which can be challenging for new entrants to the market to prove.
2. Brand Recognition: Investors often prefer investing in established funds with well-known and respected brands. Emerging VC managers need to work on building their reputation and brand in the industry, which can be a time-consuming process.
3. Relationship Building: For rich families, investing is often about relationships. Developing trust and credibility takes time and can be challenging for new managers who are still proving their ability to manage investments effectively.
4. Industry Expertise: Family offices often seek funds with managers who have specific industry or sector expertise, as well as a deep understanding of the startup landscape. If an emerging VC manager lacks this, or operates in an industry that the family office isn’t familiar with, it may be a hurdle.
5. Minimum Commitment Levels: Since private office investors are usually opaque about the amount of money they manage and the checks they write, it can be difficult for an emerging manager to know if a potential LP is capable of writing the right sized checks. Some groups may only be able to make small investments - others may need to put in huge amounts of capital to make it worth their time. This usually requires a few conversations, which can be a time suck.
6. Operational Infrastructure: Emerging VC managers might not have fully developed back-office operations, rigorous compliance processes, and robust reporting capabilities. Some LPs may want a very specific reporting or tax compliance process, which a new manager may not have set up.
7. Due Diligence: Emerging VC managers have to be prepared to provide in-depth information about their investment strategy, team, operational structure, risk management processes, and financial projections. This can be challenging and time-consuming for new managers. And you never know what any particular investor might ask for!
To overcome these challenges, emerging VC managers can focus on building strong networks within the high networth community, clearly communicating their unique value proposition, and demonstrating their industry expertise. Additionally, robust reporting, transparency, and alignment of interests are critical to building trust with potential family office LPs.
Implications for founders
Founders pitching emerging managers should realize that the majority of that VC’s money is likely coming from high networth offices. It’s worth asking the VC where they get their capital - some can be transparent, and may let you know if they have a particular major investor or investors (who might even be able to provide some help to their portfolio companies, if the industries overlap decently). You never know who may be able to help you!