How family offices can beat venture capitalists

• Early-stage tech investing is characterised by high risk and failure rates. 
• Family offices have more flexibility in investment decisions and time horizons. 
• Family offices can build concentrated portfolios with higher potential returns by focusing on a smaller number of promising companies.

Traditionally, the idea of direct investing in a portfolio of 25-30 early-stage tech companies has frightened family office investors. The likelihood of losing money on 10-12 investments (yes, the majority of early-stage investments die) has often led to strong resistance on the investor side.

Roger Federer, during his speech for the graduate class of Dartmouth College, revealed that winning just 54% of total points in his career translated into an 80% match-win rate.

This highlights that significant success may be achieved in portfolio management when your most considerable wins outperform benchmarks, and transform the high ratio of failures into substantial long-term gains.

Family offices have all the necessary knowledge and resources (as well as some hidden advantages) to earn significant returns from investing in early-stage tech companies directly and can outperform the vast majority of VC funds. 

Why the traditional VC fund model is not perfect

Let’s admit we are in the middle of a venture winter that started in early 2022. Fundraising is getting considerably more complicated and more than 20% of total VC deals last year were downrounds. Cash-heavy companies are running out of runway and either dying or being acquired at prices much lower than liquidation preferences from previously raised capital.

There has been hardly any relief on the exit front either with a 46% year-on-year decline for this year.

The last two or three years of the market downturn have further highlighted the fundamental shortcomings of the VC fund model as VC funds move further away from reasonable value investing. 

VC funds need to raise new funds constantly. To do this, they need to show that they are entering into high-profile deals (often at extreme valuations). They need to invest in hype trends, where there is a chance to show rapid revaluation. And they have to try to find trillion-dollar markets that do not yet exist to return the inflated billion-dollar funds somehow. Sequoia Capital recently published an article in which the US venture capital firm expressed doubt that, theoretically, the AI market could be as large as the amount of investment poured into it. 

At the same time, large funds are too comfortable with the high management fees that they can charge. 

All this is aggravated by the fact that the past few years have been unsuccessful for the market, and the portfolios of many funds are unprofitable. This means they must be more aggressive to compensate for this. Unfortunately, investors who allocated their capital in generalist VCs in 2019-2023 may suffer painful losses. Industry rumours suggest that the average Total Value to Paid-In Capital ratio is significantly below one

At $317 billion, VC dry powder remains at a record-high, but perhaps this doesn’t mean as much as we would like to think. Much of this dry powder is already earmarked to support existing investments rather than to fund new companies.

Does all of the above mean that Family Offices should not allocate any capital to tech? I believe the opposite: the current market environment may be a good time for building an in-house portfolio of early-stage tech investments.

Family offices are flexible

With their flexibility, family offices can combine the advantages of large and small VC funds. On the one hand, unlike billion-dollar funds, family offices can focus on value investments and not get involved in hype stories with unbelievable valuations. On the other hand, unlike small funds, it is possible to reallocate capital and add more money to successful companies

Family offices may outperform professional VC investors over the next ten years mainly because of several hidden solid advantages. First, their ability to invest more in portfolio leaders. On average, a VC fund has a portfolio of 30 companies. The majority of the investments fail. However, the successful ones may generate significant returns. The most essential part of the VC job is probably to double down on portfolio winners. Ownership protection in the most successful companies with pro-rata as long as possible is critical. VC investors often can’t protect their ownership long enough due to the shortage of capital.

Family offices have higher potential because the potential follow-on capital is high. Let me give an example. A family office builds a 25-30 early-stage tech investment portfolio. A few years after the initial investment period, there are five or six strong leaders, each with a good chance of becoming a fund returner. With such a setup, the family office is capable of double-triple or even more the initial investment amount in the best companies, which potentially will lead to a way higher return and ownership than a traditional VC fund can probably achieve. 

The significant disadvantage of the traditional VC model is that many funds fail to protect their stake in successful projects. Family offices can be uniquely successful VC investors because they have deeper pockets and don't have follow-on limitations (e.g., the best-performing company may have 25-30% of the total allocation).

• Evergreen funds. Another advantage is the ability to invest with longer horizons. Typical VC investors have a lifetime of eight to ten years and are often forced to sell outstanding companies early. Family offices are evergreen and are not forced to sell at a certain point in time. 
• There is no pressure to allocate capital fast. The investment cycle of the typical VC fund is usually limited by two or three years (otherwise, there would not be enough time to grow and harvest). Investing too fast leads to a portfolio with a significant number of mediocre companies. Family offices have a luxury of being patient and forming a high-value portfolio. Also family offices do not need to raise a new fund and may spend all of their non-investment resources on the current portfolio.
• A vital area of expertise in specific industries. Many family offices grew up from several strong, established businesses. This expertise in particular sectors is usually higher compared to an average VC team. 

Traditionally, the advantage of the VC fund has been a high-quality pipeline, but with the current market environment, the competition for outstanding companies is not that tough, and family offices are becoming investors of choice more and more often

Vital timing to enter the market

There are two kinds of forecasters: those who don’t know and those who don’t know they don’t know. It is always hard to be a contrarian.

Still, I am highly convinced that the current market timing is preferential for family offices to start building their portfolios of early-stage tech companies.

I already see many examples of such activities from family offices in the market, including us, Begin Capital. And my forecast is that there could be many more. 

Starting early with the small tickets, and the ability to invest way more after specific achievements gives an excellent opportunity to outperform the vast majority of VC funds significantly.