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Volume #27 TL;DR:

• We learned that were most aligned with our strengths, risk/return preferences, and our thesis as Limited Partner vs. direct investors in the Venture space.

• The best founders get to pick their cap table. If you can pick, you won’t be picking a family office unless they are ultra strategic.

• It probably took us 1,000+ live calls with founders until we started to have the conversations with the founders we really wanted to be talking to.

• The best returns are no longer limited to a few established fund managers, who oftentimes can be difficult to access for the majority of LPs.

• Your risk of picking a bottom decile/quartile startup vs. fund is substantially higher.

• When analyzing fund performance for Fund-of-Funds investing in the US and Europe, the data makes clear that early vintages show strong financial returns across both the top quartile, median, and third quartile.

• Some funds are more incentivized around their Management Fees and some are more on their Carry.

• A big part of the process towards discovering whether being a Limited Partner was the right pathway to pursue for the family office was contemplating the strengths an investment strategy requires.

Table of Contents

• How We Started in Venture Capital

• Access

• Risk/Return Profile

• Taking a Fund of Funds Approach

• Better Alignment

• Thesis Alignment

How We Started in Venture Capital

A couple of years ago I joined a single family office shortly after their liquidity event, which begun the process of incorporating and structuring the FO. Over the last years I had the privilege of going through all the learnings that come with the early years of building out a family office. At this point, I am spending most of my time in the FO building another business with the 1st and 2nd generation, which builds on their previous experience in the leasing and financing space. We are also continuing to have active conversations with new Emerging Managers.

While it would be too lengthy of a write-up to share our entire journal into the Emerging Manager and Limited Partner landscape, I wanted to share a few highlights that were influential in my thinking, how we stewarded the process of becoming an LP, and why we ultimately decided that being an LP was the right pathway.

As we started our Venture strategy we were pursuing all pathways simultaneously. I am a big believer in the convergent and divergent thinking/design process. So we constantly moved between “openness” and “refinement” phases. This obviously meant that we had to spend an enormous amount of time learning, taking calls, screening for startups, sourcing funds, due diligence, etc. I talked with 2,000 startups in our first two years and hundreds of funds - all while building out other strategies at the early stage of incorporating the family office.

We learned that were most aligned with our strengths, risk/return preferences, and our thesis as Limited Partner vs. direct investors in the Venture space.

Here is why:

Access

The most simple and honest way I can put it: the best founders get to pick their cap table. If you can pick, you won’t be picking a family office unless they are ultra strategic.

It probably took us 1,000+ live calls with founders until we started to have the conversations with the founders we really wanted to be talking to. And that was with us being scrappy. I even built out a community of almost 300 VC Associates where we all shared deal flow, etc.

And once we started talking with the best founders, we often experienced that Emerging Managers who we had invest in, had invested in these founders at earlier stages and at better valuations. They knew founders before they ever raised - a relationship position in the ecosystem that is almost impossible for a Family Office to achieve.

So we started to do more research around the risk/return profile of Emerging Managers and here are the things we were finding (reminder, this is a couple years ago).

Risk/Return Profile

For Limited Partners it is important to understand how the risk and return profile of Venture Capital investing has changed over the last years. Especially for family offices, which generally invest over generations, not cycles, it is crucial to constantly re-assess how returns are driven and where risk can most effectively be mitigated. The Venture Capital landscape has evolved into one of broad-based value creation across sectors, geographies, and funds.

This means that the best returns are no longer limited to a few established fund managers, who oftentimes can be difficult to access for the majority of LPs.

On returns:

The below figure highlights this evolution and shows that top returns have consistently been generated by Emerging Managers (Funds 1-4):

From 2004 to 2016, the top-performing Venture fund was a new or developing fund (Fund 1-4), 9 out of 13 times. Out of the Top 10 funds over the observed vintage years, only 35 out of 130 were established funds.

My friends at Pattern Ventures, a Fund of Funds focused on funds of $5-$50M in size, published a report underlying this story (this came out after we started investing in Emerging Managers).

Their report on 2,500 funds from 1980 onwards also supports the forming narrative of smaller funds having great potential to outperform.

To summarize their report: a portfolio of smaller funds (up to $50M in fund size) has the potential to outperform a portfolio of larger funds (funds above $150M in size) by 45-60%. This calculation excludes the top 5% performing large funds, suggesting the improbability for many LPs to access those. Below the expected MOIC by fund size.

On risks:

As a family office you are in two businesses: wealth creation and wealth preservation. This is what causes Venture capital to be so attractive and simultaneously an industry FOs can be very skeptical of. There are exponential returns to be made, but exponential returns are the reason why you should invest. A 2x return is not good enough to be a serious Venture investor. So optimizing for the worst case scenario will lead you away from Venture - it should. Venture investments have a serious potential to go to zero, or return at a ratio where your dollars would have been better invested elsewhere.

Side-note for Emerging Managers: A simple way to address perceived risk from LPs on the front-end is to signal that you are running tight and transparent operations, including subscription docs, capital calls, and investor reporting through integrated platforms like Sydecar’s Fund+. Tools like this help FOs feel confident that even first-time managers are equipped to handle the operational rigor that institutional capital demands.

Curious what that looks like in practice? Check out their interactive demo to see how Fund+ supports FO-approved fund administration from day one.

Let’s also be honest: your risk of picking a bottom decile/quartile startup vs. fund is substantially higher. And even if you pick a bottom decile/quartile fund, the probability of your investment going to zero is not as high as with a startup. Again, optimizing for the worst case scenario is not a good way to approach Venture, but it’s good to think about these things when you are getting comfortable with the space.

I would like to encourage to keep in mind that there is a survivorship bias woven into the data we currently have on Emerging Funds. Many first funds, that have had to shut down, will not have been reported and therefore the data might not accurately represent reality, even though it can be indicative of what is true.

Also, the figure showing that Emerging Manager Funds have been the top performing fund 9 out of 13 times from 2004 to 2016 is encouraging, but looking at the best 10 funds of any given vintage year should not lead to any major conclusions. It can show LPs the excellent potential to outperform any established fund with Emerging Funds but is not necessarily predictive of the outcome of the LP’s portfolio. The probability of finding those top-performing funds needs to be considered.

With that in mind, the risk profile of establishing a strategy around Emerging Funds is shaped by the access LPs have to the top-performing GPs. Many funds are popping up and finding the best Emerging Managers while also cultivating the right network of access can often take a long time and a significant amount of intentional pursuit. Having access does also not equate to the ability to pick winners.

Another risk is that the performance is simply difficult to predict based on a lack of track record in comparison to what LPs would be able to assess when investing in established funds. For VC Funds, previous top-quartile performers managed to keep top-quartile performance for their next time 45.1% of the time. This means that you almost have 2x better chances of hitting a top-quartile fund when investing in a fund with an established track record indicating top-quartile performance. Many Emerging Managers won’t be able to show this performance in their first fund (hint: that’s the whole point why investing Emerging Managers requires you to embrace emergence)

Taking a Fund of Funds Approach

A great way for LPs to access great Emerging Funds and get insights to best practices is through investing in Fund-of-Funds. There are Fund-of-Funds in my network, who offer strategies and insights that need to be cultivated over decades. Some LPs simply outsource the competence of investing in Emerging Managers to Fund-of-Funds, which makes complete sense. For those LPs who really want to learn the craft, it is worth spending time hunting down those Fund-of-Funds that execute a strategy you truly are unable to (either due to time restraints, experience, capital, insights, etc.).

At the same time, LPs have the opportunity to build out their own portfolio of Funds and mimic the returns of FoFs, which can generate strong upside:

When analyzing fund performance for Fund-of-Funds investing in the US and Europe, the data makes clear that early vintages show strong financial returns across both the top quartile, median, and third quartile. Any vintages post-2016 also show reasonable upside but are still early in maturing their fund cycle and full return potential.

We concluded that building out a portfolio of funds vs. investing directly in startups would be much more efficient, less risky, and most likely bear equal if not better upside.

The point I am making is that when LPs build out their own portfolio of funds, they have a good chance of outperforming funds that invest directly in startups. The additional benefits for LPs are strong diversification, mitigation of risks, and access to co-investment opportunities, learnings, etc.

Better Alignment

Show me the incentive and I show you the outcome.

In almost all investments, the main incentive is of financial nature. And the alignment around the financial incentive between LPs and the fund matters!

The financial incentives for any Venture Fund lie in the Management Fees and the Carry. BUT, some funds are more incentivized around their Management Fees and some are more on their Carry.

Here is a paradox of Venture Capital: larger funds often take higher fees than smaller ones.

This can create misalignment for LPs, since some funds might be more focused on raising larger funds to monetize more on fees, vs. focusing on generating returns through their portfolio to monetize on Carry.

Emerging Managers often leave a lucrative career and salary behind to start their fund. Often they have to bridge a significant timeframe through their personal capital until they can actually pay themselves.

The management fees typically just serve as a way to cover expenses and salary for the Emerging Manager, but it is not the way to financial freedom. This is where the LP and GP find alignment: they both need to produce Venture returns in order to make money. Plus, if the Emerging Manager does not generate the appropriate returns, the likelihood of raising the next fund drops significantly.

Emerging Managers had the type of skin in the game that aligned well with us as LPs.

Thesis Alignment

A big part of the process towards discovering whether being a Limited Partner was the right pathway to pursue for the family office was contemplating the strengths an investment strategy requires.

In the first two years I helped develop an overarching investment thesis that would be applicable to the entire family office: We invest in people who invest in people.

A big element to the family’s journey towards their position was investing in people and taking a long-term view on people. They understand how to build with people, they understand who to bet on and why, and they understand that people are the most predictable pathway towards success.

Betting on founders and Emerging Managers both believes in this fact.

However, when being a direct investor, you have less time to develop the type of relationship that will enable you to take that bet well. At least that was true for us as a family office.