Session 1 - Direct Investment for Family Offices
December 1, 2021
Koch Center for Family Business
Olin Business School at Washington University in St. Louis
Guests & Moderator
Scott Wilson, CIO, Washington University Investment Management Company
Brent Beshore, CEO and Founder, Permanent Equity
Peter Boumgarden, Koch Professor of Practice for Family Enterprise, Washington University in St. Louis
In Goldman Sachs’ 2021 report assessing the investment behavior of large family offices across the globe, the authors note a growing exposure of these groups to venture capital and private equity investment. Specifically, 90% and 100% of these offices had exposure to venture and PE-like investments, respectively, with investments made both directly and through specific funds.
Despite the growing frequency of family offices pursuing direct investment and investing in PE and VC as an asset class, there is less known on the performance of this strategy and specific tactics for doing it effectively.
On December 1st, 2021, the Koch Center at Washington University in St. Louis convened a session focused on family office direct investment strategies, exploring everything from seed to venture growth to private equity and mature companies. Given that much of this investment in the private market occurs through venture capital and private equity funds, we also discussed the performance of this asset class.
The first of a broader series on Family Investment and Impact, this session was moderated by Koch Professor of Practice for Family Enterprise, Peter Boumgarden. The panelists included Scott Wilson, the Chief Investment Officer of the Washington University Investment Management Companies, and Brent Beshore, the Founder and CEO of Permanent Equity. While neither runs a family office, each was able to speak of their work and its implications on the family office and investment space more broadly.
Below we outline a few critical takeaways from this session, the first of three in the 2021-22 Olin Family Investment and Impact Series.
1. The Differential Expertise, Resources, and Goals for Direct Investment
In the 2021 Goldman Sachs report, the two most common family offices goals were capital appreciation and wealth preservation. So, it stands to reason, which of the two is most likely to drive the increasing direct investment footprint?
While some growth of direct investment could be in service of wealth preservation by investing exposure to asset classes less correlated with the rest of the portfolio, many families seem to search for returns seemingly not possible in a more diversified index-like approach. However, achieving desired returns requires having the capability to make such investments effectively. After all, a series of non-successful direct investments can quickly dilute capital that took a long-time to appreciate.
Both Scott Wilson and Brent Beshore highlighted the challenges of doing this work well. In particular, Scott referenced that their team might make one-tenth of one percent of the potential investments that come across their plate, thus approximating a 1 to 1,000 ratio of investment opportunities to closed deals. Therefore, much of his team’s work is spent assessing investment opportunities that never come to pass, a process that is quite time intensive. Brent highlighted a similar selection process for his team to make 2-3 deals in a given year.
Many families, especially under the $1B threshold, attempt to make these decisions with a limited staff allocation– at best, a fractal CIO, and often no surrounding team. This resourcing results in a deck that is easily stacked against the office achieving its goal of capital growth and even undermining the other important objective of wealth preservation.
2. Acknowledging (and Addressing) the Negative Selection Bias
Beyond the challenges of picking winners, both Beshore and Wilson highlighted a challenge with many family offices and university endowments– that of negative selection bias.
Put another way, if a university endowment or family office is less likely to be seen as providing the same kind of value-add support as other potential investors, it stands fair to reason that many family offices do not hear about a potential deal until after it has been passed over by “smarter” money. Recalling the advice of a previous mentor, Brent framed this as you never want to take an oil deal coming out of Texas, given how many other investors have already passed on the opportunity.
Building upon the previous mathematics, if a private equity investment fund with a strong reputation is likely to see 1,000 deals before making one investment, a family office with a similar quantity of opportunities is unlikely to have the same high-quality deal flow. As such, you might expect a need to see even more potential deals than the hypothetical 1,000 to identify a high-quality investment opportunity. This adverse selection bias only further exacerbates the direct investment challenge.
3. The Direct Investment Risk of Recent VC and PE Growth
While some family offices invest directly in an early stage or turn-around company as a part of their approach, many instead invest indirectly through a VC or PE fund. If the challenge of direct investment is picking a winning company, the related challenge with venture or private equity is understanding the evolving performance of this broader asset class.
One challenge for these two asset classes is specific to the increasing multiples paid at the acquisition point. A recent Bain & Company report found that nearly 2/3rds of PE deals are paying multiples of 11x EBITDA in 2020/21, a number that was less than 10% as recent as the mid-2000s. Another study by Pitchbook found a similar growth in valuations of early-stage ventures.
Opining on such trends, Brent expressed skepticism that such valuations were warranted. While one could make a case that the growth of venture valuations is justified if and when technology enables a categorically different kind of scale and resulting downstream exit, Brent argued that this is a more challenging case to make in sectors that lack such enabling technology.
Furthermore, Brent saw some portion of the growth in multiples due to investors applying a logic that works in one part of the market to another where it doesn’t fit. This mismatch between mentality and market leads to significant capital chasing opportunities in sectors where investors lack relevant expertise. For example, Brent and his team have seen several investors come into the middle market and pay multiples far beyond what his team has done historically and perhaps beyond what is prudent for the investment space. For Brent’s team, the challenge is diligence in maintaining rigor in not letting the market get away from their investment approach.
In response to these trends, Scott expressed some concern about the current valuations within this space and suggested his team has moved a good bit of their portfolio out of traditional private equity. In addition to Brent’s broader point, Scott identified a concern that much of the stated investment in venture or PE could be found on paper but perhaps not actualized gains.
4. Assessing the the Investor & Portfolio Design
When deciding to invest in either venture capital or private equity, Scott argued that teams should rigorously assess the portfolio of any given investor, asking whether they agree with the operationalized investment approach. Similar to the work required to engage in direct investment successfully, this strategy requires a good deal of time and resources.
Recent work by Paul Gompers, Steve Kaplan, and others has explored the investment approaches of private equity and venture capital investors, research covered during the session and shown below. At a high level, the authors found venture investors spend more time assessing the team, and PE investors invest more based on the company’s financial fundamentals and look to add value to the revenue side. While not necessarily indicating which strategy is optimal, such a framework provides ways of assessing the investor’s underlying mental model of valuation creation. It also provides a method of determining whether an investor aligns with the investor thesis of others in the portfolio.
Another broader strategy highlighted by Scott Wilson was his team’s approach toward greater concentration. While on the face of it, increased concentration might appear to be a movement away from diversification. That said, Scott was quick to highlight how diversifying across a set of partners can result in a portfolio that functions much like an index fund would, but with the unfortunate fee structure of an active management model.
In contrast, by diversifying across a smaller set of managers, the team can better assess the investment risk to reward ratio of underlying investments under the manager and pay attention to how any given investment impacts the risk balance of the portfolio. Furthermore, in being more concentrated, the group can build a lower fee structure across all managers in the collective. For family offices more broadly, the critical item is to ensure the underlying diversification strategy does not merely end up canceling its return potential.
5. Constructing, Leveraging, and Learning from a Network of Partners
Both Scott and Brent highlighted the importance of a robust network of co-investors and partners for effective direct investment. Specific to this symposium, Brent and Scott themselves represented an example of a deep partnership, with the WashU endowment being the largest investor in the recent Permanent Equity fund. For Brent, having a trusted partner in their investor allowed them to explain their distinctive investment approach, buying and holding companies for cash contribution the shorter-term hold of many PE funds.
In this interview and others (see below), Brent has argued how a network of partners provides access to significant learning and co-investment opportunities. Embedded long-term relationships both across investors and between inventors and managers can provide sources of new ideas, insights, opportunities for shared diligence, and broader education. As such, as one attendee of the virtual event, Koch Center Executive in Residence Spencer Burke, noted, this “makes your organization bigger by multiples at no cost—but requires long-termism and loyalty, something few have.”
For a family fund, one potential benefit of long-term partners is the possible expanded expertise that these other family offices or funds bring to the table. In the case of investing in a PE or VC fund and then doing a side deal with a company in their portfolio, such partnerships reduce the evaluation expertise required. This strategy puts the focal evaluation on the point of PE or VC managers while retaining the secondary ability to allocate the fund in different proportions if the family thinks there is a unique opportunity in play.
For Scott and his team, their network within a university helps extend the expertise they can bring to bear on a given investment opportunity. These partners can be funds they learn from or scientists whose research dovetails with an investment opportunity. This capability is one that few family offices have built-in naturally, but perhaps provides a way of articulating an aspirational model built over time in a family fund.
6. Building Capability Over Time by Building on Strengths
A number of the trends identified above suggest that family offices should be wary of direct investment. In particular, the negative selection bias at the point of deal flow would mean that the potential pool of private investments for many family offices likely lags that of the professional firm, thus making it even more challenging to pick winners. Furthermore, effectively evaluating opportunities requires time and expertise that many family offices lack, even those that are quite large in size.
That said, if one does go in this direction, one particular recommendation highlighted by Brent is the importance of starting small in this work. In some ways, given how Permanent Equity is in some ways akin to a family office organized around direct investment that eventually professionalized by taking on external capital, it would be disingenuous for Brent to suggest one should never pursue this work. Brent’s recommendation, however, was to focus on the expertise they have embedded in the family as a resource to build a strategy around.
For example, this might be market experience within a particular vertical, for instance, or a network based on previous work that provides unique and valuable deal flow. Scott also highlighted hesitation for smaller family offices but was more open when an individual or family had a distinct market advantage that was not present for other professional models. The critical thing for families attempting to do this work is to be highly discerning when it comes to the inward look of determining if the skill is, in fact, there as they hope.