In our article, How To Start Direct Investing In Your Family Office, we outlined five key success factors that contribute to successful direct investing for family offices: Right Experience, Right Reasons, Right Strategy, Right Team and Right Discipline. So, let’s jump in…what do we mean by Right Experience and Right Reasons?
RIGHT EXPERIENCE :: The family’s ability to successfully execute direct investments in companies based on prior business and investing endeavors.
Family offices that directly invest in companies typically begin in one of three ways:
1. The family is courted by friends and acquaintances to invest in their half-baked start-up ideas. These opportunities come out of the woodwork for families of wealth, and oftentimes neither the family nor the family office professionals have the fortitude to say no.
As you can imagine, this scenario is a recipe for disaster – at least from an investment perspective. These deals rarely involve any sort of due diligence and often lack ongoing fiduciary oversight, all without appropriate communication. Coming back to the well to secure funds to survive the latest “rough patch” often becomes the sole investee interaction.
2. The family or family office has been investing as an LP in VC or PE funds, and they decide to go it alone.
This scenario has mixed results. The biggest mistake I see is that the family and their family office professionals treat direct investments like another financial asset. They expect higher rates of return for their investment dollars, but don’t recognize that direct investments are different from other financial instruments. Direct investors become co-conspirators in the work of the company, and the family may face important decisions about how to intervene when there are problems with the business. Interventions can range from additional investment to help the company buy time to assuming some degree of hands-on management. It can be very difficult to walk away and risk losing an entire investment. It’s even harder if the family considers the potential implications of business failure on employees. Ultimately, these investments can become a huge financial and emotional strain impacting the fabric of the family.
This approach can work – but, it’s harder than it appears. And, both the family and their family office professionals have to get the other four factors right to make up for their lack of experience.
3. The family’s direct investment aligns with the primary driver of the family’s wealth – either in the same industry or a new application of the existing capabilities or technology.
You probably guessed that the Right Experience I recommend relates to this approach – where the family has a right to win based on its prior experience. As the former CIO of a family office with a large portfolio of direct investments pointed out to me, you can’t expect to earn outsized returns unless you’re deeply focused on something you know more about than everybody else. This requires a combination of a significant concentration of resources (investments, talent, etc.) and a strong commitment to the topic.
RIGHT REASONS :: The family office pursues direct investments that include aspirations beyond financial gains.
It bears repeating that direct investments are not simply another asset class of financial investments. Direct investments in companies have broader implications and should include more than financial goals. In my experience, the Right Reasons include two factors:
1. Sophisticated families of wealth establish a Vision, Mission and Values statement to coalesce what is most important to them. It’s crucial the entire family contributes to setting, refining or recommitting to the statement as it serves as the “north star” that guides your family’s decisions and actions. The family office professionals need to understand and embrace them as their “north star” as well. The importance of the Family Vision, Mission and Values increases with every generation and each additional family unit.
2. Even though direct investing shouldn’t be primarily motivated by finances, it remains important to consider financial goals and risk tolerance. The family should assess the financial needs of the family. While direct investment may be a good tool for creating wealth, it is a high-risk (and mediocre at best) way of protecting wealth. If you seek to create wealth through direct investing, you’re more likely to be successful if you invest in areas where the family already has intimate knowledge. However, keep in mind the risk of additional exposure to industries or technologies where the family is already heavily invested.
If you have the Right Experience and the Right Reasons, your family office is well on its way towards profitable direct investing. Look for future posts that go deeper into the other three key success factors – Right Strategy, Right Team and Right Discipline.