Portfolio managers’ ongoing thirst for alpha has many firms dipping their toes in the water of technology and healthcare investing
Investing in technology and healthcare opportunities, done properly, represents an opportunity to include a sexy, alpha-generating asset class to a family office portfolio. Done improperly, it represents a dangerous asset class that can rapidly become valued at zero, just as easily as it can deliver 10x returns.
For the family offices and wealth managers that include illiquid healthcare and technology investments in their portfolios, most gain access in one of three ways:
1) Directly investing in technology and healthcare companies that somehow make it to their office.
2) Allocating to a technology/healthcare focused venture fund.
3) Investing in a fund-of-funds vehicle focused on venture capital managers.
And, while each provides exposure to the asset class and great upside potential, all three can deliver unwanted challenges to the investor.
The following paper takes a closer look at the challenges facing family offices, multi-family offices and RIAs attempting to add this asset class to their platform, as well as a few additional opportunities available to portfolio managers looking to make this asset class available to investors.
With most industry prognosticators predicting 4%-5% returns from the public equity markets for the foreseeable future, the price of investment liquidity has reached a level many consider to be too high. Consequently, many portfolio managers have begun to look to the return premium offered by illiquid investments. With many underlying investors developing an appetite and understanding for long-term alternative bets, innovative portfolio managers have increasingly begun to view private equity as a mainstream source of performance alpha. With the appeal and excitement around potentially investing in the next Google, Amazon, Snap or Uber, many portfolio managers are starting to look toward early-stage technology and healthcare opportunities, not just as a source of alpha, but also as a means of firm differentiation amongst the crowded industry of similar multi-family wealth platforms.
The Current State of the Alternative Industry
The competitive landscape of multi-family offices is as fierce as ever. Robo-advisors, firm mergers and government regulations cloud an already crowded road to success. Today there are over 12,000 wealth managers competing for the investment capital of high net worth families. Portfolio managers around the country are declaring the death of the old 60/40 portfolio model, and many of these firms are seeking competitive differentiation via unique access to alternative asset managers and investment vehicles capable of delivering above average performance.
With that in mind, multi-family office portfolio construction is evolving. Many institutionally trained PMs are beginning to construct portfolios comprised of investment strategies capable of capturing the illiquidity premium found in private investments. The investment thesis is to buy cheap beta while capturing performance alpha available in alternatives to offset the dismal performance expected from public equity investing.
The Illiquidity Premium Found in Private Equity is Alive and Well
With private equity consistently outperforming public equity market returns, illiquid strategies have become more and more attractive to portfolio managers, fueling the growing interest in alternative investing amongst family offices and fee-based wealth management firms. Today, family office portfolios are more closely resembling their institutional cousins; pensions, foundations, and endowments. As stated above, many portfolio managers seem to be following the lead of an investment thesis most often credited to long-time Yale Endowment CIA, David Swenson by dialing up portfolio allocations to privately managed investments in an effort to generate alpha. Swenson believes the most viable roadmap to long-term performance resides in strategies capable of capturing the market premium found in illiquid, private investments and has suggested that portfolios unable to capture liquidity premiums will not be able to keep pace with those that can. According to Preqin, pensions, foundations, family offices, charities, and other investors currently have more than $2.49 trillion allocated to private equity. In return, many of these portfolio managers have been rewarded, with private equity returns delivering an average return of 16.4% over the last three years. And, while economists continue to pile on the dismal results expected from public equity investing, the pressure on wealth managers to generate portfolio alpha will only escalate the “gold-rush” to return opportunities created by illiquidity premiums.
|*Venture Capital data represented by the Cambridge Associates U.S. Venture Capital Index (Net returns)|
|**U.S. Equities data represented by the MSCI Broad Market Index (Gross returns)|
The Appeal of Return Premiums Found in Venture Capital
While many portfolio managers include a stronger mix of private equity strategies in their portfolios, the interest in technology and healthcare focused private equity has also increased. However, with more than 1,224 venture capital funds, representing more than $165 Billion under management, deciding how to access the asset class requires much consideration. In addition to the 124 established funds, today’s market shows more than 225 managers actively raising capital for new funds. On top of that, we haven’t even considered the numerous geography-driven “direct deal” opportunities that continuously seem to attract capital in the backyard of the investor. Simply put, choosing how to add a technology or healthcare flavor to a family office portfolio will require further consideration.
Adding to the challenge of selection, many of the larger, more prominent fund managers that dominate headlines like Sequoia, Kleiner Perkins, Benchmark, and Andreessen Horowitz, are not available (closed) to new investors. While identifying “investor friendly” top-quartile funds is challenging, meeting their investment minimums is yet another challenge, as many have minimum investment requirements that are impractical for non-institutional allocators.
If it is one of the fund vehicles (rather than direct deals) you choose, consideration must be given to vintage year expectations, technology sector, and investment stage focus prior to the process of sorting through available funds. Once available funds are identified, you then must begin the process of determining whether a fund can generate consistent risk-adjusted returns. This will include an in-depth analysis of the firm’s management pedigree, deal flow pipeline, follow-on investment policy, venture ecosystem, and previous track record.
The three most common ways that family offices access technology and healthcare are by investing in direct deals that are brought to them, direct fund investing, or via a fund-of-funds vehicle:
1) Direct Deal Investing | Allocating to technology on a deal-by-deal basis:
- Can be appealing to investors, but they must be able to provide industry resources, as well as expertise to the entrepreneur to better protect their investment;
- Can build deeper ties with investors who may ultimately become future clients of the firm;
- Recognition from deal successes can help attract other tech investors to the firm.
- Represents significant concentration risk;
- Expense of diligence and on-going management of each deal can represent a challenge of bandwidth and expertise for a FO investor;
- Opportunities that become available to this market may have been passed over by the venture community and often lack the sophistication/structure/expertise to attract sophisticated capital and the benefits that come with sophisticated capital, including a developed ecosystem, customer channels, & exit expertise.
2) Single Fund Investing | Allocating to a venture capital fund manager:
- Can leverage the expertise and ecosystem of a sophisticated venture group as well as their unique deal flow;
- If a “brand name” fund, can be an extremely attractive source of differentiation for the MFO to leverage with existing and potential clients.
- Many of the best “household names” in venture are closed to new investors, or have such high minimum investments it can be prohibitive for a HNW family to commit;
- Most venture firms have a very specific focus, which eliminates the safety of strategy diversification;
- Investing in one fund creates a “vintage year” challenge, as well as “market cycle” risk, which can be devastating to long-term performance.
3) Fund of Fund Investing | Allocating to a vehicle made up of various funds:
- Leverage the ecosystem and focused expertise of multiple venture firms;
- Eliminate vintage year, market cycle and strategy concentration risk by investing in multiple managers in different investment stages and fund vintages;
- Provide significant strategy diversification.
- Fee structures are often arduous. Paying double fees to the fund, on top of the fees charged by the MFO, can be extremely unappealing to HNW investors;
- A fund of funds is only as good as the quality of its underlying managers, and many of the best funds and firms will not allow fund of funds to become LPs.
Seeking a Unique Solution
While all three strategies have positive attributes, each also brings challenges that portfolio managers go to great extremes to avoid. Lack of diversification, negative bias (weak managers), or being on the wrong end of a cycle or strategy can wreak havoc on long-term performance. However, while researching the “ins and outs” of each strategy, we continued to come across portfolio managers that had success, in some capacity, with all three. The challenge was to find consistency in accessing any of the three strategies that offered safety of mitigation of the risks discussed above. We went to the market to explore more efficient ways to access this asset class without increasing risk parameters or diluting returns. After significant analysis, we believe we came across two strategies that offered risk mitigated access to technology and healthcare investments, without having to manage against vintage year risk, cycle risk, double fees, negative bias on managers, or dilutive returns by getting to the party too late in the game. The two strategies that seemed to stand out were: 1) Venture Access Funds (Co-Invest Funds), and 2) Venture Secondary Funds. We believe each represents a hybrid approach capable of mitigating many of the challenges associated with direct, single fund, and fund of funds investing, while still providing the kind of return profile often associated with technology and healthcare investing.
Venture Access | Co-Investing with the best and brightest venture managers
This unique strategy is built on the premise that 90% of the best venture-backed companies come from 15% of the best early-stage funds in the venture community. The Venture Access thesis is simple: identify and develop partnerships with the most reputable and highest performing early-stage funds and then co-invest alongside them at later-stage financings. The key success factor seemed to depend on who the firm identified as venture partners. Having anyone that wasn’t a high-quality, brand name venture fund has a negative impact on performance. The strategy may seem simple, but the challenge of developing the relationships is substantial, as when most venture firms are focused on a “hot” deal, they are not willing to give up any piece of it. While the universe of “venture access” managers was a small one, we were able to identify a few firms over time that built significant strategic relationships/partnerships throughout the venture world to replicate this strategy. Among those that stood out the most were two Silicon Valley firms, DAG Ventures (founded in 2004) and Focus Ventures (founded in 1997). Both were positioned similarly in the fact that they were both mid-stage, growth and expansion focused and both had established admirable networks of venture partners throughout Silicon Valley.
Venture Secondary | Acquisition of existing LP positions in select companies and funds
The secondary market is one of the fastest growing sectors of private equity. Secondary investing involves the buying and selling of LP positions in either an entire portfolio or in individual companies. The secondary market has exploded in private equity, with the venture space becoming the latest sector to see a number of large firms enter the game of buying and selling LP positions. The proliferation of the secondary market lowers the risk involved in the asset class by providing investors with a venue for early exit of their illiquid positions, at a discount to Net Asset Value. It also provides investors with an ability to obtain positions in quality assets from sellers that are simply seeking liquidity, as opposed to having a desire to shed unwanted investments. Preqin lists Ardian, Lexington Partners, and Coller Capital as the top secondary firms by funds raised in the last ten years.
Fear drives many investment decisions. We see it continually as the amount of capital invested in corporate and government bonds escalates when uncertainty is present. Today many portfolio managers are being pushed into alternative investing for competitive reasons, not because of choice. The issue is, when a pushed portfolio manager does decide to dip their toe in the water, they do so by allocating to the “well-known” firms for which they can never be criticized. This strategy often benefits no one. The truth is, as private equity investing has grown, the sophistication of pedigreed managers has as well. For those family offices willing to invest the time, which can be significant, to source and diligence emerging managers, there is a reward – identified opportunities with risk mitigating strategies designed to produce above average returns. The result of these efforts is satisfied clients, due to increased portfolio alpha and meaningful differentiation for the firm in the marketplace.
Written by: Joe Worden | Managing Partner | AciesGroup | email@example.com | 4518 N 32nd Street, Phoenix, AZ