After the gold rush: Family offices approach tech investing with caution

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Opportunity may be knocking for intrepid investors in technology. But a big dose of caution is also required, whether it’s for public equities or private venture capital funds.

“Markets were so frothy in early 2021, when everything shifted toward companies that could dictate more favourable terms from investors,” says Spencer Clark, portfolio manager and senior client relationship manager at Richter Family Office in Montreal.

“But that has gone the other way now. Capital is not free, and it’s a little bit scarcer from investors.”

Gone are the days of tech stocks fuelled by low interest rates, though companies affiliated with artificial intelligence (AI) have soared in recent months on the hype surrounding generative AI, such as ChatGPT, he adds.

As well, valuations for venture capital (VC) funds specializing in finding and investing in the next big thing have also come back to earth. Globally, VC funding fell 53 per cent year over year in the first quarter of 2023, according to Crunchbase.

Even before the interest rate hikes started in March last year, many family offices had scaled back their exposure in both publicly traded technology companies and venture capital funds on the private side, recognizing the coming change of tides.

“We would say that we were probably neutral-to-cautious for VC by late 2020 when valuations were already very high,” says Arthur Diochon, director and head of alternatives research at BMO Private Wealth in Toronto, which provides guidance to family office clients on investing in VC.

Today, however, far fewer “tourist” investors are chasing high returns in VC like they were in late 2020 and throughout 2021. “They’ve been flushed out, and so valuations are starting to rationalize,” he adds.

Now, some family-office money managers see a “blood in the streets” moment for VC, Diochon adds.

Yet today, the focus is much less on the hot themes of VC such as AI, blockchain and cloud computing. Instead, capital is flowing into VCs with the best track records, he says.

“That’s because the best managers tend to get a disproportionate amount of access to the best deals,” he adds.

Investors also have more clout than before. They are able to secure more favourable terms, such as liquidation preferences offering the right to get back their money back — if not more like two times their investment — if a company in the VC fund is sold, Clark says.

“The only exception to that these days is AI, where there is still a little bit of frothiness,” he says.

Even there, Clark notes, some strategies for investing in private companies — either directly as an angel investor or through VC funds — involve looking for profitable use cases where AI tech can improve business operations.

“Of interest would be a company developing AI technology for financial services or insurance, where they’re using it to improve underwriting,” he adds.

Other previously hot areas of tech — blockchain, software as a service (SAAS), the metaverse and cloud computing — are offering more attractive valuations than a year or two ago. That does not mean, however, that VC offerings focused on these companies are sure things, says Thane Stenner, senior portfolio manager with Stenner Wealth Partners+ at CG Wealth Management in Vancouver.

“With VC, it’s like wine vintages,” he says, noting capital raises for companies in late 2020 and 2021 had high valuations, making them in retrospect not ideal investments. “So even though there are great opportunities now in the space, the danger is you could be taking over somebody else’s problems.”

Significant due diligence is obviously needed given the nature of early-stage tech companies, Clark notes. “You want to ensure the potential for high returns is worth the higher level of risk.”

Typically, family offices, with their large portfolios, are able to take on the risk. Also, many are contrarian, entering beaten-up sectors when other investors are fearful, which describes VC investing, which is focused mostly on early-stage technology and biotech.

Even still, family offices generally understand that only a fraction of investments in a VC fund’s portfolio will be very successful, generating most of the returns, Diochon says.

“It’s referred to as the ‘power law,’ meaning if you invest in 10 companies and one of them is a 10X [10 times multiples return] and the others lose money, you’re still flat,” he says.

Of course, the goal with VC funds is to find one or two companies among 10 investments that are wildly successful, resulting in high multiples that far outweigh losses on other investments.

That’s likely easier today than it was two years ago, when many private tech companies were raising capital at high valuations, making it more difficult for winning investments to drive overall returns on capital, Diochon says.

“If you have an environment where you get one 10X in every five companies, that’s great because you then double your money,” he says. “But if that goes to one in 20 companies, like it was two years ago, profitability in a VC becomes much more challenging.”

For publicly traded tech companies, the environment remains challenging as larger firms — Nvidia Corp., for instance — are already arguably overvalued based on their AI exposure, Stenner says.

“We’ve been taking profits on the tech side, reducing risk in that area,” he adds. “When you have massive gains relating to a trend, the smart money takes chips off the table.”

Among the publicly traded technology stocks that are of interest to family offices are China’s internet tech companies, which have been beaten up over the past two years.

“The Chinese government really dampened technology investing by putting those companies under review,” Stenner says. That crackdown has largely ended. “So that would be an area of tech where I am somewhat bullish,” he says, noting that many trade below 10 times earnings.

Patient money can find opportunities in technology today, whether it’s public or private investment, Clark says.

“When it comes to tech for family offices willing to take a prudent approach, 2023 could turn out to be a very good year to deploy capital,” he says. Investing in those opportunities today, at lower valuations than just a few years ago, could end up being very profitable “five to seven years down the road.”

More from Canadian Family Offices:

• If you want to leave Canada (and its taxes) behind, prepare for a very long goodbye
• Canso CEO John Carswell on the allure and risks of private markets
• The beer-brewing family who lost it all

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