In recent years, family offices have shown an escalating interest in alternative assets, a strategy aimed at enhancing returns and bringing diversity to their portfolios. They've delved more deeply into this realm, discovering numerous avenues for capital deployment. Concurrently, many are evaluating how these private investments can elevate their social impact. Navigating these myriad options can be challenging for most family offices without an in-house team possessing the requisite expertise to determine promising opportunities. One area that has proven to be of significant interest, even before the advent of COVID, is the segment of digital health focusing on innovative diagnostics. Family offices prioritizing the impact of private investments should carefully examine this particular segment of the healthcare sector. The most judicious approach involves investing in funds targeting this area. Although family offices have been increasingly keen on direct venture investments, they often fall short in understanding the scientific basis of advanced diagnostic technologies and the rise of personalized medicine. Therefore, many family offices should concentrate on fulfilling the role of Limited Partners (LPs) in venture firms that are setting their sights on the future of medicine and digital health, as this approach could optimize their returns and social impact.
Power of Indirect Investments
The ongoing COVID pandemic illuminates why indirect investments can provide a safer avenue for family offices aiming to preserve capital, especially in sectors with knowledge-related barriers to entry. Grasping the complexities around COVID testing, serological testing, and vaccine timelines is a challenge even for seasoned scientists and medical professionals, let alone investors lacking medicinal and pathological expertise. The Theranos saga underscores how even astute investors can be misled. Beyond the unique aspects of healthcare investing, investing early in the venture capital spectrum often introduces additional hurdles. Compared with investments in established companies, vetting ventures—assessing founders, taking into consideration dilution issues, and understanding the risk-return profile demands a distinct approach to deal diligence and execution. Therefore, family offices intending to invest directly in these burgeoning startups must possess industry-specific knowledge and technical valuation aptitude. Proficiency in market terms, cap table resets, and financial modeling amid high uncertainty are fundamental to venture capital, which might necessitate external consultancy or new in-house hires. This level of expertise suggests that fund investments are the most sensible method of capital allocation in this fast-evolving investment domain. As per a UBS Research Report, out of 360 surveyed family offices, 57% were making venture investments (either directly or through funds). To prudently engage in this area through direct startup investments, family offices should prioritize sectors that align with their primary operating businesses. However, only a meager 6.3% and 1.6% of the surveyed family offices in the UBS report have operating businesses in technology or healthcare/social assistance (see chart below). Not surprisingly, over half of the surveyed family offices originate from traditional sectors like real estate, manufacturing, or finance/insurance. This doesn't imply that most family offices should exclude potential investments outside of their expertise, rather, they should explore them via a specialized venture fund.
Indirect investing not only allows family offices to capitalize on the expertise of sector-focused investors, but it also brings other significant advantages to the table. In the cutthroat world of venture capital, securing a spot in the most attractive deals can pose a formidable challenge. Even when a family office thoroughly understands a specific vertical and agrees on an investment decision, there may not be sufficient space on the cap table for direct involvement. As pointed out by a single family office's CIO in the UBS report, "We appreciate direct investing, but it's challenging to allocate larger amounts there. Committing substantial sums is more feasible at the fund level." While family offices might want to avoid the fees associated with fund investments, the fact remains that indirect investments offer a more streamlined route to gaining access to deals. Certain funds accessible to family offices enjoy proprietary deal flow, derived from their standing or investment history, which could make serving as a Limited Partner particularly rewarding. The exclusivity of such opportunities may even increase in the healthcare investment landscape given the current economic conditions. Digital health investors are likely to be more cautious in their new investments during a recession, while simultaneously supporting their existing portfolio companies. Consequently, capital may converge on fewer deals, intensifying competition for the most promising opportunities. Moreover, a comparison of the average pooled returns of numerous US venture capital firms from 2000–2016 shows 11.73%, significantly lower than the 18.01% average return from 2007–2011, the years during and following the 2007–2008 financial crisis. Coupled with the selective nature of digital health, this trend makes a strong case for considering investments in the sector, regardless of the current economic scenario. Indirect investing also has the added advantage of maintaining a degree of anonymity for the family office, which might not be possible with direct investments. Many family offices understandably seek to avoid the spotlight due to the potential for unwanted attention and an influx of unsolicited requests. As cyber threats rise, maintaining privacy will become ever more critical. Investing as a Limited Partner ensures that the family office does not have to reveal their identity, protecting them from unwarranted scrutiny or demands from entrepreneurs, while still allowing them to share in the potential gains from a venture investment.
Exerting Influence as a Limited Partner
While many family offices value privacy and discretion, there is an increasing trend towards seeking active participation in their investments, especially in early-stage companies they support. This shift is a result of the younger generation taking on major roles in the family offices and the desire to generate meaningful impact through their investments. Millennials, in particular, prefer active involvement over passive capital deployment, leading to an uptick in direct investments by family offices. This could involve acquiring a board seat or gaining direct access to the founder for input. However, being a Limited Partner (LP) does not necessarily negate the possibility of exerting control. A popular approach includes co-investing alongside the fund partners where the family office has already committed capital. In the later stages of growth or traditional private equity, 43% of funds allow for co-investing through sidecar vehicles, a trend that is likely to permeate early-stage investing as well.
Co-investing allows family offices to increase their exposure to a specific portfolio company in a safer manner than through a standard direct investment. It provides an opportunity to gain experience in unfamiliar sectors while leveraging the expertise and access of an experienced capital provider. Furthermore, co-investing affords family offices access to the extensive research and due diligence conducted by the venture firm, offering a level of support that may not be ordinarily available. Even when a venture firm ultimately decides against funding a company, the family office can still utilize the resources from their LP relationship to assess potential direct investments.
A hybrid model, in which family offices contribute to sourcing deals and conducting due diligence while also being an LP, can offer an appealing alternative. Concerns over fee structures can often deter family offices from becoming LPs. However, emerging funds like DigitalDx Ventures, which focuses on AI-powered diagnostics, are more accessible to family offices in terms of financial commitment and feasibility for entry. Moreover, smaller funds often perform better than larger ones, as shown by Preqin’s data sets evaluating average pooled returns across hundreds of funds from 1969–2015. In the diagnostic healthcare space, it is advantageous to align with a specialized team that can leverage growing opportunities.
Intersection of Social Impact and Healthcare Investing
The ongoing global health crisis has undeniably amplified the focus on healthcare investments for numerous family offices, driving a deeper exploration into the intersection of social impact and healthcare. The underrepresented communities of color have borne the brunt of the pandemic, and this stark disparity has not escaped the eye of impact investors. While this surge in healthcare technology investment is a response to the current situation, it builds upon a pre-existing trend of increased capital flow into this sector, outpacing many other traditional sectors watched by venture investors. From 2011 to 2019, annual venture funding in digital health swelled from barely over $1B to a staggering $7.4B (refer to the chart below). Assessing the overall performance of these investments is not straightforward due to inherent delays in calculating venture returns. Yet, the consistent capital influx over the past decade has laid a solid groundwork, enabling data accumulation, business model iteration, and the beginnings of standardized impact measurements relative to health outcomes improvement. This groundwork is crucial as the healthcare venture ecosystem strides into the new decade with high expectations of transforming healthcare service delivery via value-based care, preventative and personalized medicine, and cost-effective care strategies. This solid foundation further testifies that healthcare venture investing represents a promising opportunity for family offices. We can reasonably anticipate that this push for healthcare reformation will gain momentum, drawing impact-focused investors to scrutinize opportunities in the sector more intensively through collaborations with seasoned investors.
Lastly, it is crucial to acknowledge the significance of focusing on startups that consider providers as their primary route to market. This strategy was distinctly observed in the first quarter of 2020, where 63% of all funded digital health firms were selling directly to providers. The concept of social impact aligns with this approach as collaboration with providers is a critical factor in achieving considerable market penetration and maximizing impact. DigitalDx’s portfolio, replete with diagnostic startups, is well-aligned with this approach, positioning it as an attractive partner for family offices exploring LP collaborations.
Concluding Remarks
In recent years, a trend has emerged amongst venture investors to support ventures that show immense promise in the realm of healthcare and technology. Family offices would significantly benefit by funding startups in this continually expanding sector, especially as indirect investors, or more specifically, as Limited Partners (LPs). For a comprehensive analysis on evaluating venture funds, refer to this research paper. As an LP, a family office doesn't have to forego its influence and control. The health and technology sector have intriguing areas such as innovative diagnostic technologies and tailored medicine, which should be the focal points for family offices keen on the convergence of healthcare and social impact. DigitalDx stands out among a myriad of emerging healthcare venture investors, making it worth consideration for family offices drawn to these opportunities.
