Running a start-up is like chewing glass and staring into the abyss. After a while, you stop staring, but the glass chewing never ends.”Elon Musk
In the past we have discussed the importance for families thinking with a multi-generational time horizon to continue to take risk to grow the family’s wealth. As we highlighted, given the almost 10% annual hurdle rate required for the family’s wealth to compound at over time, portfolios of public equity and bonds are simply unlikely to compound at high enough rates to keep up.
Of course, this does not mean the family’s immediate destiny is the poor house. Instead, it means that the family has started down the path towards seeing the dissolution of its wealth. Generally that process takes about 3 generations. What happens is that even without a significantly profligate generation, the simple desire of each generation to live at a standard of living consistent with that of their parents enjoyed means the family’s tax (aka distribution rate) on a pool of assets continues to grow. After about 3 generations, that distribution rate can hit 6-8% easily. At that point, the portfolio is unable to take enough risk to grow and enters an accelerated run-off.
The only way to counter this tendency is for the portfolio to continue to grow at strong rates of return over time. To do so, some portion of the assets must be earmarked for higher compounding opportunities – knowing that there will be both winners and losers.
Alternative investments were a generational opportunity from the 1980s to mid-2000s. But with the maturation of both the hedge fund and private equity industries, the available pool of potential returns continues to shrink Hedge funds are now being positioned as fixed income alternatives – especially for arbitrage driven strategies.
Private equity still has the potential to generate strong returns simply from capturing the illiquidity premium vs. public alternatives. That said, with average multiples paid in certain parts of the market cresting into the double digits – lower returns and/or great risk of capital impairment in the event of market volatility seems highly likely. To counter some of this pressure, some families have worked to lower the fees paid for their private equity investments through the use of co-investment opportunities with financial sponsors and/or the pursuit of direct deals – aka cutting out the middle man (the private equity fund themselves).
That said, there remains another path towards growth that families could consider, namely entrepreneurship. There are a host of challenges in pursuing such a path, but today I want to consider the challenge that Elon Musk aluded to in our opening quote.
There is no doubt about it – entrepreneurship is hard. Having started or helped to found 4 companies (and ~10 total ventures including nonprofits), I have found that while building new things is gratifying work, it is also exceptional hard. New entrepreneurs regularly remark to me that they were unaware how emotionally draining the work of building a new company is.
Showing up to chew glass every day take a capacity for suffering that often times in anethmatic for a family of wealth. As Greg Curtis has highlighted in his book, The Stewardship of Wealth (affiliate link) , wealth is a unique resource in its ability to reduce much discomfort and suffering. For many families of means, the development of entrepreneurial capability within future generations of the family necessarily entails the question of finding individuals within the family system with the requisite character capabilities to push through the demanding work of new venture creation.
Entrepreneurship from a place of balance sheet strength can be advantageous. The removal of existential terror can be liberating to the entrepreneurial conscience and provide a place of fertile creativity. That said, the absence of terror can conversely limit the capacity for suffering and prevent the entrepreneur from simply getting the ‘reps’ in necessary to discover product / market fit.
Enterprising families would do well to consider where entrepreneurship fits within their ecosystem. Certainly, there are many technical dimensions to consider – where/how/what to fund. But more key is building the human capital of the family in such a way that it is ready to ‘take the risk’ of new venture formation, as well as develop the character depth required to persevere in the face of the certain obstacles every new enterprise faces.