One Key to Successful Direct Investments

A few months ago, we had a $1B+ single family office that we are working with come speak at one of our family office workshops in New York. They showed case studies of businesses they had purchased and the over 1,000 patents that they now hold, and shared how they come up with new ideas and access deal flow. This family office is 100% vertically integrated: They can source or come up with an idea, prototype the product, bring it to market, get mass consumer distribution for it, and keep it long-term as a revenue generator, or sell it off to a major conglomerate such as Proctor & Gamble.

This single family office understands its core competencies and is careful not to stray from those strengths. If you look at the best investors in the world, they often stick to what they know. Warren Buffett, for example, has long-espoused the philosophy of maintaining a “circle of competence.” The circle encompasses the areas within which you have a firm understanding and experience. Mr. Buffett was pilloried in the press and by investors for failing to join in on the tech bubble and invest in soaring tech companies. Instead of giving in and investing in the hot stocks of the time, Mr. Buffett preferred to wait on the sidelines. He knew that he lacked a full understanding of internet businesses and believed an investment in them would be too far outside his circle of competence. Mr. Buffett was rewarded for his prudent patience as the bubble burst and many once-rising stocks were driven to the ground as investors realized the companies were overvalued and revenues were weak or non-existent.

Mr. Buffett continues to make a killing by investing within his circle of competence. His commitment to staying inside that circle has made a compelling argument for sticking with what you know. The so-called Wizard of Omaha told University of Florida MBA students in 2007, “Everybody’s got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.”

For family offices, staying within your circle of competence enables you to invest confidently. For example, one family I know well has committed capital to pre-revenue companies that may appear very risky to outside observers. However, the family office team has exceptional experience developing companies and products by prototyping, developing, and bringing to market consumer mass market products. Because they are operating only within their niche, the investments do not feel as risky as they might to someone who has less experience in the consumer goods space.

Of course, no one is right 100% of the time, and family offices that have made many direct investments in the industry have probably suffered through a few bad investments along the way. However, what separates the strong investor from the weak is the former’s commitment to investing in what he knows and understands, rather than chasing returns in a hot market or a new company outside his circle of competence. By investing in companies that they understand and can capably evaluate, some very focused family offices have been able to achieve a solid batting average of good investments, even if every single investment isn’t a home run.