Risks (Not) Worth Taking

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Last week on the newsletter, we covered the topic of risk - the possibility of something bad happening. We talked about the subjectivity of risk, such as individuals being differently exposed to certain risks as well as the differences in perceived probability of a risk event. Lastly, we spoke about how I like to categorize risks into four categories through dividing them into specific and general risks as well as hedgeable and non-hedgeable risks.

Admittedly, last week was quite a theoretical exercise. So this week, let’s change that: Let’s talk about risks worth taking, and risks not worth taking. What do I mean by that?

First, risks that are worth taking. Risks for which investors, in my view, receive proper rewards if things go well. ‘Go well’ of course doesn’t mean a guaranteed return: It simply means an attractive risk-reward ratio.

And second, risks that are not worth taking. That might include risks which investors, in my view, are not worth taking at all. But it might also include risks that are hedgeable: In which investors can simply pay to outsource the risk to another party, whether it is through transaction structuring, insurance, or other (market) mechanisms.

As outlined last week, the perceived probabilities and impact of risks are a deeply subjective matter. They are based on my experience as a family officer, and today, as someone advising high-net worth individuals and/or their family offices. Your views and experiences might be different, based on your background, but also based on your personal views. If you have a strong opinion where you think I am wrong, always feel free to let me know.

Risk (Not) Worth Taking #1: Active Management

In What’s Your Alpha, I outlined how investors should go about deciding between ‘Beta’ and ‘Alpha’-oriented investments. My mindset was shaped in my last years working at a family office, where I spent a lot of time developing our approach to various liquid and illiquid asset classes.

In the end, the deciding metric for me was dispersion - the spread between outperforming and underperforming managers relative to the market average. The higher the dispersion, the more it might make sense to try to pursue an Alpha-oriented approach, given that proper manager selection would allow for me to capture this comparably larger share between the average and top-quartile managers.

In public markets, my choice continues to be beta-oriented investing. Here, dispersion is typically limited, as many managers ‘hug the benchmark’ in order to avoid significant tracking error. As a result, there are countless studies outlining that active management through stock selection struggles to generate long-term outperformance, especially after fees. And while managers like to compare their performance to the performance of other managers, they fail to show how much they struggle to perform well relative to a humble index fund. Take the example of an ETF replicating the MSCI All-Country World Index: Over 1-, 3- and 5-year periods, the passive investment outperformed more than half of all global large-cap stock funds. 

Dispersion, and thus the appeal of manager selection, is more present in illiquid markets. I recently wrote about performance dispersion in venture capital: Outlier venture capital funds have historically offered unparalleled returns between 17% and 79% per year. The same applies to private equity, with more ‘modest’ outlier returns of 12,5% to 19% per year (but still 5% to 11,5% over the S&P 500’s return over the relevant period). Things, especially in venture, look equally extreme to the downside, with bottom-quartile managers achieving between returns of +0,3% and minus 22,4% per year. In other words, performance dispersion is extremely large, but that is exactly where active manager selection can pay off handsomely, compensating you for the manager risk you take.

Of course there is no guarantee that an investor will achieve such returns. Sourcing and accessing attractive managers, when you start out, is akin to a full-time job. Also, you can’t just pick one or two managers, you need to build a portfolio of funds, and have to deal with liquidity management and ongoing tax and accounting tasks. But if you are willing to take the risk, and invest the time, things can pay off handsomely. 

Risks (Not) Worth Taking #2: Angel Investing

Given my presence in Berlin, Germany’s tech capital, many of my clients (as well as the two family offices that I worked for) have some sort of tech background, having successfully founded and sold one or multiple start-ups. Hence, it is not surprising that such individuals think about how angel investing (i.e. investing in early-stage start-ups) can fit into their asset allocation. Yet investors that don’t have experience in the world of venture capital might be more skeptical, given the significant loss ratio: As I outlined recently, more than 30% of VC-backed start-ups fail to return the capital invested in them (i.e. a return between 0 and 1x), and more than 22% are complete write-offs (i.e. a 0x return).

In the absence of cases of excess leverage, such cases are somewhat less frequent in other asset classes. But the more time you spend in venture capital, you learn that it is more “feature than bug”. It is the so-called Power Law at play, in which outlier companies generate returns capable of returning capital equal or in excess of the capital invested across the entire portfolio or fund. Individual write-offs aren’t just unlikely. If anything, the absence of write-offs, in venture capital, might imply actually taking too little risk. Said differently: The risk of individual write-offs in venture capital investing is not just a risk worth taking, it’s a necessity.

Of course, proper portfolio construction is just one part of the equation. What else should you keep in mind?

First, there’s the necessity of having high-quality deal flow. To me, one of venture’s key challenges is that its hurdles to entry are so low. Anyone with 50.000€ can start investing in increments of 5-10.000€, and if you tell people you are open for business, you can be sure that investment opportunities will start piling up in your inbox. But of course, there is massive adverse selection: Companies messaging you directly either do so because they don’t know better, and companies that would know better investors likely message you because all of the prior ones turned them down. (Even I’m skeptical when a top-tier serial founder offers me to invest in their company, because I was definitely not their first choice.) Building high-quality deal flow takes time, and is quickly lost if you don’t stay on top of it.

Second, there is the time factor. As mentioned, the hurdles to angel investing are very low, and it’s very easy to get sucked in: Attending events in search of proper deal flow, meeting up with fellow investors, and of course spending time helping your portfolio companies. In the end, returns on your invested capital might be satisfying, perhaps exceeding those of some of the VC funds you invested in. But often, people fail to factor how much time they spend on the asset class, especially as VC typically is a smaller allocation within an overall portfolio given the associated risk. 

I shared my personal experience with VC previously in What’s Your Alpha: In my last family office job, we had great deal flow, and the portfolio overall did really well. But managing the portfolio took up a considerable amount of time, even though the value of our investments (including mark-ups) made up less than 5% of our portfolio. We knew how to tackle portfolio construction, and we had great dealflow, but we didn’t want to increase our allocation to make it worth the effort - and hence, the unfortunate choice was to reduce the amount of new investments, and for me to be more mindful of how I spent time with our portfolio companies.

If you can ensure that all of those factors - proper portfolio construction, access to high-quality deals, and adequate time investment - are a given, the risks associated with angel investing are a risk worth taking for me. But if one of those conditions isn’t present, really reconsider if it's worth the time and effort. A good VC fund of fund, or even a tech ETF, might be the safer route.

Risks (Not) Worth Taking #3: Tax & Legal Risk

Tax and legal questions are almost certainly not the favorite topic of most entrepreneurs. Take the example of a VC investment: They’d happily negotiate the deal terms, and help the founders post-investment with strategic questions - but most certainly, they’d rather not spend time drafting the legal docs. To former bosses and clients, legal documents - especially everyone’s favorite topic of representations & warranties - were at best a boring necessity, and at worst a waste of time and legal fees.

And to a degree, I understand that. Unfortunately, many lawyers and tax advisors are focused more on highlighting problems rather than providing solutions - behavior disliked by many, but especially by entrepreneurs. I had my fair share of phone calls dealing with what even I, as an overly careful family officer, would consider as non-problems, such as properly accounting for 12€ of hospitality expenses, very unlikely data protection questions, and many more. I particularly ‘enjoyed’ situations where dealing with the situation incurred higher professional services fees than the worst-case outcome of the ‘problem’ at hand.

While today taking such ‘risks’ might be laughable to actual risk takers such as (former) entrepreneurs, it is actually a big step for a family officer like me. After all, I am paid to protect my bosses and their wealth, no matter how little the risk. Yet over time, I’ve had to learn how to be more pragmatic here: It might be nice to have the more-than-perfect convertible loan contract or legal structure for a specific situation or start-up, but as with the time investment around VC investing, you start to learn that a perfect contract might be overkill at such an early stage. Companies change their business model, or might simply fail for reasons entirely unrelated to the quality of their contracts. If not mission critical, significant in impact, or easily avoidable, some tax and legal risks might be easier to endure than to hedge.

But that is not always the case, especially when we get to higher-stakes, higher-value matters. Founders and investors might not care about mitigating every single edge case of a shareholder’s agreement for a venture capital investment, especially when they see expensive lawyers racking up hours discussing topics that the actual decision makers (i.e. the founder and VC partners) don’t care about. In the end, like I said, most companies tend to fail for reasons entirely unrelated to the quality of their contracts. But unfortunately, that’s not always the case, and it’s those few cases in which going the extra mile to be protected against somewhat likely risks pays off.

I recently had to write off a portfolio company because of exactly such an issue. In a group of 10+ angel investors, we all forgot to ensure that the company had vesting provisions in place. When things got challenging, one of the founders left - and we had no way to claw back his shares, essentially dooming the company as no VC would be willing to invest in a pre-seed stage company with such significant ‘dead capital’. The co-founder and the investors tried hard to negotiate with the departing founder, but there was no solution to be found, and the company filed for insolvency as they ran out of money. Especially when such risks are ‘hedgeable’ through spending another day and another 1.000€ on lawyers, having such an avoidable risk event occur makes for a painful lesson.

The same principles apply to questions, and risks, around tax. We live in a world of very complicated tax rules (and an even more challenging German tax regime, that I get to deal with on a daily basis), and affluent individuals often enjoy dealing with taxes even less than they do with legal work. In some cases, I’ve learned that taking the tax risk - i.e. not being able to deduct a <100€ as a business expense - might be easier than spending hours trying to figure out a solution.

But unfortunately, it’s the big tax questions - think offshore entities, relocation, and more - where entrepreneurs get creative, and where subpar solutions are incredibly dangerous. Negative rulings or turnouts might not only result in back taxes or legal fees, but might even result in much more harsh treatments, ranging from criminal charges to jail. In The Tax Playbook, I only touched upon such negative consequences superficially, but it is a topic where I seem the highest risk, yet lowest upside, to what are often very affluent individuals: At best, you might save a few more millions in taxes, but it might mean that you have to spend a majority of your time in a Caribbean or Mediterranean ‘tax haven’, and often, such individuals are already so rich that a few more millions don’t change their quality of life at all. At worst, you might have to deal with substantial legal headaches, millions in lawyer fees, or might even face criminal prosecution. I’ve not yet earned millions, and of course I want to save taxes, but from my experience, risk around creative tax structuring is definitely not a risk worth taking to me. (I also don’t find Germany to be a bad jurisdiction tax-wise, but that’s for another article.)

Other Risks (Not) Worth Taking

There are a lot more topics that I could write about. 

There’s creative hedges in liquid and illiquid markets, aka the wonderful world of alternative risk transfer. 

There’s the world of (re-)insurance providing solutions to many insurable risks both in investing and the ‘real world’ - my go-to person for those is my friend Sebastian Urban, who also was an inspiration to this little series. 

And many, many more. If there is a risk that you would love to see covered, let me know and I’d be happy to consider it for a future article. 

For now, I hope that this little series not only gave you a view on what risks I find worth taking, and which ones not - but most importantly, that it opened your eyes to thinking about risk factors as something beyond maximum drawdown and volatility. And that perhaps in your next investment decision, you think about risks a bit more holistically.

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