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Exploring the Performance of Family Office Equity Investments

September 6, 2017

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As a result of their successful business careers, many of our clients have accumulated a significant amount of capital. Retaining these earnings in an investment holding company has led to the need to make investment decisions.

Rather than leaving this capital in low-risk marketable securities, clients often choose to invest it in one or more early stage companies. Having a great deal of experience running a business, the ability to identify promising business opportunities and entrepreneurial talent comes as second nature to these individuals.

After holding these investments over the years, clients will often want to take stock of their investments and assess their performance. With that in mind, we decided to base this article on a few basic performance measures that should be considered when evaluating a family office investment portfolio.

Return on Investment (ROI)

ROI is used to measure the rate of profitability of a given investment over time. In its most basic form, ROI is calculated using the following ratio:

Value received (the return)
Amount invested

The ROI formula is widely used in finance and investing as it can be applied to a variety of different investment forms, including an investment in a company, projects within a company, or a personal investment by an individual, including appreciable assets such as real estate.

Importance of measuring total returns

For family office investments, it is important to note that the value received must reflect the total return. This means that both realized returns (i.e., cash dividends) and unrealized returns (i.e., appreciation in the value of the investment itself) need to be considered.

For obvious reasons, measuring the unrealized portion of the total returns is the most challenging part of the equation. This is because it depends upon the existence of a reliable equity valuation being available for the investment. This can be a challenge for private company investments, particularly for early stage technology companies that have not yet matured into stable, dividend-paying investments.

In addition, the unrealized appreciation in value is frequently a more significant portion (and sometimes all) of the total return, because dividends are often deferred while management builds the business.

Adjusting the ROI to an annual return

It is also important to adjust the calculation to show the annual ROI. This is a more relevant measure of performance because it allows you to compare the ROI across different investments.

For example, consider the following scenario:

  • Family office investor makes a $100,000 investment to acquire a 25% stake in a tech company’s shares upon its formation.
  • Over a five-year period, the family office investor receives $50,000 in dividends.
  • The value of the tech company increased by 100% from $400,000 (upon formation) to $800,000 after five years.

Based on these facts, a basic ROI would be calculated as follows:

  • Total return = both realized + unrealized returns = $50,000 (dividends) + $100,000 (unrealized capital appreciation) = $150,000
  • Amount invested = $100,000
  • ROI = $150,000 / $100,000 = 150%

An ROI of 150% sounds very impressive; however, the family office investor took a lot of risk and wants to compare this return to a riskless investment (i.e., a government bond that pays 2%) to see if the premium over the risk-free rate of return was sufficient to compensate for accepting the risk.

In order to do this, you need to express the ROI as an annual rate of return. This requires using a present value analysis, which takes into account the time value of money.

The mechanics of this calculation involves deriving an ROI that results in the present value of total investment returns being exactly equal to the original investment, as illustrated below:

This analysis shows that the family office investor earned an annual ROI of 20.9% on his investment over five years. This represents a premium of 18.9% over the risk-free rate of return, which the investor might consider to be reasonable (but not excessive) given the risks associated with the tech company.  More importantly, the investor now has a performance benchmark with which to compare against other investment opportunities that may arise, possibly having a more attractive ratio of risk vs. reward. This might suggest it’s time to sell the investment and redeploy the capital.

In future blog articles, we will examine other measures of financial performance from different perspectives. This will include the Return on Capital Employed (ROCE), which measures the efficiency with which capital is employed. This can be used by the investors to measure how management (being the stewards of their capital) has performed. For example, is management making capital allocation decisions that generate a return greater than the cost of that capital?

In summary, this article explored how a family office might go about assessing the financial performance of their equity investment, or a portfolio of investments. From our case study, it should be readily apparent that the most important input into the ROI analysis is a reliable estimate of the current fair market value of the investment. Our team at Smythe Advisory has a wealth of experience in valuing early stage companies and would be pleased to discuss how we can assist in this regard.

Please contact any of our Chartered Business Valuators to see how we can help.

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