Direct investing strategies for family offices
Family offices have traditionally focused on passive investments, allocating capital to funds and sponsors in a limited partner (LP) capacity. For those raising capital, family offices were often viewed as the most desired investor base because of the meaningful size of their checks, which often came with few strings attached. In recent years, this dynamic has changed materially. As family offices have become more seasoned and more sophisticated, a passive LP role is no longer the desired structure.
The change has been driven by families’ desire for a more direct role in the management of their investments in order to increase control and net returns. Many families created their wealth from their own privately held businesses, so the role as investors in private companies is a familiar one. For many of these families, direct investing can be an opportunity for an older generation to get back into day-to-day management with younger generations playing integral roles as a shared experience.
These families tend to invest in companies that operate in the same industry as that of the legacy company, or a related industry. This strategy gives them a decided advantage relative to industry-agnostic funds. Families with LP interests in private equity funds generally have not been granted a board seat or otherwise been involved in management of the companies in which the funds invest. Over the years, these investors have begun to question whether the funds are providing value commensurate with the fee structure.
Making direct investments in companies can be difficult for family offices at first. Many will build out a team internally to generate deal flow (receipt of investment proposals) and provide the appropriate operational support to the business. This can often prove to be an inefficient use of time and capital. A phased process with assistance from external advisers can often give the family office staff the opportunity to try out team members without committing long-term capital upfront.
Co-investments and club deals can often be an effective stepping stone. Co-investments involve lower fees and more control than LP interests in private equity funds as well as a layer of day-to day oversight. Club deals, where the family partners with other similarly minded families, are the logical continuation of this process. This structure will reveal more of the potential operational weak points that a family office needs to address by hiring staff or through external partnerships.
As with all investment strategies, the key starting point is to identify the goals of the endeavor. The obvious answer is profit, but there are many other considerations. Is training of a younger generation a driver of the investment? How long will the duration of the investment be? What industry or other features of a company are we targeting? How will the investment fit within the family’s broader portfolio?
Every party to the endeavor must have a clear plan for the direct investment and allocate where the responsibilities for the various aspects will sit. Without goals established beforehand, mission creep can lead a family office down unwanted paths or cause them to waste time on investments that are not properly aligned with the family office strategy. Most family offices decline the vast majority of opportunities that cross their desk. Getting to “no” efficiently pays future dividends.
When seeking out direct investing opportunities, family offices have features that distinguish them from the usual players. Flexibility is one of the main reasons why working with a family office appeals to companies. In contrast to institutional investors like pensions and discretionary funds, family offices are not constrained by very specific mandates. This flexibility enables family offices to work toward the optimal solution for a specific opportunity.
One example of this is family offices’ reputation for providing “patient capital.” This makes family offices more appealing than funds that require an exit in three, five or seven years. as is typical with professional investment funds. However, that competitive advantage should be tempered to align with the family’s total wealth, liquidity and strategic goals across their portfolio.
A family’s history in an industry can also give them a leg up on the competition when chasing deal flow. However, the privacy that many family offices fight so hard to maintain can sometimes be a disadvantage for direct investments. While anonymity is desired, it limits sector name recognition. As mentioned previously, internal infrastructure and controls can often be a weakness of family offices. Many family offices were originally an extension of an operating business that the family controlled. While the accounting, legal and operational functions are likely to have been built out as needed over time, most family offices lack the necessary structures and processes to handle multiple direct investments.
Getting into the game
How do family offices get into the direct investing game? There is no one strategy that fits all; however, the family office must efficiently leverage and grow its network of valuable relationships. Like the oft-quoted real estate phrase “location, location, location,” a critical asset to develop is “deal flow, deal flow, deal flow.”
Any family office will already be in contact with independent sponsors, investment funds and other family offices. Office staff should immediately begin to leverage those relationships in a more organized way. A focus on quantity and quality of investment opportunities is of the highest priority. Certainly, family offices will have a web of experienced professionals, such as lawyers and accountants, but a wise family will seek out advisers who not only provide substantive recommendations but also propose potential deals and provide advice outside the scope of their professional engagement. These counselors should be supplemented with industry partners to perform diligence and sector advice, including insurance and regulatory experts.
Experience proves it is impossible to predict who will introduce the next valuable investment. This approach will allow a family office to gain experience, deploy capital more efficiently, share resources and cement relationships for deals and exit opportunities. This can be tracked in parallel with assessing the speed at which internal resources should be added: to increase talent and expertise in sourcing deal flow, conducting due diligence, negotiating direct investments, analyzing market trends, understanding transaction documents or providing technological support. The conclusion may be that it is too expensive to build out these functions internally. However, it must be noted that more family offices are being formed each year and a higher percentage are actively pursuing direct investing. In order to identify and close quality investments, it’s necessary to establish a formalized approach to business development, proprietary deal flow and analysis of market trends.
Even large, established family offices sometimes lament their perceived lack of deal flow compared with professional investment funds. A direct investing strategy will take time, patience, fortitude and some investment. Yet a family office seeking higher returns and greater control in its corporate equity investments is likely to conclude that a direct investing capability is essential to achieving their goals and a competitive advantage.
William N. Haddad is a partner in Venable LLP’s corporate practice (www.venable.com).