Global wealth has reached historically high levels, and many wealth-creating families are becoming more organized via the structure du jour: the family office (FO). By some accounts, the number of global family offices has increased tenfold over the past decade. Family offices have assumed more prominent roles across society — and increasingly in the private capital markets. In this two-part series, we explore the family office's increased role in direct private equity investing.
In a nutshell:
• Private equity asset class is growing
• Family offices are growing in number and assets
• More family offices seek direct private equity investments for returns and other goals
• A family's goals and resources will drive its strategy and execution model
• Various family direct investing models are emerging
I. The Trend
The proliferation of the private equity (PE) asset class is a well-documented trend. PE fundraising in North America has grown from approximately $90 billion in 2009 to a record $350 billion in 2019 and global PE “dry powder” stands at an approximate $1.4 trillion (Source: McKinsey Global Private Markets Review 2020). As limited partners, large institutional investors have fueled this growth, while family offices have participated to a lesser degree. This more passive fund-level approach has illuminated the return and other benefits of private equity and, in part, led the family office community to increasingly explore direct investing.
In 2019, family offices allocated an estimated 16% of their investment portfolio to private equity – over half of which was allocated to direct investing (Source: UBS Global Family Office Report 2020). Further, it is estimated that over 65% of recently formed family offices are making direct investments, up from over 40% in 2000 (Source: FINTRX 2020 Report). The trajectory is clear.
II. The Rationale
In the past several years, there has been a noticeable migration from passive PE fund investing to more direct investing, with the following cited as key drivers for this shift:
a. Opportunity to capitalize on entrepreneurial and “business building” instincts of a family enterprise.
b. Increased discretion over investments and management.
c. Better transparency and control of costs and fees.
d. Ability to co-invest with other like-minded families.
e. Improved liquidity management.
III. What's the Strategy?
Family investors benefit from a clear strategy that reflects resources and goals, including financial returns and other factors such as control, diversification, impact and education – especially for the next generation, or “NexGen.”
Families should also consider where they fall on the spectrum from being a hands-on operator controlling the business, to being an active or passive investor, to being an asset allocator. This mindset and approach will affect the family's strategy and ultimate execution plan.
One family may pursue a “corporate M&A” approach in acquiring and operating companies, perhaps as add-ons to a core operating company where management, back-office and control is centralized with the family. Other families may create a direct private equity portfolio of control and/or minority stake investments in diverse companies where management and infrastructure are decentralized.
With the vast pools of “dry powder” available, the private equity market is competitive. In addition to addressing the above-referenced goals, families would be well served to craft a strategy that might “play to their strengths” and capitalize on unique advantages. These could include operational or industry expertise, a relevant network or perhaps the distinctive wisdom derived from owning and managing a family business. When targeting family-owned businesses, family-office-backed investors can position themselves as “kindred spirits” relative to more transaction-minded sources of funding. Families should self-assess and ask, “Where can we be relevant and add value?”
If, as Peter Drucker once noted, “strategy is a commodity, execution is an art,” what are the models by which a family direct PE strategy can be successfully executed?
IV. Family Direct PE Models
Investing as a passive limited partner (LP) in a private equity fund requires human resources, but much less so than executing on a direct investment strategy. As an increasing number of family office groups invest more directly, various models have emerged. There is no “one size fits all,” and a family's model should reflect strategy, available resources and goals.
A. Lean and Opportunistic
Many groups make “one off” direct investments while utilizing the resources of their existing staff, which might include finance, accounting and tax skills, but often lack PE investment acumen and experience. In this model, direct PE investments tend to be more reactive than proactive, and deal flow can derive from several sources, including business brokers, other families, friends and private banking relationships. In these cases, the family office might conduct high-level due diligence and rely on the investment source and/or partners for further due diligence and execution.
As a family office principal stated, “I started out approving one or two direct investments and years later suddenly realized that I had stakes in over 15 different private companies. That's not easy to manage.” This is not an uncommon scenario for families who eventually discover that they are ill-equipped to monitor and manage an illiquid pool of assets, which might span geographies and industries with varying levels of profitability and/or management resources. What might have started as a curiosity and desire to create outsized returns can evolve into a maze of disparate holdings in need of attention but perhaps without the information, resources, investment expertise and governance rights to exert the necessary influence for success.
B. In-House Dedicated Team
A larger single FO may wish to build an in-house team and effectively serve as a single LP to their own captive fund. Typically, an FO taking this approach will allocate a significant amount of financial capital to making direct investments with the associated, and often significant, fixed overhead costs and variable deal-related expenses. An in-house dedicated team is typically incentivized and compensated in a similar manner to PE fund professionals with a heightened emphasis on alignment of interests with the FO. Once a track record is established, some larger FOs have included outside sources of capital to effectively serve as a fund manager.
An in-house approach typically includes the goal of “leading” select investments and performing the specialized tasks required to optimize successful outcomes (these details are explored in Part 2 of this article). In leading PE transactions, families must be prepared to compete against larger players and be able to differentiate themselves as referenced above. Unlike PE funds, which have a defined life and are compelled to invest with a certain velocity, families tend to have a longer time horizon and may not feel the same time pressure to deploy capital. As described by one senior FO professional, “Yes, we can be patient and long-term-oriented, which can be a selling point to a target business. But we do have a cost structure and a mandate to build long-term equity value, so we must be careful to balance patience with delivering returns.”
C. Hybrid Outsourced Solution
Sitting somewhere in between A and B above is a hybrid solution. Most FO groups do not have the resources to allocate to an in-house team, yet wish to gain direct exposure. Some FOs negotiate rights to co-invest directly alongside PE funds in which they have an LP stake. These “LP co-invests” may come with reduced fees and can be an efficient means to improve returns while leveraging the resources of a larger enterprise. Other models include FO groups allocating — but not contractually committing — a certain amount of capital to direct investments and to fund an agreed-upon level of overhead to an outsourced manager. Unlike a PE fund obligation, the FO does not commit to a blind pool and maintains discretion over each investment.
Under this model, the FO can influence the construction of a customized portfolio without incurring the fixed costs of a larger captive team. The outsourced manager is aligned with the FO while earning most of his/her compensation on the back end consistent with the traditional carried interest structure. In many cases, such an outsourced manager works with multiple FOs. This carries certain benefits including risk and cost sharing, enhanced intelligence and deal flow. However, matters of disclosure and potential conflicts of interest must be explored and resolved with full transparency.
Pledge funds and independent sponsor opportunities are a variation of this model and can provide attractive “one-off” opportunities.
There is a common pitfall often underestimated by FOs making direct PE investments: the unexpected need to invest additional follow-on capital. A business may unexpectedly change course and require additional capital (as occurred during the COVID-19 pandemic). If a family allocates a certain amount to a direct PE investment, they should be prepared to fund an additional amount in order to sustain the business – and potentially avoid dilution.
No matter the model for execution, it is important for the FO to define why they are embarking on a direct investment strategy. To purely enhance financial returns of the overall investment portfolio? To diversify away from a core holding? To have an impact on an important cause? To learn about a certain industry?
The following are perspectives from different family office principals:
“We like to invest in what we know and where we can add value.”
“Two of my children are interested in technology, and we are actively pursuing tech-related investments for both the financial return and the learning benefits.”
“Our core business generates significant cash flow, but we need to diversify our holdings. While we have some exposure to the public equity markets, private market investing is more interesting.”
What are the best practices in family direct private equity investing? We will explore that in part 2 of this article.
Molly Simmons is the founder of McFarland Partners, a boutique firm focused on private investments and business strategies, especially for family offices and family-owned enterprises (www.mcfarland-partners.com). Patrick McCloskey is the founder of Aeterna Capital Partners, a family office-backed private investment firm. He also leads a family office affinity group, which shares investment ideas and best practices (www.aeternacp.com).