Direct Investment: The Latest Family Office Trend
Single-family offices currently account for more than $2.4 trillion in investable capital, according to Family Capital, making them sizable competition to the private-equity industry.1 Over the past five years the trend in this capital base has been toward direct investing. Historically, family offices have focused on fund investments. The 2008 downturn negatively impacted those allocations. Driven by poor performance, high fee structures, and a lack of transparency, family offices increasingly have allocated away from private-equity funds and toward direct investing. The projected future low-return environment for traditional private equity groups has further fueled this interest.
The Direct Investing Environment
Direct investing can be described generally as a private investment in real estate, operating businesses (growth capital or leveraged buyouts), venture capital, and direct lending. Each asset class brings with it a different risk-return profile and requires a broadly skilled investment team. These asset classes historically have been dominated by private-equity funds. As an increasing number of families monetized their assets during the 2000s, there has been a proliferation of family offices that are beginning to become a force in the direct market and competition for traditional private-equity funds. In addition, traditional registered investment advisors are seeing more interest from clients in this alternative asset class and are finding it challenging to access and vet transaction flow for them.
Why Are Families Entering This Market?
Jeff Rupp, president and managing director of View Capital in Dallas, shared his thoughts on why family offices are entering the market. “Over the last five years people have become more leery of the big funds and have attempted to make their own investment decisions,” Rupp said. “I think that the trend is people attempting to manage their own private-equity investments versus going with co-mingled vehicles.”
In addition to poor performance by private- equity funds, desire for more transparency and dissatisfaction with fee structures have led family offices to become increasingly attracted to the sector. Control is a major factor in this trend, Rupp said.
“Private equity is viewed as a sexy business because families believe that they can utilize control to affect a better outcome—the key is having the right tool kit to execute,” Rupp said. “The key question is whether or not the returns will be as good as if you went with a financial manager.”
Indeed, two key considerations—transparency and fees—compelled the Vinik Family Office (VFO) to develop a direct-investment program, said Noam Abrams, who works as vice president for VFO. “We like to know what we are investing in,” Abrams said.
“We like to know where our money is going. Why pay a substantial management fee and carry for something that you don’t know? We believe that we can get better alignment doing one-off deals.”
Others start direct-investing programs as a means to educate the next-generation client families about risk-adjusted investing, according to Ryan Cortner, a principal at the Clearwell Group. “We believe that there is a moral imperative to teach family members how to take smart risk and expose them to the portfolio companies so that they can understand the dynamics of both entrepreneurship and investing. We want to build a family of businesses and continue legacies started by great family entrepreneurs.”
Another dynamic that has caused Clearwell to use more direct investing is what appears to be a trend in the private-equity fund market. It seems that the deployment of capital from a fund perspective has not accelerated, but the cycle of raising funds has, Cortner said, and going more “direct” leads to more transparency and control.
Challenges to Entering the Direct-Investment Market
A number of challenges face the family office seeking to do direct investing. These include portfolio strategy, staffing, deal sourcing, deal execution, competition, defining the investment process, and asset management. Many family offices prefer to maintain small professional staffs. As a result of the inherent intensive nature of the direct-deal business, these offices tend to struggle with the asset class. For example, deal sourcing can be a full-time job. If the family office is thinly staffed, then once a deal is sourced, the staff must turn its attention to diligence and execution, causing the sourcing process to grind to a halt. Similarly, once the deal is complete, it is necessary for staff to manage the investments and reporting. Again, without adequate infrastructure, this can put a significant strain on the office, particularly when the investments are performing sub-par and require additional attention.
Family offices also face challenges through competition with existing private-equity funds. Most funds have well-developed infrastructure with significant staff. This infrastructure can give them a substantial advantage over a family office with a smaller staff. It will enable them to execute the transaction more quickly, which can be a major selling point for a deal that is being marketed by a broker or an investment banker.
As Abrams put it: “There is a lot of competition from private-equity funds and very high prices are being paid for large, mature buyouts. There are many players bidding up prices.”
According to Cortner, another challenge facing family offices is defining investment parameters. A well-thought-out investment thesis coupled with stringent investment criteria helps mitigate the challenge of family members “lobbing bunnies over the fence for one to chase,” he said. “We support high integrity entrepreneurs when we believe a business can generate a positive impact in addition to investment returns.”
Initial Entry into the Market
As a result of these challenges, a number of family offices enter the direct market through baby steps. This entails seeking co-investment opportunities with funds where they have existing relationships. Co-investments enable the family office to leverage the work of the fund’s staff, they provide transparent transactions, and they generally have lower fee structures than the traditional 2-percent management fee and 20-percent carried interest that is the industry standard.
The independent-sponsor model is another vehicle that has emerged for family offices. Independent sponsors are individuals with either industry or private-equity experience, who identify and put under contract single deals and then seek financial groups to provide funding. They often provide family offices with industry expertise or increased deal flow.
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Anna Maria Nekoranec is the chief executive officer and co-founder of Align Private Capital, LLC, which provides tailored private-equity solutions to families. She is the co-author of How to Buy a Business: Entrepreneurship through Acquisition. She earned a BA from the University of Virginia and an MBA from The Wharton School, University of Pennsylvania. Contact her at [email protected].
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