The author of this item takes a look at the current much-touted trend of family offices investing directly in business.
As noted by Family Wealth Report - and by those speaking at our events in New York and elsewhere - family offices are becoming more interested in direct investing and in private capital. (See this report here, for example.) With returns in some conventional assets unenticing in a low-rate environment, such interest is understandable. A question may be what may happen if or when there is a market reverse or economic slowdown, or if some of these new strategies become overcrowded in a rush to a “new thing”.
With such considerations in mind, Michael Slemmer, chief operating officer, Americas, at FundCount, takes a look at how family office investing is evolving. As always, the editors of this news service are pleased to share such insights with readers and invite responses. They don’t necessarily share all views of guest contributors. Email firstname.lastname@example.org
The family office world can be a secretive bunch. Keeping a low profile is not unusual when millions - or billions - of dollars are involved. What is less of a secret, however, is the family office’s growing appetite for private equity, particularly through direct investment.
Soured by underperformance in hedge funds over the last several years, family offices turned to private equity for its non-correlated diversification and promise of greater returns. But that did little to take the bite out of the standard 2 and 20 per cent fee structure the funds charged. Direct investing, which includes private investments in real estate and operating businesses, buying distressed debt, financing startups and getting involved directly in other ventures, neutralizes those fees and has been providing superior returns.
According to a study by Family Office Exchange, a peer-to-peer industry network, direct investment represented 7 percent of a family offices’ approximate 12 per cent allocation to private equity funds at the end of 2016. With direct investment returns in 2016 averaging 8% versus 6% for private equity, it’s no surprise that nearly 60 per cent of family offices expect to increase their direct investments in the next two years.
Not just about fees
Family offices can save millions of dollars in fees and carried interest by going direct and “cutting out” the private equity firm middleman, or by negotiating more favorable terms as a co-investor alongside the general partner. While side stepping high fees is a significant reason for the interest in direct investment, it is not the only fuel feeding the trend.
The goal of a family office is to preserve and grow wealth for generations to come and to do so in the most tax efficient way possible. Investment decisions are not dictated by short-term market movements or time-frame limits. This long-term mindset is out of step with a private equity fund’s typical five- to seven-year hold period. But, it aligns well with direct investing, which enables the family to hold an investment for as long as it sees fit. And, unlike private equity firms, family offices don’t need to continually raise capital so they can ride out market gyrations without investors breathing down their necks.
In addition to controlling timing, direct investing provides transparency. By hand-picking its own investment opportunities rather than going in on a blind-pool fund, the family knows exactly how its money is being used. And, since the family can impact decisions, there is a greater opportunity to deliver value, particularly where the family’s expertise in technology, finance, operations, real estate or another industry can be leveraged.
A new strategy for investment firms
Private equity firms have taken note of family offices’ growing interest in direct investing. Greater competition for dry powder - not just from family offices, but from pension funds, insurance companies and hedge funds - has made it harder to source deals. As a result, private equity and investment management firms are reaching out to family offices as co-investors. They are restructuring fees and adjusting timeframes to meet the longer-term goals of the family.
A more favorable fee structure is likely to entice family offices as it contributes to stronger performance results. Plus, co-investing saves time on deal sourcing, due diligence, and accounting and legal review, all of which are undertaken by the private equity firm.
In spite of the benefits, some families prefer full control and would rather seek their own opportunities.
It’s a family affair
Going direct isn’t as daunting as it once was. The internet and web-based investment marketplaces like Palico or matching services such as Axial and AngelList provide a wealth of information that makes it easier than ever to research and source investment opportunities and connect with like-minded parties.
And families aren’t necessarily investing on their own. They are networking and partnering with other wealthy families on a range of deals. Collaborating on a deal in an industry sector in which a family’s wealth was accumulated brings great expertise to the table and can significantly mitigate risk.
The growing number of family offices involved in direct investing has sparked a demand for investment professionals with proven hedge fund and private equity experience. The good news is that qualified managers are out there. However, family offices are realizing they must adjust their compensation structure to attract and retain high-caliber talent. It seems to be working as an increasing number of investment professionals are leaving high-powered jobs at private equity and hedge fund firms to join a family office.
According to the 2017 FOX Global Investment Survey, 81 per cent of family offices employ at least one full-time person to source and evaluate direct investments. More than half of the respondents said they had two or more people dedicated to direct deals.
In addition to hiring investment personnel, direct investing in private equity-type deals requires top-notch tax and regulatory advisors. Family offices are also finding that they need institutional-quality infrastructure and systems to support the complex accounting and reporting that they are now managing directly.
Here to stay
Direct investing is not a death knell for private equity and hedge funds. Family offices are simply fine-tuning – and diversifying - their investment allocations in response to market forces and an opportunistic landscape. Nonetheless, with an estimated wealth of $3-$4 trillion globally and growing, family offices are a force to be reckoned with and one that will certainly impact the investment marketplace for the foreseeable future.