Industry experts discuss family offices’ growing willingness to cut out the middle man and invest in private deals without an intermediary.
In spite of most affluent individuals creating wealth through entrepreneurial endeavors of their own, family offices have historically been reluctant to take investments into their own hands through private placements. In recent years, however, a number of economic and industry environment factors have driven an uptick in direct investing that shows no sign of slowing.
Jolyne Caruso, CEO of New York-based The Alberleen Group, which connects family offices with direct investing opportunities, attributes this change in part to the less-than-desirable performance of other investment opportunities. “We saw a pick-up, starting post-2008, in direct investing mostly attributable to the weak performance of hedge funds and PE funds,” Caruso says. She points out that family offices have become less enthusiastic about hedge funds and private equity due to high fees, clawbacks and lack of liquidity.
Charles Lowenhaupt, founder of St. Louis multi– family office Lowenhaupt Global Advisors, agrees. “Yes, I am seeing increasing interest in direct investments worldwide,” Lowenhaupt says, adding that he would qualify that information by stating that most high-net-worth individuals (HNWIs) made their business through a type of direct investing, namely a family business.
He points out that a family that has had a business of its own for some time may find it “more instinctual and easier” to perform due diligence on a direct investment than on products that are being sold by private bankers or fund managers.
Axial, a New York-based platform for online deal sourcing, points to two more reasons for this shift in investment strategy. The firm, which provided PAM with data that indicates family office activity is in– creasing, says: “First, there is an interest in investing in areas and connecting to businesses in the industry that led to the establishment of a family office. The investor benefits from staying connected to a field of interest, and the business owner benefits from the expertise of an industry leader. Second, family offices are changing to improve the visibility and impact on the business execution of their strategy.”
Axial reported that family offices are not only increasingly joining its network, but there is a rise in activity from these offices, both in expressing interest in deals by sharing their investment mandates, as well as contacting companies to pursue business opportunities from other network members. The average number of companies contacted by family office clients increased to 20 in 2013 from six in 2011. Not only are family offices seeking companies for investments, but the company said it is seeing family offices bring opportunities to market: 29 in 2012, 40 in 2013 and 29 in 2014 so far.
SOME DEAL SECTORS GROW
The types of direct deals that families are doing are varied, though there are some clear standouts. Caruso has seen some families interested in investment in direct deals to address socially responsible or impact investing, particularly in the sectors of alternative energy, agriculture and biotech. “They’ll say: ‘I can invest in a project that will generate a strong economic return, but at the same time, I’m doing something good,’” she says.
Caruso notes that many of her clients at The Alberleen Group have expressed interest in deals that generate consistent cash flow, such as real estate or bridge financings. “If a family can invest in a company, or specific project where they can get their money back in one to two years or get some cash flow along the way, we see interest in these types of deals,” she adds.
Michael Felman, president of global multi-family office MSF Capital Advisors, agrees that real estate deals are often attractive due to their familiarity. “If somebody is going to start doing direct investing in– stead of [investing] through funds, real estate is usually the first place to start,” he says. “You see some type of real estate holding in almost every wealthy family, even if that’s not their main expertise.”
Another related type of deal that Lowenhaupt highlights is farmland investing, which can boost family values and educate the next generation in the basics of business, while bringing relatives together. “If you’re really talking long-term, a piece of farm– land has historically been a superb long-term investment [for a family],” he says. “It can help define [the family’s] place geographically and historically…and reinforces value and community.”
PRIVATE DEAL CHALLENGES
Once a family office decides to pursue a private deal, it is only the beginning of a longer journey. One frequent roadblock for families once they decide that they are, in fact, interested in direct investing, is access to quality deals, as they “have never been on the radar of Wall Street or bankers,” Caruso says. These deals were often brought to PE funds and then sold to investors via funds.
Caruso sees three challenges to the direct investing paradigm, including limited access to quality deals, having the resources to perform the due diligence and the ongoing monitoring once the investment has been made. She says: “Finding quality deals where you are investing in quality management teams is not easy…Second, it’s a question of [as a family office], how do you do the due diligence? It’s overwhelming and it’s different than assessing a fund…Then, it’s the ongoing monitoring. When you do five of these investments, how do you keep [track] of them? Somebody has to have a board seat and be actively monitoring the investment.”
She elaborated on some of the monitoring difficulties that direct investing can present, as private companies do not have the same stringent reporting requirements that public companies have. A limited liability company, for example, only has to provide reporting to investors once per year through a K-1, while other company structures can vary. “With a private, direct deal, you are really beholden to a management team to get you the reporting on time and make sure that it’s accurate,” she adds.
Felman notes: “With direct investing, there is more work that you may or may not have to do. When you invest [with] a manager, it’s not only them finding the deal, or finding something to invest in. The manager monitors that on a constant basis. If you’re doing a direct deal, you either have to do it yourself, or find somebody else to do it. It takes more work than just calling a manager on a monthly or a quarterly basis. There is definitely more work, and it all depends on what the trade– offs are for the family.”
When discussing the downsides of direct investing, Lowenhaupt says these types of investments can often be extremely illiquid. He cautions that family offices that make a direct capital investment should be sure they have enough cash on hand to tend to their needs. “I’ve seen family offices [that didn’t make sure that] all their cash needs [were] going to be met and that can create a crunch, which is hurtful,” he says.
Another pause for families that Lowenhaupt red flags is “due diligence, which I don’t think is as difficult as [performing due diligence on] the financially manufactured stuff but is more difficult than [doing so on] a portfolio of stocks and bonds”. He continues: “Another is a family member’s willingness to get involved. If you don’t have family members that want to be engaged in a business, it might be difficult to [invest directly].” The choice of how much a family wants to be involved once the money has been handed over is purely theirs, Caruso says. Some families want control positions so they can have an active role, while others are much more comfortable having a passive investment with a minority stake in the company, she notes, adding there is also interest among families to work together as part of a “club deal” to invest in these direct investments.
THINGS TO LOOK FOR
Marino Marin, managing principal of 1055 Partners, an affiliate of MLV & Co., says the company looks for investing opportunities that provide capital preservation, yield and returns when investing. The New York company works with family offices and, among other things, facilitates partnerships with private equity backers to co-invest directly in deals, both on equal footing. He says: “One thing that doesn’t work is say you have a $25m deal, ‘passing the hat’, [and] raising money [for an investment], because no one is going to manage it.”
Marin says the firm maintains a strict and aggressive vetting process for its deals, adding that it is crucial for direct investing opportunities to have an exclusive angle, a thesis and a good management team in place of the business. He says that family offices looking to enter this type of investing should avoid “pass-the-hat deals,” and instead try to partner with private equity and invest in growing sectors.
Marin adds that once a direct investing opportunity has been identified, the structure of the deal is important. “It’s not just about the right deal, or the right price for the deal, but also about the right terms and conditions,” he says.
Felman highlights the importance of looking at track records of those involved, risk controls and the management team before proceeding with a direct deal. He says the process mirrors that of vetting a fund manager. “It really is no different. When you look at a direct investment, you’re really just bypassing one step. The measure that you would use to decide if you’re going to make that [direct] investment is re– ally not that much different. You should be asking the same questions.”
In spite of an initial reluctance to doing bigger deals directly, family offices seem increasingly open to making private investments without a fund serving as an intermediary. Caruso describes it as “kind of a new wave”, saying families have an interest in allocating to directs as part of their alternative asset allocation. “I believe that this trend will continue over the next five, 10 years, [and] it’s going to become more prominent.”