Direct Investing and Family Offices

The world's wealth is at an all-time high, and many wealthy families use the family office structure (FO) to organize. Over the past decade, global family offices have multiplied tenfold. Family offices have grown in society and the private capital markets. This article examines the family office's increased direct private equity investing.

In summary:

• Private equity asset class is growing;
• family offices are increasing 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; and various family direct investing models are emerging.

Trend

Private equity (PE) asset class growth is well-documented. PE fundraising in North America rose from $90 billion in 2009 to $350 billion in 2019, and global PE "dry powder" is $1.4 trillion (Source: McKinsey Global Private Markets Review 2020). Large institutional investors have driven this growth as limited partners, while family offices have made less of a difference. This passive approach at the fund level has shown the return and other benefits of private equity and encouraged family offices to look into direct investing.

In 2019, family offices invested 16% of their portfolio in private equity, with over half in direct investing (Source: UBS Global Family Office Report 2020). Over 65% of newly founded family offices make direct investments, up from 40% in 2000. (Source: FINTRX 2020 Report). Clear trajectory.

Rationale

The following factors have caused a shift from passive PE fund investing in directing investing in recent years:

1. Capitalize on family businesses' entrepreneurial and "business building" instincts.
2. Investment and management freedom.
3. Cost transparency and control.
4. Co-investing with like-minded families.
5. Enhanced liquidity management.

Strategy

Family investors, especially "NexGen," benefit from having a clear strategy that considers their resources and goals, such as financial returns, control, diversification, impact, and education.

Families should also consider where they fall on the spectrum, from hands-on operators controlling the business to active or passive investors to asset allocators. This outlook will impact the family's strategy and execution.

One family may acquire and operate companies as "corporate M&A" add-ons to a core operating company where management, back-office operations, and control are centralized. Other families may invest directly in decentralized companies with control or minority stakes.

Private equity is competitive due to abundant "dry powder." Families should also "play to their strengths" and take advantage of their unique advantages. One or more of these could be operational or industry knowledge, a relevant network, or knowledge from the family business. When going after family-owned businesses, investors backed by a family office can position themselves as "kindred spirits" to investors who want to do deals. Families should ask themselves, “Where can we be relevant and add value?”

According to Peter Drucker, "strategy is a commodity, execution is an art," so how can a family-directed PE strategy be executed?

Family-Directed PE Models

Passive limited partner (LP) investments in private equity funds require fewer human resources than direct investments. Models have emerged as family office groups invest directly. No family model fits all; it should reflect strategy, resources, and goals.

Lean and opportunistic

Many groups make "one-off" direct investments using their staff's finance, accounting, and tax skills but lack PE investment expertise. Direct PE investments are reactive rather than proactive, and deal flow can come from business brokers, other families, friends, and private banking relationships. The family office may do high-level due diligence and then rely on the source of the investment and partners to do more due diligence and carry out the plan.

"I started approving one or two direct investments, and years later suddenly realized that I had stakes in over 15 private companies," said a family office principal. "That isn't easy. ” Families often find that they can't keep track of and manage a large pool of assets that aren't liquid and are spread out over different places and industries with extra profits and management resources. What started as curiosity and a desire to make much money can turn into a confusing web of different holdings that need attention but may not have enough information, money, investment expertise, or control rights to succeed.

In-House Team

A larger FO may want to build an in-house team and act as a single LP to their captive fund. This strategy requires a FO to put much money into direct assets with high fixed costs and variable deal-related costs. With a focus on FO alignment, in-house teams are incentivized and paid like PE fund professionals. Some larger FOs use outside capital to manage funds after proving themselves.

In-house strategies try to "lead" investments and do the specialized tasks needed to make them as successful as possible. As was said above, families who lead private equity deals must compete with more prominent players and set themselves apart. Families have a longer time horizon than PE funds, which must invest quickly.

Hybrid Outsourcing

Hybrid solutions fall between A and B. Most FO groups cannot afford an in-house team but want direct exposure. FOs with LP stakes in PE funds can negotiate rights to co-invest directly. "LP co-invests" may reduce fees and boost returns by leveraging a larger company's resources. FO groups may allocate capital to direct investments and fund an outsourced manager's overhead. The FO invests at its discretion, unlike a PE fund obligation.

With this model, the FO can have a say in how the portfolio is put together without paying for a fixed team. The outsourced manager aligns with the FO and earns most of his/her compensation on the back end. Many outsourced managers work with multiple FOs. Risk and cost-sharing, intelligence, and deal flow are benefits. Disclosure and potential conflicts of interest must be resolved transparently.

This model can offer attractive "one-off" opportunities with pledge funds and independent sponsors. This is what we do at Infinity; we seek to become the family office's right-hand team in real estate investing.

Infinity's Solution

We remove three barriers to entry: specialized knowledge, time commitment, and network.

1. Knowledge

Choosing an alternative investment is a difficult task. Understanding the deal, where the money is in the capital stack, and how it will be used requires specialized knowledge. The more alternative the opportunity, the more technical knowledge it necessitates. A person who is an expert in office assets, for example, is different from someone who is an expert in hospitality assets, venture capital, or private equity.

2. Resources/Time

To find the right deal, we may look at over 100. How do you know which is superior to the other? We have implemented a proprietary algorithm to compare and contrast "apples to apples." Also, we use private equity standards for due diligence and underwriting, which require expertise and knowledge of the local market. Finally, for every deal, we always stress test for the worst-case scenario, reducing the potential risk for our investors.

3. Network

To get the top 100 deals to analyze, you must first have them sent to you. All of our transactions are off-the-market, private, and confidential. We provide access to deal flow that is usually limited to family and friends and reserved for a small group of people because the sponsors of these deals are very picky about whom they accept funding from. Also, we choose an investment because we trust and know the person who is behind it.

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