Most industries and business models eventually go
through some form of maturation, consolidation, or structural change as the
industry has more entrants and as profits for the early entrants and rule
makers start to decline. A maturing
market directs participants to squeeze profitability or yield in different
ways. For a product-based company, for
example, outsourcing product development and manufacturing, or going from a
distribution to a direct sales model, are possible maneuvers.
If one looks at the current availability of private capital through fund structures chasing high priced deals and looking for yield, “outsourcing” or “going direct” models are each impacting the LP base. A day does not go by when deal creators and deal participants are not inundated with emails and calls from service providers and event organizers touting their access to family offices, limited partner events, and trade publications targeting private capital providers. The email blasts give the impression that the “anonymous LPs” are emerging from the shadows to invest directly in their own deals.
While we should not view these events as shocking, or representative of the end of committed capital styled private equity funds, some LPs are become more involved and asking questions of GPs. Ultimately, do the market dynamics and supply of cash in the private capital markets make chasing yield worth it for a family office LP to invest directly? With any smart allocation of wealth, why not have multiple options that include investing as an LP through a fund and direct investing?
Why and How for the Family Office
The family office structure, and role of Chief Investment Officer within it, will impact the need and participation in the deals. If capital must be deployed to meet objectives, acting outside of a fund could be the best approach. Historically, most CIOs put the walls up and limit outside opportunities. The CIO and wealth management and preservation functions are often risk-averse in both strategy and execution. This is contradictory to the family office founders who probably made their wealth through risk taking and business investing. Bridging these behavioral characteristics is the key. Both the founders/creators of the wealth and the ones charged with preserving it need to consider:
- How much of the investment allocation should come from direct investing?
- Which infrastructure is/will be put in place to source, vet, execute and manage investments?
- What is the degree of comfort to be more visible in the marketplace?
Investment committee transformation is a sensible first step. This is critical to answer the question of why this investment versus another. The discipline also limits costs in chasing and putting time into investments that simply do not fit. A traditional CIO and Family Office Leader can chair such a committee. The balance of the committee would be the investment and deal professionals. Another emerging approach to the governance is to keep managed investment account leaders separated and not in the direct investment decision group. Both strategies provide options to achieve return and enhanced yield, but both have different timelines, requirements for third party providers and different commitments to post investment monitoring.
The direct investing CIO also has the added role of considering if an exit from a long ownership or day to day leadership is needed. Unlike a PE fund there is no timeline for sale. Rather sales are delayed and put off due to governance, legacy and non-financial performance reasons. Assessment of all direct investments as a majority or minority owner should be fully assessed a parallel path. Some investments may not be performing as expected, fit has changed, the industry is out of current favor as an investment and the opportunity cost to deploy elsewhere can be fully considered.
Direct Investing also has requirements for skills and talent that may not be resident in the Family Office in the short term. In addition to a specialized CIO for such investments the need for an Investment Process Coordinator and Leader can emerge.
Quickly needs and roles emerge in the areas of:
- External Marketing Messaging
- Event Marketing and Deal Sourcing
- Diligence and Deal Execution
- Post Close board development
- Post close investment monitoring and reporting
- Human Capital issues internal and external to Family Office
These roles can be addressed in a hybrid model of internal and external resources. However, an internal leader acting as “Program Manager” with the direct invest CIO will allow the direct investment sub steps to be executed and become more professionalized. This part of the Family Office must begin to look like a lean Private Equity firm within a family office that also has the need for new governance and separation of critical strategic thinking.
What family offices need to do
- Establish a visible presence and strong message to the PE community that communicates that they want to be majority or minority co-investors outside or inside the current funds they are in.
- Become a well-known resource of capital to the growing pledge fund and independent sponsor community. This community loves to say they have family office money and evergreen access to capital.
- Become more closely aligned with active visible family office investors. Pick up the phone and call them. The family office club approach is a way to push money, maintain anonymity, and consider new options to push money.
- As new, smaller funds emerge, an LP can have more sway on fees, greater visibility in the fund, and use their family office club as a feeder to a new fund. All parties win here.
Yield or model change
While the chasing yield argument makes sense as fund returns continue to outpace the S&P500, the returns are not what they were. Perhaps the larger driver is that the 2/20 model is having challenges. The market is driving the funds to pay more per company, to use more business development resources, and to have longer holds. These factors are all contributing to reduce IRR. Market maturation and LPs wanting more control over the outcome will not disappear. The issue now is how many family office and other private capital providers wish to fund and organize along the functional lines of a PE fund in order to boost return and perhaps benchmark against the market they currently invest it.
Direct sourcing is brutal, a numbers game, and moves quickly. The family office will need to consider how to develop an infrastructure with the functions needed to increase the probability of success. Discussions should also center on not having the CIO at the top of this function for the family office.
Aligning with experienced operators in the spaces they invest in will allow easy transition of ownership. Investors can board sit and guide rather than manage hands-on. This may deliver the longer-term benefit of being able to harvest deal and investment opportunities from the executive stable.