For most of the past two decades, private equity (PE) funds have had only two types of competition: strategic investors and each other. Special purpose acquisition companies, business development companies and hedge fund side pockets all emerged during this period, but none have really challenged the primacy of PE funds. In the past few years, however, a new form of competitor has emerged: their own limited partners (LPs). To be more specific, the threat is coming from high net worth (HNW) families that used to form the backbone of many PE funds, before institutional money came pouring in.
This is the group that, in the late 2000s, several PE funds shunned, either explicitly or by raising minimum investment requirements. The recession, however, changed the financial landscape and PE funds faced new challenges. The drying up of credit for two years slowed exits to a trickle and created barriers to executing PE’s favoured leveraged buyout model. LPs were still required to pay the yearly management fee, but were not seeing their cash being put to work, or any consistent return on their investments. The illiquid nature of PE investments and the restrictions on transfer began to rankle at least some HNW investors. Perhaps contrary to expectation, these investors did not shy away from the sector. Indeed, in the period post-2008, many HNW families upped the allocation to alternative assets in their investment portfolios, confident that the difficult financial conditions could throw up fruitful investment opportunities. There was, however, a need to diversify and, unhappy with the PE funds, the answer for some was to go it alone.
The rise of the family fund
Though many HNW families had made direct investments in the past or had co-invested alongside PE funds, making a commitment to investing directly requires a different level of infrastructure and a high-grade team, neither of which comes cheaply or easily. Bringing these activities in-house typically means overhead costs in excess of US$1.5 million a year, making it a feasible prospect only for those HNW families with an asset base of US$100 million or more, or those who club together to gain economies of scale. In the past, there was no way to lure a young manager away from the promises of riches offered by a PE fund, but, especially in the mid-market, the recession created a significant shift in the expectations of managers. Many saw less potential in carry, facing frustrating restrictions on their investment activities and the prospect of fundraising in a daunting market. In this environment, a well-funded, single source of capital, coupled with the freedom and flexibility to invest creatively became all the more attractive.
Meanwhile, PE funds were becoming less competitive. Where credit was available, lenders were cautious, requiring extensive diligence and making the acquisition process cumbersome and uncertain, as well as offering, at times, unattractive pricing. The traditional model became redundant, and the PE funds had to rethink their strategy. In being forced to change, PE funds have become more comfortable with writing large, up-front equity cheques and looking at ways of creating value in their portfolio companies, rather than relying on financial engineering to generate returns. That said, deal flow remains slow.
PE funds are also restricted by the strict investment criteria on which they are mandated by their LPs (e.g., in terms of asset grade, structure, sector and geography) and these constraints have led to PE funds competing against each other for the most attractive assets. Given the flexibility afforded by the structure of their private funds, HNW families are best advised to sidestep this battle, and many do just that, concentrating their efforts elsewhere to good effect and finding that opportunities are plentiful.
HNW families are often prepared to accept a greater degree of risk than PE funds in terms of sector and stage of investment. This places them in a good position to look at industries, geographies and deal structures considered too exotic or risky for PE funds. This can be seen clearly in Europe, for example, where family offices have been, and are predicted to continue to be, prevalent investors in technology development and pre-operational assets (e.g., clean tech), plugging the funding gap left by venture capital departing the sector in favour of “safer” assets and locked-in value. HNW families typically take a longer term view, with a focus on building capital value rather than securing a rapid return on their investments. Likewise, in territories such as Africa, where there is a significant need for growth capital, PE funds tend to struggle to accommodate founders’ reluctance to part with equity or relinquish control. Here, HNW families can differentiate themselves, offering up flexibility in the form of debt instruments with simple downside protection mechanics.
No two families are the same
Not all HNW families operate in the same way; there is no standard investment strategy. Instead, a variety of approaches and attitudes are taken by family offices operating at different stages of development and serving the investment profiles of different numbers of family members. Small family offices with fewer family members tend to be more nimble, as they have a leaner decision-making process and often look to add value by getting actively involved in the management of their investments. This in itself can be an attractive attribute for a company looking for investment, particularly where it sees synergies with the family’s existing businesses and an opportunity to leverage off the family’s reputation and network.
Larger family offices operate investment vehicles that look to the outside world much like PE funds, but the stories these family funds tell prospective investee companies differentiates them from PE funds. For example, there is no requirement to look to exit within the three to five years usual for a PE investment. In addition, the head of the family fund is often a former operator-entrepreneur, whose story may sound familiar to many founders. Lastly, the family fund operates outside the constraints of financial regulation and without the structural constraints included in many PE fund documents.
Family funds do lack some things that successful PE funds have: name recognition, an LP network and, most important, a track record. These drawbacks can, however, be overcome. Hiring a successful manager from a well-regarded PE fund can help minimize the track record obstacle, and a prominent family backer can outweigh the name recognition and networking connections of all but the best-known PE funds.
Family funds are still in their infancy, and there’s no doubt there will be missteps along the way. As PE funds survey the competitive landscape, however, they will likely find that the seat next to them at the bidding table is filled not by another PE fund or strategic investor, but by a family fund with deep pockets and a growing appetite for deals.
Mark Davis is a partner based in the Firm’s London office. Mark’s practice focuses on cross-border leveraged buyouts and exits. He also has a wide range of experience in private equity and other M&A transactions and has represented a number of the largest buy-out funds in Europe and the United States in connection with complex cross-border deals.
Mark Selinger is a partner based in the Firm’s New York office. Mark represents family offices and investment funds in all aspects of their direct investing activities, including initial and follow-on investments, restructurings and exit transactions. He also represents fund portfolio companies in commercial and transactional matters.
Eleanor West is an associate based in the Firm’s London office. Her practice focuses on UK and international private equity investments and buy-out transactions, acting for both institutions and management teams.
Reprinted with permission from McDermott, Will & Emery, International News, Issue 3, 2012. For more information, please visit www.mwe.com.