For most family offices, engaging in direct investment PE deals really means finding the right partner, and the diligence required to find the right PE partner for direct deals is much more involved, and probably less of a metric-based exercise than selecting a good asset manager.
There is much talk among family office circles these days about making direct investments in private equity (PE) transactions and, in particular, direct investments in PE control buyouts and growth transactions. The rising interest in ‘going direct’ can be traced back to the wake of the most recent financial crisis, when a number of trends converged on the family office community. As inflows of institutional capital to alternative and illiquid fund strategies dried up, more managers began focusing on the family office community in their capital-raising activities.
Established managers sought to diversify their limited partner base, and emerging managers, many without any ability to attract institutional capital, began designing fund vehicles with the family office investor in mind. At the same time, the stress placed on investment banks and PE firms resulting from the lack of deal flow and tighter credit markets resulted in a large migration of investment banker professionals and PE professionals into the independent PE sponsor model. Independent PE sponsors have long viewed family offices as a valued source of capital. The amount of people looking for family office capital rose dramatically.
The professional conference industry, always mindful of these types of developments, responded with a proliferation of conferences focused on the family office space that has since provided an effective medium for the message that family offices should be expecting more from their allocations to PE — less fees, some ability to engage in deal selection, better control rights and, most importantly, better returns.
Many very large family offices have been engaged in the direct investing game for a while, and many have formed their own PE groups. We believe that, for midsize and smaller family offices, the movement toward ‘going direct’ has been slow but steady. For many family offices, direct investments are a matter of curiosity and interest but not the within the realm of an actionable strategy. They probably have made some level of illiquid investments in the past, with mixed results. They do not have the capabilities to originate, execute or monitor and manage a direct PE investment. At the same time, they value some level of anonymity — they do not want deal guys beating at their doors with teasers. They want to know how other family offices are approaching direct investment.
For family offices, investment decisions often revolve around choosing good asset managers. Family offices generally have experience and tools available to assist in choosing fund managers. For most family offices, engaging in direct investment PE deals really means finding the right partner, and the diligence required to find the right PE partner for direct deals is much more involved, and probably less of a metric-based exercise than selecting a good asset manager.
We have seen family offices adopt a few different models for ‘going direct’. The first model involves being part of a network. The network can be informal, e.g. pass the hat, or something more structured, like a pledge fund. Under this model, a family office is receptive to being part of a network that an independent sponsor can tap into when raising capital for a deal. This is a low commitment model and allows a family office to build a track record with an independent sponsor. Another model involves expanding the family office infrastructure to include one or more PE professionals. Obviously, this involves a much higher degree of commitment to direct investing.
We see a growing number of independent sponsors that are still ’independent’ but that are fairly reliant on one family office as their equity partner. In these arrangements, family offices feel that they have someone committed to their direct investment mandate, without having to increase their internal infrastructure. At the same time, an independent sponsor will have a more reliable source of capital, and there is less herding of cats needed to close a transaction, as well as a funding source that could serve as an anchor investor once an independent sponsor has built a successful enough track record to launch a committed fund.
How does a family office find the right partner to do direct deals with, whether that person is brought in house or not? First, a family office needs to understand its set of capabilities and its investment profile with respect to a direct investment program. Does the family have experience running businesses? Does the family intend to take an active role on the board of acquired companies? Does the family view itself as truly patient capital, and how much does it value current return? Second, in the same way that a family office would conduct diligence on a fund manager, a family office needs to conduct diligence on its direct investment professional, with a view toward understanding their skill set and experience in sourcing deals and operating companies. For example, much of the benefit of “going direct” is based on the fundamentals of PE investing in lower-middle-market companies, i.e., companies that can be bought at lower multiples and that are not being operated to their full potential. These companies often lack decent financial reporting and controls and come with various other challenges. Lower-middle-market PE deals require a certain set of skills, and a family office investor may not have the opportunity to know whether an independent sponsor has these skills until they are actually involved in a deal with them.
Despite the challenges for many family offices in making direct investments, we encourage family offices to consider going direct. We see a lot of great PE deals getting done every year that are backed by family offices, and we expect the number of families offices engaged in direct investing to continue to grow. There are a number of forces that will continue to contribute to this trend, including the growing number of lower-middle-market family-owned businesses in need of an exit or succession.
This article was published in the August 13, 2015 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG).
John A. Rogers is a partner in the Corporate and Securities Practice Group of Pepper Hamilton LLP, resident in the New York office. Mr. Rogers engages in a broad range of private equity, venture capital and hedge fund transactional matters, including acquisitions and divestitures, investments, joint ventures, financings, restructurings and CLOs.
Pepper Hamilton LLP is a multi-practice law firm with more than 500 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world. For more information, please visit the website at www.pepperlaw.com.