After seeing vast sums of their wealth disappear in the financial collapse of 2008, family enterprises have been increasingly turning to direct investments to grow their assets.
Families are also making an effort to exert more control over the companies that they invest in, with more and more of these direct investments involving a significant or controlling interest. As a result, family enterprises have entered a playing field previously reserved for strategic acquirers and financial investors such as venture capital funds, private equity funds and hedge funds.
Single-family offices increased their allocations to direct investments—both private companies and real estate—from an average of 6% of portfolio value in 2009 to an average of 11% in 2012, according to a recent study by the Wharton Global Family Alliance.
Families have used different forms of direct investing for many years. From the Rockefeller family office, which dates to the 1880s, to Bill Gates’ investment vehicle, Cascade Investment LLC, family offices and family-controlled investment vehicles have been leading investors in companies such as Waste Management Inc. and Berkshire Hathaway. Many other families have acted as “angel investors,” investing relatively small amounts of capital in companies at an earlier stage than even venture capital funds have been willing to, or going into industries where other investors fear to tread.
Direct investing these days generally means a family investor, either an individual or more typically a family office or family-controlled investment vehicle, invests directly in a privately held company. The investment can be in a passive minority share, in common or preferred stock, or in a significant or controlling interest, which typically would be in the form of a highly negotiated preferred stock instrument. This instrument often includes control or veto rights, as well as representation on the company’s board of directors.
Of course, high-net-worth investors have long invested indirectly in operating companies through venture capital, private equity and hedge funds. But as institutional investors flocked to these alternative investments, wealthy individuals and families became a smaller percentage of these funds’ limited partners. When the 2008 recession hit, some of these family investors became disillusioned by the illiquidity, performance and costs of these funds. This has led to an increasing number of family investors investing directly in operating entities.
Regulatory changes have helped spur this movement.
In 2011, the Securities and Exchange Commission eliminated the investment advisor registration exemption for many collective investment structures, but preserved the family office exemption. This means virtually all investment advisors must register with the SEC and publicly reveal their investment portfolio. Family office investments, however, retain their shield of privacy. This regulatory change has led private investors—including notable figures such as George Soros—to stop investing for others and instead to invest directly through their family offices.
Direct investing has several benefits for family investors: It allows a family to concentrate in its areas of expertise or interest; it permits entrepreneurs who have built businesses to mentor a new generation of business owners, as well as the next generation of their families; and it offers an opportunity to shape companies not offered by outside funds. In addition, direct investing allows a family to structure transactions creatively, in a manner that may be more sensitive to the family’s estate planning, taxes and governance.
To be sure, most family funds lack the advantages of private equity funds—name recognition, an LP network and, most important, a track record. But hiring away a successful manager from a well-regarded private equity fund can help overcome the reputation gap, and a prominent family backer can be a bigger advantage than the name recognition and networking connections of all but the best-known funds.
Families that are contemplating implementing a direct investing strategy should be aware of its potential pitfalls, because direct investing is not for the faint at heart. There are certain issues that families contemplating a direct investment strategy should consider:
1. Competing for opportunities. In the competition for deals, family investors often compete with private equity, venture capital and hedge funds, many of which have been in business for years. In addition to having the advantages of experience, these funds also have access to deal flow, which means that family investors may not be offered the best investment opportunities, at least until they’ve established a track record and a network of referral sources.
2. Competing for talent. Families will also compete for the topflight talent needed to implement a direct investment strategy. It was once difficult to lure a young manager away from the promise of riches offered by even a mid-market private equity fund. But the recent recession reduced or at least delayed returns for many managers, and the prospect of raising the next fund has become even more daunting. In this environment, a well-funded single source of capital has become a more attractive alternative, and more private equity professionals than ever have migrated to family investment vehicles. But family investors should note that, even with these changes, the allure of the funds remains strong.
3. Devil in the details. Direct investing requires working in the trenches. From deal sourcing, due diligence and deal execution to follow-on investments, exit strategies and liquidity events, direct investing requires a dedication of resources and a deep understanding of business, legal and accounting considerations, as well as a knowledge of market terms.
4. Corporate governance challenges. Direct investing generally includes a seat on a company’s board of directors. In addition to understanding the fiduciary obligations of a board member, a controlling investor should be aware of the potential liability if he is deemed a de facto member of the company’s management team.
5. Reputational concerns. Families, especially those active in philanthropy or community affairs, must be aware of the potential risks to a family’s reputation if a company controlled by the family receives negative publicity. These risks can be mitigated, but not necessarily eliminated, by thoughtful governance provisions.
One mistake families contemplating direct investing must avoid is reliance on advisors without experience in complex transactions. Angel investments and most other early stage venture investments typically have fairly simple debt or preferred equity structures. As transactions grow in size, advisors’ familiarity with the complex structures employed by the most sophisticated private equity funds is often the difference between winning and losing a deal. Even after a deal is won, the way an investment is structured—from the legal, tax and accounting perspectives, taking into account the family’s estate planning and taxes—can determine whether the investment is a success or a failure. As a result, sophisticated advisors, particularly those with experience representing family enterprises in complex transactions, are crucial to a successful direct investment strategy.
Despite these challenges, direct investing remains an attractive opportunity for committed, well-financed family enterprises. In fact, family investors can have several advantages when competing for deals and talent:
Many families engage in direct investing in areas they’re familiar with; often these are areas related to the business in which the family accumulated its wealth. This expertise can give a family an advantage in spotting opportunities and differentiate the family enterprise from competing funds.
Fewer Structural Constraints
Family investors can set themselves apart from private funds in ways that appeal to investment targets. Unlike private equity funds, family enterprises are not required to exit within the typical three to five years. Often, the family includes a former operator-entrepreneur whose story may resonate with a company’s founders. Lastly, the family fund generally doesn’t have the structural constraints found at many funds: for example, limits on how much can be invested in one investment, governance and information requirements, or restrictions and limitations on certain investment areas.
No Fund Fees
There’s no doubt that establishing the infrastructure for a direct-investment portfolio is expensive. But many families have found that being free of the usual 2%/20% fund fee allows the family to tailor its direct investment platform to its tax and estate planning needs. Family resources, such as a family office or an operating business, can be utilized to increase efficiency. In the long term, this flexibility should result in reduced costs and increased investment returns.
Families have for many years accessed networks of other family investors for co-investment opportunities, and as families increasingly take the lead in executing transactions these networks will prove invaluable. Many family enterprises looking to increase their involvement in direct investing have already developed networks for sourcing and analyzing deals, and have access to a network of capital, which helps close the gap between the family enterprise’s resources and those of well-established funds.
Direct investing permits a family to be directly involved in the growth and success of entrepreneurial businesses—to directly impact and be involved in the management of its portfolio companies. In addition to keeping family members who have accumulated or are managing family wealth in touch with current technologies and financing structures, direct investing also presents families with the opportunity to provide the next generation with management and board-level experience.
Building the infrastructure of talent, deal flow and processes necessary for a serious commitment to direct investing requires a focused effort and dedication of resources. But for families who are willing to make the commitment and stay the course, direct investing can be a fascinating and profitable component of a family’s overall investment portfolio.
Helen R. Friedli, Mark Selinger and Jake Townsend, partners in the law firm McDermott Will & Emery, advise family offices and family investment funds in all aspects of their business, including direct investments, financings and exit transactions.