For traditional private equity investors, today’s market conditions present challenges in putting their money to work. On the one hand, the amount of investable capital remains plentiful and interest rates remain relatively low. On the other, however, a shortage of quality investments has pushed valuations outside of the consideration set for many investors.
Market conditions are no different for Single Family Offices (SFOs). SFOs that have adopted a co-investment or direct investment model, and that are without a structured acquisition strategy, may be challenged when sourcing and closing quality deals.There are four key reasons why SFOs are adopting co-investment or direct investment models:
- Potential for greater returns when compared to investing as an LP
- Increased transparency
- Loss of interest as a blind pool investor
- Increased control of investments
Although difficult to quantify, the trend toward additional
co-investment and direct investment activities by SFOs could actually be
contributing to the broader acquisition challenges. This is making it
even more difficult to sustain a legacy and fund the needs of the next
generation.However, the following strategies provide you with a few key options to avoid any unnecessary struggle when it comes time to consider investing.
Acquisition Strategies for SFOs
Family offices interested in pursuing a co-investment relationship may want to start with the traditional private equity firms they’ve come to know and trust. Depending on the size of the fund and the size of the allocation, this may be the easiest route to co-investing. SFOs can likely participate as a co-investor in funds with up to $300 million in assets under management. As funds grow in size, and without corresponding increases in allocations, some family offices may not be in a position to co-invest. If an SFO pursues a co-investment relationship with a fund in which they already maintain a Limited Partner (LP) position, they need to be mindful of their increased exposure with that one fund.They should review their governance and investment guidelines before moving forward.
To effectively pursue a co-investment strategy, SFOs should design a rapid response diligence and evaluation process — especially in the case where the SFO does not know the co-investor.
Investing in a fund of funds may prove interesting from a diversification point of view, and it leaves the heavy work to the fund even though it may not provide the control desired. There are trade-offs with the degree of control desired compared to cost and added administration involved in building an infrastructure to support an acquisition process.
Club deals have been a good fit for a long time and may be a more comfortable one for SFOs that have never co-invested. A club deal provides deal access to investments through a lead SFO that may look like, and market itself more like, a traditional private equity fund. Here, the lead SFO shares investment opportunities with a small number of other SFOs to provide the capital needs of the investment. This “investment club” offers a test for the SFO to work with other co-investors and perhaps gain some experience with board sitting, post-close.
Some family offices are enthusiastic about this model and have immediately thrust themselves into the position of lead SFO. But before doing this yourself, you need to proceed with caution and perform proper diligence. As the relationship with your club of investors becomes more structured, you may place yourself in a position requiring registration with the proper regulatory bodies.
No matter which acquisition strategy an SFO chooses, he or she needs to understand that there will be a number of challenges to face moving forward. These include:
- Building an infrastructure that is able to quickly and thoroughly evaluate investment opportunities
- Sharing investment philosophies with other investment partners
- Becoming over-exposed by co-investing in the same funds where they are already an LP
Scope of Options Today for SFOs — Everyone Must Address Alignment
Networking among families continues to be a strong and viable investment strategy considering the popularity of club opportunities. But here are some other deal sources that deserve consideration:
Buy Side Advisors: The option to retain a buy side investment bank to search and structure an investment opportunity has always been available. A new twist is the boutique SFO advisory that offers a suite of services to the Chief Information Officer (CIO) that can include introductions to deal flow. This approach allows the SFO to control the message. Its intent can be made clear to the advisor, but the SFO does not have to directly identify that intent until later in the process, — which could be attractive. The boutique approach will grow as more SFOs engage outsourced advisors for a range of needed services.
Independent Sponsors: Private equity firms without committed funds have proven to be worthy sources of deal flow for SFOs. They will request closing fees, a percentage of carry based on performance, and potentially management fees. Within the SFO community, independent sponsor deals with outsized front-end fees, five year exits, and carried interest are not likely to attract interest. Instead, those independent sponsor deals that focus on the industry and operational expertise of the independent sponsor, along with more reasonable investment requirements, will win the day.
Hybrid Model: In lieu of building out their own direct investment structure, but with many of the same advantages, an SFO could develop a more exclusive relationship with an independent sponsor. In this type of relationship, the sponsor receives investment funds and working capital from the SFO to make investments and support operations. The SFO parent has greater control of investment decisions and can be somewhat anonymous as the ultimate funder of the sponsor. As SFOs continue to covet direct investment deals, plenty of options exist to support deal activity.
The direct investment environment has many entry points for the single family office looking to access deal flow consistent with their overall mission and financial goals. Having the scale up of professionals and a model similar to how private equity sources, structures and closes deals in the lower and core middle market is an important requisite for success in the space.
The follow up question is: how active and involved does the family and
the board wish to be? Investing in this part of the market comes with
all the upside PE looks for and the operating
challenges to transform a business for the long term.