Family Offices and Private Equity - Navigating the Minefield

“When a family builds a portfolio of focused investments where they have an edge, they become part of the specialist eco-system and the ‘go to’ investor in that market segment.”   

With families looking to increase their exposure to private equity, there has never been a more critical moment to assess the landscape with eyes wide open.      

The private market has grown 10-fold over the past 20 years with endowments, sovereign wealth and pension funds rushing to join the party.  Family offices’ exposure to private equity has also been rising steadily* and increasing in its importance as asset class.  This is due to a combination of attractive returns (reinforced by current low interest rates) and the longer-term investment time frame.

However, access to promising private equity funds and co-investments is becoming a minefield due to record amounts of available capital and competition for top quartile funds. Here we consider the key factors that will help families navigate the challenges and maximise their competitive edge.

1. Gaining access to top quartile funds

Access matters for family officers.  Being invested in the top quartile funds makes a huge difference to performance (see chart 1) and is critical for co-investment opportunities, where more and more families want to invest.  

Source: Burgiss

Savvy family offices blend expertise, combining in-house teams with external partners, large private bank or specialist PE asset manager who have developed the long-term relationships that increase access to the top funds.  This also provides broader analytical and due diligence resources. We have recently seen families joining forces on deals to achieve higher critical mass, cutting out the bank and extra layer of third-party fees. 

Health warning: in these cases family offices need to be super scrupulous about due diligence as they are taking responsibility for it.

One of the best ways to gain access to good funds is to poach talented managers from buyout firms. 

These specialists are plugged into what is going on, who is attracting the best deals and critically who is under pressure to deploy capital and buy at silly prices. The prospect of getting away from the intense pace of sourcing transactions and constant fundraising is likely to be attractive.

Another alternative is to buy funds in the secondary market.  This has the added benefit of giving the family office much greater transparency around investments and the ability to build a diversified portfolio in a shorter time frame. 

There are also opportunities for families in ‘First Time Funds’ which are easier to access particularly for well-connected families. Other opportunities include successor, continuation or ‘re-up’ funds with established managers who create a new vehicle so investors can either ‘roll’ into the new vehicle or sell.  Single asset funds of this nature are increasingly being used as an alternative to a traditional IPO exit and provide families with the opportunity to become cornerstone investors in pre-IPO deals. 

2. Understanding and unpacking the numbers

It’s critical family offices understand the key factors that will impact on your returns.  

Private equity investing involves high fees, with the difference between net and gross returns often as much as 7 or 8 per cent for global PE funds (see table 2). It is therefore essential to have a transparent view of the fees involved. 

Performance calculations use methodologies which seem to be benefit the private equity house.  

The more family offices challenge the quantum of management and marketing fees charged to the funds the greater the chances of lowering the high fees.

It’s also imperative that you understand how performance is being calculated.  This enables you to have a consistent view to monitor your performance over time.  

The most commonly used tools to measure the success of a private equity investment are the internal rate of return (‘IRR’) and a multiple of money (‘MoM’). Neither creates a level playing field.  The IRR assumes that cash flows will be re-invested at the same IRR and the MoM can be misleading without knowledge of the duration the returns achieved. One needs to use both to give greater clarity of the underlying performance. Also watch out for the impact of subscription (credit) lines as in the early years they inflate the IRR, enabling funds to reach their hurdle returns sooner and trigger extra fees. It always pays to read the small print.

3. Balancing vintages and cash flow management

We encourage our clients to have a core portfolio of diverse managers, vintages, strategies and sectors and stick with it, not over-commit and over-invest in the first two years. 

Unlike in public markets, the investor in private markets funds no longer has control over the core investment decisions, which assets to purchase, when to call and return capital or when to exit. It is best not to try to be too clever as it is difficult to rebalance a position when it gets overweight and hard to predict 10-year business cycles.  

Proactive risk management is at the heart of a successful long-term strategy.  

‘Illiquidity modelling’ ensures that the family office is forced into selling liquid assets or borrow at high rates to meet capital calls at the wrong time.  Diligent monitoring of any over commitments to invest and access to credit facilities are critical to avoiding unexpected capital calls. No-one wants to be caught out like the Harvard Endowment which, in the financial meltdown of 2008, had to raise $2.5 billion in one year to meet capital calls. 

4. Steering the family through the tricky times

PE funds require a long period of time before they provide any indication of their ultimate performance.  We believe that the minimum is six years and within that time funds can regularly shift quartiles. According to Cambridge Associates one should allow eight years.

In order to maintain confidence and support a family new to private equity investment, it is essential to manage expectations about performance and cash outflows and inflows.  This is particularly important in the early years when few companies are able to return capital.  Knee-jerk reactions can lead to poor decisions about investing in follow on funds and in some cases, families halting their commitments to further investments. A seasoned investment committee and good family office team will help make sure the principals do not lose their nerve. 

5. Hiring a great family office team

Families with a strong purpose, a powerful legacy and who create a partnership culture with their private equity team can attract and retain the best in a very competitive industry.

Gone are the days when a discretionary bonus would do the trick.  The team need skin in the game, compensation aligned to private equity returns and to feel valued, and part of the family eco-system.  The family needs to ensure that they build a team that is totally aligned with their objectives, investment time horizon and business strategy.  We have seen families putting in place a strategy to attract other families to invest alongside them, finding that too challenging and then losing the team who are motivated to manage a larger pool of assets.  

Successful family offices work hard to ensure low turnover in their teams.  

They understand that good working relationships within the industry take years to build and are key to accessing good investment opportunities.

6. Finding the direct investment holy grail

Family offices have a competitive advantage over other investors. Entrepreneurs looking for investors often prefer to deal with them as they like the long-term patient capital model, recognise the family’s entrepreneurial expertise and see their potential value as board members.  

This is why we recommend families focus on sectors where they have deep domain knowledge.  For family offices with limited resources, VC and early-stage growth investments are a good place to focus. When a family builds a portfolio of specialist investments where they have an edge, they become part of the specialist eco-system and the ‘go to’ investor in that market segment. They should be comfortable to achieve diversification via the core private equity funds and public investments.

To reach the holy grail and build a portfolio of direct investments family offices need to be realistic about the budget required to do the specialist due diligence.  This involves hiring top-quality third-party specialists including specialist sector consultants and lawyers and accountants.  On-going resources are also needed to stay close to the business, take a board seat and mentor the top team. Be ready to take advantage when things go wrong, for example misalignment amongst the other co-investors.  We have seen co-investors lose their appetite to continue to support a business, allowing the family to take control. 

Family offices need to prioritise, avoiding the trap of spending too much time on investments that are going wrong instead of supporting the winners. 

It’s clear that private equity markets are an attractive asset class and a fertile ground for family offices.  Yes, there are pitfalls but with the right strategy, team and approach, you can navigate them.  

The most successful family offices investing in private equity have perspicacity, patience and prudence in common.

These attributes are as important as access to the very best funds. They have the perspicacity to back their judgement, the patience to build a well-diversified portfolio and the prudence to stress test their forecasts.

* UBS report