Family offices continue to play a prominent role as lead investors in the alternative investment industry. As family offices continue to become more sophisticated, they are seeking new avenues to expand and diversify their changing investment portfolios. One investment model that has recently picked up momentum is the strategy of investing directly in a private company, rather than investing in companies through a private investment fund, also known as direct investing. According to a 2023 report by FINTRX,[1] approximately 69% of single-family offices have made direct investments as part of their investment portfolio.
In general, direct investing enables family offices to have greater control over their investments including controlling entry and exit points. Additionally, direct investing gives family offices the opportunity to utilize their expertise to assess specific industries and investments to make decisions that can help increase the value of their investments, all while avoiding fees typically associated with investments managed by third-party investment fund managers.
This article will (1) discuss the benefits of direct investing by family offices, (2) analyze some of the costs and concerns that need to be accounted for when engaging in direct investing, and (3) suggest another investment option available to family offices, namely co-investing, which provides many of the benefits of direct investing, while also mitigating some of the costs and concerns.
Benefits of Direct Investing
The key motivating factor for family offices to engage in direct investing is their ability to have more control over their investments. Specifically, they can seek to structure the investment terms, negotiate deal points, and/or dictate entry and exit points. This can only be done by family offices that have specialized knowledge in a sector, giving them a leg up in structuring, managing and monitoring their investments. Industry knowledge can motivate family offices to make their own investment decisions, which has led family offices to become “players” within various industries. Moreover, many family offices are not only willing to make direct investments, but are also finding themselves in controlling positions with respect to their investments. In fact, according to a 2023 family office report from William Blair, 37% of family offices have taken a controlling position in their direct investments, with the average investment size being $17.6 million.[2]
Some additional benefits of direct investing are that it allows family offices to avoid (1) fees and (2) “lack of visibility” issues typically existing when investing through a fund, as further explained herein. Typically, a private fund will require a family office to pay management fees and/or carried interest as part of the family office’s investment in such fund. Furthermore, a family office will be subject to the private fund’s own timeline for the deployment and harvesting of capital, rather than controlling the entry and exit points itself. In contrast, a direct investment strategy: (i) would allow a family office to avoid the foregoing fees and (ii) would also give it room to create its own timeline based on its internal expectations, rather than relying on, or being subject to, the whims of a third-party fund manager.
Potential Costs and Risks
Although direct investing can potentially provide many advantages to family offices, implementing the strategy is usually a substantial task for family offices and requires a sophisticated understanding of the industry applicable to their target investments. Family offices need to be capable of addressing everything required in the direct investing process, including: (x) understanding investment and operational risk, (y) appreciating the importance of conducting due diligence and being able to execute due diligence review, and (z) if necessary, integrating an outside team for assistance.
Expense
While direct investing generally leads to better control over investments, such control comes at a cost. Direct control often requires significant work and time from the family office, and, as discussed below, at times, the engagement of an internal or external team that can assist with the task. While charges of third-party management fees and carried interest can be avoided, the operational risk associated with any potential missteps makes direct investing a high-risk/high-reward strategy. In order to capitalize on the expense-saving, family offices need to be experienced in the relevant industry or sector so that they have a thorough understanding of the risks associated with their target investment.
Due Diligence
The considerable expenditure of time and cost of due diligence led 66% of family offices to tell William Blair that it is a challenging legal aspect of direct investment, by far the highest response rate among other issues.[3] A comprehensive due diligence process requires market analysis, an understanding of the industry competition, and a financial analysis of the potential investment. While the due diligence process may seem daunting and costly, identifying any underlying issues during due diligence is critical in order to mitigate operational risks and reduce future costs, and possibly provide a stronger negotiating position than would otherwise be possible. Additionally, because direct investing will require continued hands-on monitoring, family offices should ensure that their due diligence process provides for a significant operational review, and not just initial investment due diligence.
Utilizing Internal or External Resources
Ideally, a family office can rely on its experience in the relevant industry sector, allowing it to create an internal team that can (x) tackle the tasks associated with making a direct investment and (y) give the family office direct oversight while reducing outside costs. A family office should first look at its current structure to determine which industries and which parts of the investment process can be leveraged by its existing skillset, thereby empowering it to focus on investments in its “sweet spot” from the start.
There may be times when the experience or size of a family office may be insufficient to take on the challenges of making a direct investment. In order to better appreciate investment opportunities and depending on the size and experience of a particular family office, such family office may benefit from utilizing outside resources that can take on some of the due diligence burden and other operational aspects of the direct investment process. While developing an outside team can be time-consuming and costly early on in the process, the additional resources should allow the family office to focus on its strengths while maintaining a complete investment strategy. Further, combining an outside resource with a sophisticated internal team may be a key step in expanding the reach and success of a family office.
Co-Investments as an Alternative to Direct Investing
One way to mitigate the cost of direct investing and to potentially share risk with other parties is to engage in co-investing with other family offices, other funds, or independent sponsors. In general, co-investing opens the door to a larger capital pool and possibly to an increased knowledge base in additional sectors that may not be already accessible to a family office. According to William Blair’s family office survey, more than 65% of single-family offices have partnered in co-investments with other family offices.[4] By developing relationships with other family offices, a co-investment strategy may offer a wider range of potential investment industries and additional investment opportunities.
Once a direct investment has been identified, the combined resources of multiple investors in a co-investment vehicle may result in a more comprehensive analysis prior to the consummation of a transaction, thereby giving a family office a clearer picture of what it may be encountering. This team effort may also provide more clout in negotiating entry and exit opportunities, thereby potentially providing stronger returns in both the short and long term. In addition to increased opportunities and sharing in potentially higher returns, family offices engaged in co-investments may also share overhead costs, thereby further reducing expenses.
Co-investments are also popular between family offices and independent sponsors. In these types of arrangements, independent sponsors find target companies and/or investments first, and then seek capital. The independent sponsor model gives family offices the ability to opt in or opt out of ventures on a deal-by-deal basis. This flexibility provides family offices with both (x) the perks of direct investment and (y) the deal-finding skills of independent sponsors, all while reducing the costs and potential risks associated with direct investment.
As direct investing becomes a more attractive investment strategy for family offices, the individuals and teams engaged in this strategy should be cognizant of the risks and benefits associated with their investments. If you have any questions about this article, please contact Yehuda Braunstein at 212.573.8029 or via email at ybraunstein@sadis.com.
