Wealthy families have been investing in businesses since the dawn of commerce. Initially, their role was as founders, managers and owners, and as success brought surplus liquidity, many developed private structures, with a strategic allocation across all core asset classes: family offices were born.
Private equity has been a well-established part of most asset allocations for decades. As investments are at the upper end of the risk spectrum, it is usually, therefore, a relatively modest proportion of total assets for most families. That risk has been largely mitigated through diversification, principally through fund investments, giving investors exposure to multiple managers and strategies, and a much broader underlying portfolio than most could finance independently. More recently, as super-liquidity events have generated even larger cash windfalls, and in particular as the generational transition has seen younger family leaders assume decision-making responsibilities, more and more families have moved away from the fund strategy to seek direct investment opportunities. Sometimes this reflects firsthand personal experience – individuals may have worked in M&A or private equity. For others the decision is about a cost-benefit assessment: fund investing can be expensive (often with two or more layers of fees) and at a certain level of scale it can become cost-effective to build your own team. This point becomes even more pertinent when linked to a third driver – the desire to be more involved. Fund investing is essentially passive and puts your capital into a blind pool, so there is no direct exposure to deal-making, to the selection of investments, or the operational value creation cycle.
By contrast, an entrepreneurial family office sees value in their own industrial experience and network and seeks to leverage this through an in-house direct private equity team. These organisations have become much more sophisticated in the last 20 years, often led by best practice from the US. Initially, families might entrust the deal-making role to an experienced line manager, someone they had known for a long period, typically the leader of a successful operational business unit, but critically not usually a proven private equity manager, putting personal trust ahead of technical training, sometimes to avoid complex and expensive remuneration structures. The results were often sub-optimal. Lessons have been learned, and the leaders in the market now routinely hire proven investors with first class origination networks and track records. Costs have often risen accordingly, but in many cases, these have been justified by more stable returns. Over the last 3-5 years, we have seen the evolution of a further model, an ambitious hybrid where families act as cornerstone investors for new private equity shops, securing better economic terms, as well as greater influence in sourcing and executing investments. In Germany, some 50+ new teams have set up since 2012, with around two-thirds supported in this way.
There is clearly a danger that this phenomenon is a text-book definition of the top of the market and we expect quite a few firms to fold if they cannot close deals as easily as hoped, or when liquidity pressures surge elsewhere in a portfolio, but even if half don’t survive the next downturn, that is still a material impact on the shape of the overall market. What about the competition for talent? Historically, most family offices were not competitive on compensation or assets under management, but this has changed. As specialist headhunters in this niche, we have been able to bring tier one investors to family office clients precisely because the source of capital is different. So much mainstream private equity is now commoditised in 10-year limited partnership structures; pricing and processes are largely generic, exit pressure remains significant, and in truth, many of the personalities merge into one another.
But these newer family offices vehicles look and feel differentiated. Fundraising is a more transparent exercise and many families actually prefer their capital to remain productively deployed rather than seeking an arbitrary liquidity event to trigger carried interest payments, so they can contemplate much longer hold-and-build horizons. Possibly more importantly, an effective family office can deploy their industrial heritage as a relationship winner in the origination stages, for example, ‘We’re not just another faceless fund, we represent a multi-generational industrial owner with a proven record of building value themselves, investors who look and think the same way you do, but can bring fresh capital and ideas to drive your business even further in a partnership of equals.’
This is not just fine words – this approach really works and brings priority access or even exclusive, incremental deal flow, the lifeblood of a successful PE firm. Working with these tactical advantages excites proven dealdoers. Our advice to candidates considering joining family office private equity teams is to focus on two issues: commitment to the asset class, and governance. Cashflows in private equity are negative for many years, not least because the lemons ripen before the plums, as the old saying goes, and one truly needs to invest across vintages for diversification so this pre-supposes a certain depth of pocket and a willingness to stay the course to reap the benefits. Similarly, in a competitive market, prices are high, and investment decisions need to be backed up by process rigour: scenario analysis, proper due diligence, negotiation and relationship building, and documentation. If an overbearing family principal can bypass these on a whim, this becomes a dangerous career move. The caricature would be for a hired professional to be greeted at his desk by a beaming owner with the news that ‘we’ve bought a football team.’ But get these two issues right, and you have a real edge in the market and for the individual, the chance to build something distinctive. Private equity has become a mature asset class, but right now some of the most innovative moves are being made by the oldest investors of all.