Editor's note: This publication is pleased to issue this article by Charlotte Thorne, Partner, Capital Generation Partners, on the subject of the different ways - both on the pros and cons - of how family offices can get access to the private equity asset class. While the views are the author's this publication is delighted to carry an article on this important topic. Responses are welcome.

Since 2009, family offices have become significantly more interested in making direct investments in private equity. According to a recent study carried out by the Wharton Global Family Alliance, families have almost doubled their investment allocations to direct investments in private companies and real estate.

Such investments now account for 11 per cent of family office portfolios, but interest in the space is still growing. In September 2012, the Financial Times’ Family Office Research paper found that one-third of family offices intend to increase their allocation to private equity in the coming 12 months, and much of this capital is expected to be deployed directly.

This interest is understandable. There is pressure on family offices to boost returns and direct deals, co-investments and club deals seem to offer a solution. The attraction lies in the fact that many family investors consider themselves to have deal flow; they have access to capital and may not have the liquidity constraints that bind other investors. Perhaps most importantly, families have become increasingly disenchanted with the asset management sector and with managers whose fees have shown little sensitivity to changing economic times. In a low-return environment, families are loath to pay 2 and 20 [percentage annual and performance fees] when they believe they have the resources and the contacts to achieve better for less. This is particularly the case for families who are still in entrepreneurial mode.

However, there are a number of pitfalls awaiting families who attempt to follow the direct route. Firstly, while many families think they have deal flow, many of the deals they are being offered have already been touted around the institutional market and rejected. Often these opportunities have been passed by because they lack scalability – a £1 million (about $1.5 million) direct deal requires the same due diligence and legal costs as a £100 million deal. For institutions the lack of economy of scale is obvious, but for families it may appear to be a benefit. The smaller deals have typically not been snapped up by institutions, but the costs and the time commitment will be the same.

Partnerships

A further issue is that families will often wish, or choose, to invest in direct deals in partnership with other family groups. Immediately this implies a loss of control and although the risk may be considered to be mitigated by the fact that the family knows and trusts the other parties, in fact this attitude tends to go along with a lack of rigor towards co-investors. As a result, on top of the normal investment risks, families may incur reputational risk that they cannot control. Additionally, becoming connected with co-investors negates one of the key benefits of family investing, which is their ability to act speedily. If several parties are involved, the time taken to agree a deal and manage the investment is increased. As a result, a family co-investment group unable to compete on speed may resort to competing on price – resulting in a tendency to overpay for assets.

Finally, families should carefully consider where their real expertise lies. There is a temptation for families approaching direct deals to try to find opportunities that lie outside of their core competence, for example in sectors outside of the established family business. Families are often reluctant to use their investment wing to look for deals in “their” area for fear of adding concentration risk, so they look for opportunities outside the field as diversifiers. The problem with doing so is that such deals tend to be a tiny fraction of the size of the main business and so are effectively useless as diversifiers, while also having the added disadvantage of being highly risky due to a fundamental lack of knowledge.

The unfashionable alternative option to direct deals - leaving private equity management to the experts – is not without its problems. Aside from concerns regarding fee levels, fund investment returns are highly dispersed – much more so than in any other asset class. Among bond managers, the dispersion of returns between the 25^th and 75^th percentile managers is 57 basis points, and in equity it is 3 per cent. For private equity, however, dispersion stands at 16 per cent and between the 5^th and 95^th percentile it raises to 53 per cent. As a result, it is crucially important to select the right fund managers.

While the growing interest in direct deals from family investors is understandable, we would counsel caution. Those wishing to do private equity deals should reconsider whether they really have the expertise and the deal flow to compete. We believe that it is a valid counter argument for paying the fee and letting an expert private equity manager do the work, take any flak and manage the relationships between investors.