This article is by Charlotte Thorne at Capital Generation Partners, looking at the different ways of how family offices can tap into private equity.

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 her views are not necessarily endorsed by this publication, it is delighted to carry this article on an important subject. 

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 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
rigour 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 centile 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 centile 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.