Benefits and Challenges for Family Offices Investing in PE

A majority of single family offices expect to invest more in private equity in the future, citing “the potential to achieve superior investment return,” according to a study commissioned by iCapital Network. 

The study found that 60% of single family offices invest in PE today.

Why PE?

Richard Wilson, CEO of The Miami Family Office and founder of The Family Office Club, says it’s unsurprising when single family offices allocate some of their portfolio to private equity investments. “Most families have made their wealth in managing businesses, selling a business, or taking a company public so it makes sense for someone to continue applying those same skills after they have become ultra-wealthy. For example, if 90% of families made their wealth trading commodities it would make sense if they then invested in commodities more often that private equity.”

Howard Romanow, COO and CFO at Island Management, LLC, a family office, says that Island Management invests in private equity both directly and through funds for three main reasons: “the potential to control and be involved in the outcome of the investment, the potential for higher returns, and improved diversification.”

Wilson points to the impact of the last market downturn as another reason for single family offices to turn to PE. “There are some ultra-wealthy families who weren’t protected very well and regardless of whether that is 100 percent or 1 percent the fault of the private banker or wealth manager they had in place, they are looking for more control in their investments and they sometimes get that by making direct investments into operating businesses.”

The survey found that 90 percent of the single family offices invest in funds while 40 percent invest directly. Says Romanow, “While PE funds can also provide improved diversification and returns, we prefer investing directly to reduce the friction from the 2/20 model and maximize alignment. As long term investors, we would prefer to continue to build our winners rather than sell them to create a track period, particularly since once we sell a business we need to pay taxes and find somewhere to reinvest that capital at a comparable return.”

According to the study, 70 percent of single family offices report “their PE funds outperformed other investments within their portfolios and three-quarters [said] their direct investments outperformed other holdings.”

The Challenges of PE Investment

“There are dozens of challenges” particular to single family offices when it comes to investing in private equity, says Wilson — “from finding and retaining talent, to incentivizing the team, to the high carrying costs of such teams if your family office goes through a period of not being very liquid, to valuation, finding off-market deals which you don’t have to buy through auction,” and more.

For Romanow, “the main drawbacks include the additional time commitment, typically higher fees and expenses for fund investments, and the illiquid nature,” which he says makes it “difficult to reallocate into more attractive investments when available.”

Independent sponsors can offer some advantages over traditional private equity, says Romanow. “Given that they are not boxed in by a fund structure, sponsors tend to be more flexible than PE firms both in terms of the way they think about the holding period for an investment and the way it is structured. There is also the obvious advantage of being able to underwrite the investment merits of the transaction as opposed to committing to a blind pool vehicle.”

When seeking private equity investments, family offices might be best served by remaining within what Warren Buffett refers to as the “circle of influence.” Says Wilson, “We always encourage families to increase their deal flow as much as possible with a focus on just 2-3 primary areas where they created their wealth, feel they have an edge, or have a high conviction, and then to continue to use strategies that often made them wealth.” These might include “partnerships, platform strategies, cross-selling, or playing larger chess games with their portfolio of operating entities that small startups and large bureaucratic groups sometimes cannot do with the same speed as a private family.”

Romanow says that historically, “family office performance has been a bit of a mixed bag driven largely by having the wrong people in place. Getting the appropriate experience is critical to building a direct investing platform. Recently, there has been a meaningful uptick in the hiring of former PE professionals by family offices.”

Looking to the Future

Private equity firms are also looking to family offices for capital — Forbes reports that more than 75 percent consider family offices when raising funds.

According to the survey, more than 50 percent of single family offices currently investing in private equity plan to increase allocation. Thirty percent of family offices not currently investing in PE plan to start. Wilson says he expects “this percentage will grow slightly” in part because the number of family offices will increase. “The combination will lead to more deals done by family offices as a percentage of total deals in the marketplace.”