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Guest Feature: How Family Offices Should Approach Direct Investing
Peter Lehrman
16 May 2014
Peter Lehrman is chief executive and founder of Axial, an online business development platform for deal professionals. Through Axial, professional investors from family offices to private equity firms discover ways to source deals and deploy capital. Here, he talks about strategies family offices should take when it comes to direct investing. Like many investors, the recession reset asset allocation strategy for family offices. Disillusionment with public markets and distrust of institutional investors has resulted in many family offices looking for a more transparent and less fee-bloated investment strategy. While family offices have traditionally invested in a variety of private equity funds and other alternative managers - playing the role of limited partner - lately, we’ve seen a shift toward direct investments. While family offices have long relied on the due diligence, company oversight and management expertise offered by their private equity partners, the high fees they’ve paid for relative underperformance have become a source of tension. Combined with the opacity and illiquidity of the blind pool fund structure, many family offices are seeking new ways to invest in alternative markets. Recognizing a need for greater flexibility and control, both single and multi-family offices are looking to direct investing as a solution. The ongoing digitization of business development and deal sourcing activities is making private market investments more accessible to family offices. Identifying the most relevant opportunities has historically been an unpredictable, laborious and extremely time-intensive process, requiring the creation and maintenance of a large network of relationships and deal flow channels. What previously required endless travel, trade show attendance and time spent networking is increasingly being replaced with targeted business development and deal sourcing activities. Just as Fidelity and E*Trade transformed online retail brokerage, new technology-driven platforms and networks have emerged to connect professional investors with private companies seeking capital for growth or exit purposes. Like any investor in the private markets, family offices face challenges of deal flow and investment management. To overcome these hurdles, family offices looking for direct investment opportunities should consider the following: Pursue specialization by industry and deal type Research shows that business owners and entrepreneurs prefer to partner with capital providers with deep domain expertise. To become the preferred partner of entrepreneurs in a given industry or market, investors must be able to deliver value through experience, a relevant and specific network, and strategic clarity. Venture capital and private equity firms are increasingly specializing to develop a deal sourcing advantage in their respective markets of interest. The same principle applies for family offices. As much of their wealth creation can be traced back to family-owned businesses or entrepreneurial ventures, family offices have a unique ability to connect with business owners on both an experiential and emotional level. The ability to tap into family offices’ proficiency in growing a business, as well as their relationships in and familiarity with a given industry, is an attractive quality as business owners look to find the ideal investment partner. We’ve seen specialization work to the advantage of many of the family offices we count as members. Most recently, a New York based single family office with a long history of taking a controlling stake in regional and national restaurant chains was looking for a new opportunity that would allow them to tap an unsaturated market. On the other end, a southeast chain of deli restaurants was looking for an exit plan for a retiring co-founder and the right investment partner to ensure future growth of the company. The two came together as a result of this very type of specialization and focus which allowed for a seamless and valuable transaction for both parties. Focusing on their expertise in core industries, family offices can quickly become distinguished from other potential investors. Conversely, by casting too wide of a net, family offices are giving up their primary competitive advantage. Bring on the right partners and talent While many family offices are investing directly, private equity general partners remain incredibly valuable, sharing complementary deal flow and inviting one another to co-invest. Deciding between a direct investment, or investing in quality and differentiated private equity funds, is a false choice. Many family offices also opt to bring a private equity professional in-house to manage their direct investments. These professionals bring experience and a rolodex to help manage the business development, deal sourcing and deal-structuring process. For the private equity professional, this model is appealing. With an ongoing fragmentation of the capital markets and increased regulatory scrutiny, financial sponsors are also looking for ways to evolve their business model alongside a changing industry. Embrace a more public profile A legacy of keeping a low profile has been one of the chief challenges for family offices looking to better access direct investment opportunities in private companies. Particularly in the middle market, family offices face a significantly larger pool of opportunities, characterized by geographical dispersion and information asymmetry. As a result, originating consistent and relevant deal flow has been an uphill climb. The democratization of information on the internet and the emergence of online platforms that connect private market actors are changing the game for investors and business owners alike. With so much available information out there, getting found is key. For family offices, embracing a more public profile within the appropriate communities will enable them to more effectively source opportunities and get found by private companies looking for capital. While some in the investment community remain hesitant to adopt these more modern business development practices, early adopters are realizing tremendous advantages in their access to larger pipelines of relevant opportunities. On the other end, businesses are also participating in the discoverability phenomenon. Especially when looking to maintain discretion on a potential sale of business, turning to the internet is a business owner's first step in researching how they might go about bringing on an investment partner or seeking out a buyer. With both sides leveraging the simultaneous anonymity and access that starting the process online offers, family offices can more efficiently source opportunities appropriate for their risk profile and investment goals. Just last year, a Chicago, IL-based single family office came to our platform looking to optimize its deal sourcing strategy. They found that because of a highly fragmented lower middle market and constant ebb and flow of relevant sellers, they were not able to effectively manage relationships and were watching deals pass them by. By bringing their deal origination activities online, the firm was better able to find the right investment bankers and M&A advisors to target and distribute opportunities aligned with their investment mandate. In just several months they closed a deal with a quality acquisition target identified through an intermediary connection they had made online. Over the next few years, we expect to see professional investors continue to be held to higher standards and levels of accountability. Increasing focus, embracing “findability,” and functioning as both limited partner and direct investor, can help empower family offices’ participation in a new age of investing. At the end of the day, the handling of family wealth is highly emotional. Embracing the new tools and tactics to consider a fuller set of investment options and better control their destiny will mean a change in the way family offices invest for decades to come.