A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide to the high-net-worth investor and consumer. Sign up to receive future editions, straight to your inbox.
Many investment firms of ultra-rich families are keen to buy stakes in private companies directly rather than through private equity funds, which come with fees and less control.
Cutting out the middleman can come at a steep cost, though, and requires hiring an in-house investment team to source proprietary deals.
But family offices have found a way to have their cake and eat it too by backing PE funds while investing directly alongside them.
Under these kind of deals, family offices make large fund commitments in exchange for the right to invest additional capital on their own to individual portfolio companies. They typically pay reduced management or performance fees on their co-investments, and the PE fund handles the burden of sourcing and due diligence.
These co-investing arrangements have grown in popularity over the past decade, lawyers to family offices and fund managers told Inside Wealth. This trend has been fueled by family offices seeking out more direct investments and PE firms facing challenges raising capital.
“The ability to share the burden, share the costs and, in some cases, rely on the private equity funds to source, [do] diligence, execute and manage those investments, is extremely attractive to families who want that exposure to direct investing, but don’t necessarily want to build all that on their own balance sheet,” said Scott Beach, who chairs Day Pitney’s corporate and business law department and the family office practice.
By teaming up with private equity funds, family offices are able to get stakes in companies they would not be able to buy outright, according to Michael Schwamm, partner at Duane Morris and co-chair of its family office practice.
“Private equity funds will almost always outbid family offices, at least in the middle market,” he said. “With the vast majority of families we deal with, most of them recognize they will never be highest bidder in room.”
PE sponsors have become more willing to negotiate co-investment rights as a way to induce family offices to allocate to the fund, according to Kevin Shmelzer, co-leader of Morgan Lewis’ private equity practice and family office strategic initiative. For instance, sponsors may give family offices the right to buy new shares to maintain their ownership percentage when more shares are issued, he said. PE firms may also offer more detailed financial or operational information on portfolio companies than a fund investors would typically get.
However, while family offices are investing alongside PE funds, they are still minority investors. They do not get the same governance or operational rights that they would get if they bought the company themselves.
“These family offices, are not in the room with the PE sponsors, negotiating with the seller,” Shmelzer said. “At the end of the day, the family office is still at the whims of the PE fund.”
Most importantly, family offices rarely have the right to hold onto their equity and prevent the PE firm from exiting. This can be a serious drawback for family offices, which are known for investing for the long term.
“That can create some tension on the back end of a relationship,” Beach said. “The PE firm is going to want to deliver to the buyer preferably 100% of the equity so they want the right to drag along the family office.”
But in turn, family offices are able to deploy capital faster than they would if they relied solely on finding their own deals or allocating to funds, according to Doug Macauley, a partner at investment advisory Cambridge Advisory.
Macauley expects family offices to allocate more to co-investing as private markets generally get more attractive. Some family clients have as much as 15% to 20% of their portfolio in co-investments, he said.
He cautioned that families need to watch their liquidity and be selective with fund managers and portfolio companies. When funds invite co-investors to join a deal, it may indicate a lack of conviction by the sponsor or a risky asset, he said.
“I don’t think the rationale to co-invest is that you’re going to get a better return because it’s a co-investment. You might get a better return because the fees are lower,” Macauley said. “It doesn’t make it a bad deal, but it doesn’t make it a better deal than everything else in their fund either.”
