A GROWING SLICE OF THE PIE
by David Turner, 12 September 2016
Private equity has a special pull for families used to running operating businesses. But with record levels of assets committed to private equity funds is it the best asset class to drive returns?
The plotline is one that has been played out countless times before. A family has made its wealth in an operating business, has exited and is now running a family office. Do they sit back and take a diversified approach to their wealth or eventually get itchy feet and pour their assets back into the sector they know best?
Jonathan Bell, chief investment officer of multi family office Stanhope Capital, rolls off three examples of family office clients that have made large private equity investments in companies in the same sector where the dynasty originally made its fortune.
Two are families with a background in consumer goods that have put money into companies in the same sector. The third is a client with a history in oil services, which has invested in a related business. It is, he acknowledges, not a great time to be in this sector – low oil prices have slashed investment in oil exploration and production, and hence in oil services. However, the family is “very happy with the investment”.
Bell’s examples bear out the picture of private equity investing revealed in the Campden Wealth-UBS Global Family Office Report 2015, published in September.
In general, families love private equity. This has only been fuelled by the low-interest rate environment. The survey of 224 family offices, conducted between February and May 2015, shows an average private equity allocation of 22%. This is more than any other asset class aside from listed equities, which, at 26%, is not far ahead. There are regional differences too with Asia-Pacific (28%) and Europe (23%) twice as likely to invest in private equity as family offices in the Middle East (12%).
The way in which family offices invest in private equity has common characteristics with the cases given by Bell at Stanhope Capital. Looking at private equity allocations as a whole, 61% on average is direct investment, rather than indirect investment through private equity funds and other vehicles.
The Global Family Office Report also reveals that much investment takes the form of active management. Of the total devoted to direct investment, 30 percentage points are through active management in private equity, and a further 10 percentage points are early-stage venture capital, which also tends to be active. Only 21 percentage points are passively managed, with the family office supplying nothing but their capital.
This suggests that a huge number of offices have followed the example set by established private equity direct investors among the world’s wealthiest families. Prominent examples include Mexico’s Carlos Slim, Sweden’s Kamprad family, and the Wallenbergs, who run their own private equity firm, EQT Partners.
Bell explains the logic of direct investing, with reference to the two consumer goods companies.
“The family offices’ knowledge of the sector, including issues such as distribution, was pretty useful,” he says. “It was certainly an attraction to the businesses which the family offices invested in.”
The companies wanted expertise, connections, as well as money – they hankered after active management, because they believed it would add value. It is what Hendrik Jordaan at family fund One Thousand & One Voices calls three-dimensional capital (see CampdenFO n.22).
The tendency towards active management in a particular sector where the family office has experience is borne out by Didier Duret, chief investment officer at ABN Amro Private Bank in Amsterdam, which advises family offices.
“There is a new generation of private investors who not only have extremely strong entrepreneurial instincts, they also want to continue to use their acumen by influencing companies in which they have a stake,” he says.
“These people want deals close to their sector and to their home base, in a kind of private equity nationalism.”
A family that made its money from a manufacturing business in Bavaria may well end up investing directly in another manufacturer in Bavaria, for example, often by “shopping around” through the personal networks they have built up over the years.
Duret confirms the growing interest in private equity, among family offices, that tallies with those of other observers of family offices.
The Global Family Office Report 2015 shows broadly stable allocations to private equity compared with the 2014 report.
“Allocations to private equity, including direct investments, have been going up over the past two or three years”, says Philip Higson, vice chairman of the UBS Global Family Office group in Zürich.
“Clients who had just a little bit of exposure 10 years ago have seen returns well above those of listed equities, so they are slowly increasing allocations,” adds Bell of Stanhope Capital.
Private equity has come to seem more attractive to family offices partly for the negative reason that many other investments now look less attractive.
One reason for this is the lesson of the credit crunch.
“The financial crisis revealed that even listed instruments can suddenly become illiquid, so it has increased the appeal of private equity for family offices, by rebalancing notions of what is liquid and what is not,” says Duret.
He adds that the growth of a secondary market in private equity after the credit crunch, as investors in urgent need of money scrambled to sell their investments, also reduced the illiquidity gap by making private equity a little more liquid.
Sceptics argue that even if private equity investing makes sense, this is not the time to be investing in it, given the large amount of dry powder in the sector – the capital committed by the increasing army of private equity investors, but not yet invested by funds (see charts).
The sceptics’ argument is acknowledged by Bell of Stanhope Capital.
“If you were to ask me, ‘is today a great point to invest in private equity?’ I would say ‘no’,” he explains.
“Leverage is back to 2007 levels, prices are higher, and a lot of funds have raised money.”
Prices are generally measured in terms of the amount paid for the company, divided by earnings before interest, tax, depreciation, and amortisation. This is high by historical standards, in most markets.
However, Bell ultimately rejects the argument against investing now because of excessive valuations. His justification: “You never quite know the right time to invest. If you had put money in funds in 2007 you might have thought it was a disastrous time to do so, but some funds did very well because they managed to buy at the peak of distress at the end of 2008. So our view on timing is that you have to get vintage diversification” – exposure to funds raised in a variety of different years.
“When markets get choppier, investments aren’t performing as well, and quality deal flow is harder to come by – family offices tend to pull back somewhat on direct and co-investing. I’m not at all predicting a drop-off in PE investing overall by families, but given where we are in the cycle, if you compare the next three years with the past three years, which we think are going to be tougher for the markets, you will probably see less direct investing/co-investing at the margin from family offices.”
Private equity experts say that one way of dealing with the utter unpredictability of year-to-year returns is to keep a fairly constant allocation. This is preferable to abruptly ramping up investment or letting it drain away by not reinvesting after periods when private equity funds have made a lot of exits from investments.
Bell also points out that returns in public markets are far from superlative at the moment – a view echoed by Michael Hennessy, managing director, investments, at Morgan Creek Capital Management, a multi-asset manager based in Chapel Hill, North Carolina, whose private equity clients include family offices.
“I think allocations are increasing”, he says.
Stanhope Capital’s model portfolio for family offices includes a relatively modest allocation of only 8% to private equity. However, Bell believes that much of his recommended separate allocation of 8% to real estate should be in “private equity-like real estate”, where an investor seeks to add value by buying property, enhancing its value through redevelopment, and then selling it on.
Aside from the returns, family office specialists also argue that private equity investment makes particular sense for family offices for certain reasons.
One is that illiquidity matters less to many family offices than it does to other investors.
Wealthy families tend, by definition, to have a lot more capital than they need. They can, therefore, afford to lock money up for longer periods, through private investments.
As Higson puts it: “Family offices can often generate enough income for their annual spending needs, through a fraction of their total assets. They can then use the remaining assets to commit to longer-term investments that offer an illiquidity premium.”
Given this situation, “it makes sense to have up to 40 or 50% of family office wealth in private investments”.
Higson adds: “This is exactly what big endowments, such as Harvard, Yale, and Princeton have done. The returns they have achieved have been remarkable – well into double-digit annual averages for the last 30 or 40 years. Family offices are following this lead.”
The illiquidity premium should, over time, add up to higher returns, but there are plenty of other reasons why private equity is attractive to family offices besides investment return.
The asset class gives family offices much greater control than public investments – from the time horizon of the investment, down to who sits on the board.
This is partly for practical reasons, to do with estate planning. If family offices opt for direct investment rather than using private equity funds, they can exercise a considerable amount of direction.
“They can decide when to buy and sell, and how much they borrow. These issues can influence your tax liabilities”, says Higson.
Direct investment also gives family offices the ability to pick their investment horizons.
The desire for control explains why investment through private equity funds has been relatively rare among family offices, with investment through funds of funds even rarer (although soon-to-be-released research suggests this may be changing).
Family offices like to be able to control their investment timetables – and they cannot do this with funds.
“Private equity is not that long-term – this is where people get it wrong,” says Bell of Stanhope Capital.
“Most private equity funds have a pretty standard life span, with a targeted turnaround of about seven or eight years. If you want to buy something and hold it for 30 years, a private equity fund is not going to do that for you, so you have to invest directly.”
“Look at how many businesses have been owned by four, five, or even six private equity funds in succession. They might have been perfect businesses for a family to have owned through all that time”, says Brian Murphy, managing director at Portfolio Advisors, a Connecticut-based specialist in private investments.
Because of the difficulty in controlling investment timetables, Bell of Stanhope Capital is sceptical even of “family-to-family” private equity investment, where a small number of families club together to make a joint direct investment.
ABN Amro’s Duret says he does encounter such deals. In particular, “people who have developed successful businesses together as partners will often continue working together, sharing private equity deals, almost like a family alliance”.
Those who do not have ready-made partners can find them through specialised events designed to share co-investment opportunities.
Henry Samuelson, director of membership at Campden Wealth*, has been successfully running family-to-family co-investment workshops for a number of years. He says the workshops focus on relationship building for the participants, which tends to lead to more aligned co-investments where each side brings qualified resources as well as capital.
However, Bell of Stanhope Capital warns: “If you are investing with another family, you want to know what the other family’s aims are. In a club-type direct investment situation, the families are still probably looking at where the exit is.”
He notes that one family that does not want to sell generally has to do so anyway. This is because such club deals generally include a “tag-along” clause, where if the majority of investors want to sell, everyone has to.
Discussion of club deals with other family offices raises an important question: are family offices good investors in private equity? Do they generate better returns, or for that matter worse returns, than other investors?
Some, though not all, observers suspect that they are quite good.
Family offices might often make for reluctant limited partners – the investors in private equity funds run by general partners – but they are often perspicacious ones. Jeff Davis is head of execution and project management at Connecticut-based fund placement agent Eaton Partners which recruits limited partners for private equity funds. He says in general family offices tend to be very good limited partners.
“They have a keen understanding of private equity in general, given their roots in family businesses, in the form of private companies.”
They have, moreover, “a sophisticated understanding of various private equity strategies and approaches, and are able to move fairly quickly and opportunistically in the due diligence process for fund commitments and co-investments. They can even be good partners for sourcing deals and acting as an extra layer of due diligence on specific investments.”
Finally, “they also understand the length of time it takes to generate returns in the private equity asset class, and are very patient investors that are not looking for huge returns in a short period of time”.
Kevin Albert, managing director and global head of business development at Pantheon Ventures, New York, the private equity fund of funds manager, is also positive about family offices’ abilities in private equity, though with some caveats and reservations. Albert speaks from his decades of experience in the industry – he is often described as the founder of private equity fund placement, back in the 1980s.
On one hand, Albert notes that it is difficult to say how successful they are because, unlike private equity funds, they are under no pressure to report returns to data providers. He is, moreover, somewhat sceptical of the argument that their long-term investment horizons are necessarily a good thing, noting: “The beauty of private equity is that if you hold out for long enough, almost every investment will compound itself and produce a positive return – even a bad one. But the annual internal rate of return” – pushed down because it is stretched out over such a long period – “might be awful.”
On the other hand, “the family offices I have dealt with are pretty savvy”, concludes Albert.
The wealthy individuals behind them are, he suggests, very driven investors rather than relaxed amateurs: “They are proud of their capabilities and management skills, so it is not just about money for them. It is about being good. Because of this, I view family office money as very smart money.”
Burns cautions, however, that KKR has not seen the majority of families sufficiently “staff up” to pursue a robust co-investment/direct investment program.
“My advice to principals and families is to build those teams, regardless of whether you aspire to be an active, direct investor or a more passive co-investor. Families are very open conceptually to seeing direct flow, but not enough of them are making the requisite investment in people and processes be really successful,” he adds.
But how smart is it to commit so much of one’s money to single direct investments in companies in precisely the same sector and even region where they have made their money, as so many family offices do?
“Of course this raises questions about diversification”, says Albert.
“But people who do this will say, ‘I know this business better than anyone else in the whole world. Why shouldn’t I invest in this sector that I know so well?’. People are not always logical when it comes to diversification.”
In the end, notes Albert, “You are talking about people. People do things for all kinds of reasons. Passion enters into it: investing in things that interest them. It can make sense to make money through passion investments.”
After all, it is often their passion for a particular business idea that made the founders of family offices their wealth in the first place.
* CampdenFO is published by Campden Wealth