Strategies for the Family Office Contemplating Direct Investments

August 8, 2019

A previous McGuireWoods legal alert highlighted the trend of single-family offices (SFOs) engaging in private equity-style direct investments. As the number of SFOs grows, so too does their desire to avoid paying fees as a limited partner in a private equity fund. This article provides five considerations for those SFOs that are contemplating direct investments.

Partner With Independent Sponsors

If the SFO’s personnel lack experience in sourcing and executing direct investments, and building an in-house investment team is not practical, the SFO should consider partnering with an experienced independent sponsor. Independent sponsors all share one characteristic — they are a great source of deal flow.

“Relationships with multiple high quality independent sponsors creates a distributed sourcing network for direct investments that a family office can access,” says Douglas Blagdon, the founder and managing partner of ShoreBridge Capital Partners. (ShoreBridge is a merchant banking firm focused on making alternative investments, including independent sponsor-led buyout transactions in the lower middle market alongside family office partners.) Blagdon adds, “For most family offices, replicating this direct sourcing capability through an in-house team is extremely difficult and prohibitively expensive.”

The SFO should ensure it is partnering with an experienced and high-quality sponsor that has the expertise and experience the SFO may be lacking, which oftentimes is the bandwidth and experience needed to navigate the various issues that arise during the course of a transaction.

Prioritize Deal-Sourcing

The success of any investor depends heavily on that investor’s ability to source quality deals. For the SFO that is new to direct investing, a focus on high-quality targets is of the utmost importance. Finding the right target can be a time-consuming and very competitive process. It is easy for an investor to become fatigued and to loosen, or even abandon, its investment criteria to justify pursuing a particular target.

However, Lee Cornwell, co-founder and president of Cornwell Capital, a single-family office making direct control investments in lower middle market companies, advises the SFO that is new to direct investing to stay true to its investment criteria. Cornwell says, “Knowing exactly what type of investment you are looking for helps you get to ‘no’ faster, which prevents you from wasting time on targets that aren’t truly a good fit and helps you conduct a focused search.”

Consider Co-investing

Conducting due diligence, managing seller expectations, securing debt financings, implementing management incentive programs and wading through lengthy legal documents are just a few of the many complex areas that require navigation for a direct investment. SFOs that have not historically made direct investments would be wise to consider a co-investing strategy, at least at first.

Co-investing can provide an opportunity for an SFO to “ride shotgun” with an experienced capital provider, allowing the SFO to gain experience in dealing with such transaction complexities. Co-investing also allows the SFO to gain that experience while deploying smaller amounts of capital, resulting in a reduced exposure in this new-to-them manner of investing.

Blagdon cautions, though, that co-investing alongside a traditional private equity fund may require a speed to closing that a family office new to direct investing may not be able to achieve. Instead, Blagdon advises, “Consider co-investing alongside another family office that has experience making direct investments.”

Understand the Industry

One advantage many family offices possess over other capital providers is a deep knowledge of the industry in which their families earned their wealth. If possible, an SFO new to direct investing should seek investments in industries in which the family has significant familiarity and operating knowledge.

Brad Batten, partner at Zwick Partners (a single-family office directly investing equity capital in the form of buyouts, growth capital or recapitalizations), encourages SFO professionals to invest in sound businesses they thoroughly understand. Batten notes, “As we built out our strategy, we were careful to avoid chasing enticing venture deals and have generally stuck to less complex industries where we can leverage existing knowledge and relationships to get smart on the space.”

If an interesting opportunity presents itself in an unfamiliar, complex or heavily regulated industry, consider club investing with another family office that has experience in that industry, leveraging their expertise when needed.

Hire Experienced Advisers

In any transaction, experienced advisers can be invaluable. This is particularly true for SFOs new to direct investing. In addition to providing the substantive advice for which they are hired, experienced advisers can be sources of deal flow, often provide guidance as to process (even outside of the scope of their engagement) and will ensure the SFO is informed as to industry and market standards and norms.

In addition to accountants and legal counsel, it is wise to hire advisers in other areas to aid with due diligence and post-closing integration and transition. For example, most investors can benefit from engaging an insurance broker to evaluate the target’s insurance policies and to advise on post-closing coverage. Depending upon the deal, SFOs should consider engaging environmental consultants, regulatory advisers and other specialized advisers, such as food safety consultants or medical coding and billing specialists.