A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide for wealthy investors and consumers. Register to receive future editions, straight to your inbox.
Many investment firms owned by ultra-wealthy families want to acquire stakes in private companies directly rather than through private equity funds, which carry fees and less control.
However, cutting out middlemen can come at a high cost and requires hiring an in-house investment team to find exclusive deals.
But family offices have found a way to have the cake and eat it too by backing private equity funds while investing directly alongside them.
Under these types of agreements, family offices make large commitments of funds in exchange for the right to invest additional capital themselves in individual portfolio companies. They typically pay reduced management or performance fees on their co-investments, and the PE fund takes on the burden of sourcing and due diligence.
These co-investment arrangements have grown in popularity over the past decade, family office lawyers and fund managers told Inside Wealth. This trend has been fueled by family offices seeking more direct investments and by private equity firms facing difficulties raising capital.
“The ability to share the burden, share the costs and, in some cases, rely on private equity funds to source, [perform due] diligence, execution and management of these investments, is extremely attractive to families who want exposure to direct investing, but don’t necessarily want to build all of that on their own balance sheet,” said Scott Beach, who chairs Day Pitney’s corporate and business law department and family office firm.
By partnering with private equity funds, family offices are able to acquire stakes in companies they wouldn’t be able to purchase directly, according to Michael Schwamm, a 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. “The vast majority of families we deal with recognize that they will never be the highest bidder.”
PE sponsors have become more willing to negotiate co-investment rights to incentivize family offices to allocate to the fund, according to Kevin Shmelzer, co-head of Morgan Lewis’ private equity practice and family office strategic initiative. For example, sponsors can give family offices the right to purchase new shares to maintain their ownership percentage when more shares are issued, he said. Private equity firms may also offer more detailed financial or operational information about portfolio companies than investors in a fund would typically obtain.
However, even though family offices invest alongside private equity funds, they remain minority investors. They do not get the same governance or operating rights as if they bought the company themselves.
“These family offices are not in the room with the PE sponsors, negotiating with the seller,” Shmelzer said. “Ultimately, the family office remains at the whim of the PE fund.”
More importantly, family offices rarely have the right to retain their equity and prevent the private equity firm from exiting. This can be a serious disadvantage for family offices, known for investing for the long term.
“It can create tension at the end of a relationship,” Beach said. “The private equity firm is going to want to deliver to the buyer preferably 100% of the equity, so they want to have the right to drag the family office.”
But in turn, family offices are able to deploy capital more quickly than they would if they relied solely on closing their own deals or allocating funds, according to Doug Macauley, a partner in the private client practice of investment consultancy Cambridge Associates.
Macauley expects family offices to devote more to co-investing as private markets generally become more attractive. Some family clients hold as much as 15% to 20% of their portfolio in co-investments, he said.
He warned that families should monitor their cash flow and be selective with fund managers and holding companies. When funds invite co-investors to join a deal, it may indicate a lack of conviction on the part of the sponsor or a risky asset, he said.
“I don’t think the rationale for co-investing is that you’ll get a better return because it’s a co-investment. You might get a better return because the fees are lower,” Macauley said. “That doesn’t make it a bad deal, but it also doesn’t make it better than everything else in their fund.”