Going Direct: Best Practices in Family Office Direct Investing

By Molly Simmons , Patrick McCloskey

Part 2 in a 2-part series.

The trend toward family office direct private investing is clear. Applying best practices helps families excel.

After reviewing key trends and execution models in Part 1 of our series, “Going Direct: The Rise of The Family Office and Direct Investing,” in this second part we outline best practices.

In a nutshell:

  • Proactive quality deal flow, emphasizing the family’s unique advantages, drives success 
  • Quick screening and family stakeholder alignment focuses resources on top priorities
  • Rigorous and consistent diligence improves negotiations and mitigates risk
  • Post-closing strategic “blueprint,” portfolio management, alignment and accountability drive results
  • Families can insource, outsource and/or use hybrid approaches, and can leverage affinity groups to achieve goals

I. Proactive Quality Deal Flow

Whether a family is an owner-operator, an active or passive private investor or even an asset manager, the competition for high-quality investments has increased because of unprecedented liquidity in the private market. Trillions in institutional private equity (PE) dry powder, accessible credit markets, growth-hungry corporate balance sheets and the influx of “patient and long-term” family office capital make it difficult to rely solely on inbound deal flow.

Proactive deal generation and relationship development will help to focus on quality deal flow.  As families diversify and/or become more investors than operators, they must emphasize their unique traits and advantages to support their deal origination strategy.

As one senior PE executive said, “Quality origination is the name of the game  –  especially in today’s market.”

Family investors benefit by mapping out their unique advantages and focusing their proactive origination efforts in those areas. Advantages may include (i) specific industry expertise, (ii) shared values, (iii) functional needs, (iv) a turnaround or other characteristics requiring flexibility and a long-term horizon, (v) relationships and networks and (vi) a family-owned business where the seller might favor a family investor or buyer.

When pursuing direct control or minority investments in private businesses, families benefit from thinking through “In which situations am I the next best owner or investor and why?” and focusing their proactive outreach accordingly. 

Families with limited resources for proactive sourcing may benefit from outsourced consultants or buy-side intermediaries, as well as relationships with other family offices (FOs), PE funds, independent sponsors, search funds and others. Many FOs develop relationships through larger networking organizations as well as smaller private, invitation-only FO roundtables, as well as  the growing number of affinity groups where families share family histories, interests, insights and investment opportunities. A principal in a FO commented:

“I joined an invitation-only family office forum which is organic and non-sponsored. We get together a few times per year in an intimate and confidential setting to share ideas, market intelligence and investments. Through this trusted network, my family office can source attractive investment opportunities and, as importantly, share best practices. We could never accomplish this on our own. It’s been a home run both professionally and personally.” 

Families, especially minority co-investors, should avoid situations ripe with adverse selection and focus instead where there is alignment across values, investment goals, hold periods, governance and liquidity plans, as well as complementary industry and functional expertise.

II. Quick Screening Focused on Key Factors

Family investors often have limited resources and high opportunity costs in spending time on investments that are ultimately not a fit. Sometimes families find it difficult to quickly respond because of inadequate internal resources and unclear investment criteria and process.

The maxim “The next best thing to a yes is a quick no” holds true. Families that string along sources due to the inability to make decisions often clog their own funnel and may also damage their reputation with valuable origination sources and/or PE funds offering co-investments.

Families may not have the same investment volume or pace as a PE firm or corporate buyer, and their private investment appetite may fluctuate over time. As discussed in Part 1, some families support deep internal investment teams. Others augment lean internal teams with external advisors and other affinity group families with the investment, industry, and/or functional expertise to help them quickly and confidentially evaluate and/or execute an investment.

Best practices include (i) identifying top criteria for an executable investment, (ii) having internal resources and/or an external network to support initial screening needs, (iii) establishing a clear investment process including the endorsement of key family principal(s) and (iv) having a properly aligned and professional investment staff — whether insourced or outsourced.

Screening considerations may include:

a. Source: Where is the opportunity coming from, and how trusted is it? Why am I seeing it?
b. Company & team: Do they meet our criteria?  Does the family have the internal resources to properly vet? 
c. Value-add: Can we bring anything to the table other than financial capital?
d. Competition: Is this a competitive auction, and am I a viable investor?  Why am I the next best investor?
e. Timing and cost: Is the opportunity executable within a manageable timeframe and cost structure?

III. Thorough and Consistent Diligence

Whether the investment is an operating company add-on, a new platform or part of a private equity portfolio, a rigorous and consistent due diligence process is critical.

Successful investors have diligence processes that include assessing: management; market size and growth; customers; competitors; quality of earnings; financial modeling; HR/employees; IT; operations; environmental considerations; product; property, plant and equipment; intellectual property; insurance; regulatory compliance; tax and legal; as well as other investment-specific factors.

In addition to the internal team’s work, independent third-party diligence helps validate assumptions with subject matter expertise. Lenders and other stakeholders may require, at a minimum, third-party quality of earnings analysis. Thorough diligence helps investors mitigate risk, improve negotiations and hit the ground running at close.

As part of ongoing due diligence, investors and management benefit by creating an initial investment thesis, including a plan for future value creation. This may include growing the top line through acquisitions, and/or organic growth through customer introductions, new products/ services/geographies, cross-selling, pricing, synergies, etc.

Financial modeling scenarios help investors understand the risk/reward equation as well as potential outcomes in base, upside and downside cases. These include the impact on cash flow, distributions, debt covenants and the overall growth plan. In creating these scenarios, investors should tap the intellectual capital of co-investors, outside advisors and/or family affinity groups to help with insights, key assumptions and value creation levers.

Control investors typically shoulder the burden of diligence, legal and other “broken deal” costs. Minority investors benefit by agreeing upfront with co-investors about the type and level of diligence (including what is done together vs. independently), approved vendors, timing expectations, process management and shared deal cost responsibilities.

IV. Portfolio Management: Value Creation & Liquidity

After the closing celebration, the real work is just beginning. As a FO investment professional stated,

“It’s not that difficult to close a deal -- especially if you write a big enough check and pay a high enough price. But we don’t generate a return at closing. We are looking to build long-term value which takes planning and hard work.”

Families with a private equity portfolio approach may not have the time pressure of a PE fund’s hold period yet may still benefit from a clear post-closing plan.

Questions to address may include:
a. What is the post-closing value creation blueprint? 
b. Under what circumstances might the investment be sold? 
c. Who is responsible for monitoring/managing the investment?
d. What outside expertise or resources are needed?
e. Do management or board gaps need to be filled?

Family-owned companies may focus on integrating an acquisition into centralized management, HR, IT, finance and other systems. This may provide clarity, as well as cost or revenue synergies. The question is, will that be enough to meet investment objectives, especially in an era when  frothy competition has increased purchase prices?  Both control and minority investors benefit from a post-closing plan, along with accountability for results, and investor alignment with management. If the investment is not working as planned, who is responsible? 

Whether the investment is an add-on or new platform, it is critical to monitor performance versus goals and make course corrections where necessary. PE funds closely align with portfolio company CEOs through equity incentives tied to the fund’s successful exit. Long-term family investors can align with management using long-term incentive plans, redeemable options, multi-year and/or event-related cash bonuses and other methods. Whether it’s cash, stock or a car lease, one size does not fit all. Incentives should be measurable, manageable and valued by the recipient, and aligned with the investment partner(s).

A family investor’s governance rights typically reflect their equity ownership. Control shareholders often have the strongest information rights, board representation and governance over major actions, including changes to the CEO or capital structure, as well as the budget, cash distributions and liquidity events. Co-investors with a minority stake often have some level of protective provisions, and all should have rights to timely and transparent performance information (such as monthly or quarterly reports), along with a clear understanding of their major action rights and alignment with control shareholders and management. This is especially true regarding additional capital needs and liquidity plans.

Family investors are unquestionably increasing their exposure to direct PE investing via several different models. Families bring unique perspectives, knowledge and relationships to the table, which will serve them well in the potentially lucrative yet increasingly competitive PE market. Best practice models are available, and each family’s unique strategy, resources and goals can help determine which investment model is best for them.

Molly Simmons is the founder of McFarland Partners, a boutique firm focused on private investments and business strategies, especially for family offices and family-owned enterprises (www.mcfarland-partners.com). Patrick McCloskey is the founder of Aeterna Capital Partners, a family office-backed private investment firm. He also leads a family office affinity group that shares investment ideas and best practices (www.aeternacp.com).


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