In this article I will discuss the growing trend for family offices to concentrate on making their own direct investments at the expense of traditional liquid asset classes and third-party funds, and why I believe that in many cases this will prove to be a mistake.
The reasons for this trend are totally understandable. First, five years on there remains a revulsion against the very complex products manufactured by banks and other organisations in the run-up to the credit crunch, and this translates into a ‘keep it simple’ mentality combined with ‘I want to be able to own assets directly.’ Second, but intertwined with this, is a feeling bordering on contempt for the intermediaries, such as banks and fund managers, who did not protect clients’ capital at that time. These factors sit well with the generally controlling nature of many newly rich entrepreneurs who have every reason to believe they are smarter than the mass of humanity, but particularly ‘the City’.
How does this trend show itself? Anyone who attends the various family office conferences will have observed the amount of interest in direct private equity, club deals, direct real estate, agricultural land, timber, art, energy and other real or tangible assets.
Just how many direct private equity transactions actually take place in this way is unknown as the family office world is by its nature discreet and undocumented. Because of this it is still quite difficult for companies with investment propositions to approach this market in an efficient way. In theory they are not necessarily so subject to the ‘tyranny’ of internal rate of return, which drives the mainstream private equity industry to seek speedy exits rather than help companies develop over time.
So while the trend is understandable, and provides a welcome new source of capital for smaller companies, why do I say that in almost every case this will end in failure for the family investors?
First, it is depressing that even the most expert private equity funds have generally found it hard to make money in early stage investing in Europe, as opposed to the US. The reasons for this are not clear but these investors are very clever, hard-working people with huge resources and very attractive financial incentives to succeed.
The success of private equity has really been driven by management buyouts of larger, more established, businesses and there is plenty of available funding for these deals.
Second, it takes an enormous amount of resource, both of time and money, to do this job properly. One needs to source the transactions – itself no easy task – and then review a large number of propositions before deciding which deals to pursue. Then there is the job of negotiating the terms and carrying out thorough due diligence, with a high chance of each transaction falling through and all the ‘sunk’ time and expense being lost.
How many family offices can genuinely say that they really have the resources and expertise to do all this work? One needs to think very clearly about this to counteract the clear attractions of this type of investing mentioned above. As I know from bitter experience, one can press on with a transaction in the genuine belief that it will be successful, only to find that it either fails completely, usually due to some unexpected or underestimated factor, or more likely just struggles along requiring a lot of investor support, both in time and further funds.
Another direct asset class which has been very popular recently is real estate and one can understand how this fits in very well with the desire to own real assets and be in control. Added to this, is perceived UK political stability and rule of law, which are very attractive factors to those from less happy lands. Investing in real estate, both residential and commercial, has the advantage over private equity of being a deep and sophisticated market in the UK; any number of agents will be very willing to help you buy and, subsequently, manage properties. One difficulty, however, is getting real diversification with all but the largest fortunes, especially in London with prices so high.
To conclude, I feel that in time a substantial number of families, although certainly not all, will come to regret building portfolios of direct investments. They will come back to seeing the advantage of liquid investments and relying on talented fund managers to build diversified portfolios. This cycle of disintermediation will very likely turn again, as it always has.
William Drake is co-founder and chief executive of Lord North Street Private Investment Office
Key Points
There is a growing trend for family offices to concentrate on making their own direct investments at the expense of traditional liquid asset classes and third party funds
It takes an enormous amount of resource, both of time and money, to do this job properly.
In time a substantial number of families may come to regret building portfolios of direct investments.
