September 12, 2018
A next-generation investor is becoming a prominent force in alternative investing, and it can go by various names: the family office, family investment firm, or permanent capital. These firms are increasing their direct investing activity at an astonishing rate, with Pitchbook reporting a 300% increase in capital committed directly to deals by family offices between 2011 and 2016. And this trend shows no sign of abating. A recent survey of 109 family offices by the Family Office Exchange found that 30% plan to increase their pace in direct investments.
For fund managers, these family investment players present a new set of challenges. On one front, they are new competitors for deals and opportunities, often with patient capital and in-depth knowledge on particular sectors. But these players also can sometimes be fund manager clients or co-investors. That makes it critical for fund managers to understand family firms’ model, approach, and capabilities, and to learn how to manage relationships with family offices as both potential clients and deal rivals.
Many family offices have organized separate investment arms to distinguish their activities from their more mundane administrative tasks. Among the most successful of these family investment firms, are the ones that focus their investment strategy on industry verticals that play to their strengths or where they have developed an expertise. On this level, these firms are competing and winning deals away from private equity firms. And, it’s not just deals that are flowing their way – they also have been successful in recruiting senior talent from large alternative asset managers, and from merchant and investment banks. With permanent capital and an entrepreneurial mindset that aligns well with portfolio company management, family offices are redefining how value is created.
What is permanent capital? Simply put, it is capital that can be invested in perpetuity – without a target date when capital must be harvested and returned to limited partners (LPs). For private equity and real estate investing, the evergreen nature of the capital removes the burden of exiting a deal before it has realized its full value – as well as the need to deploy capital prematurely. For hedge fund strategies, permanent capital can ride out the cyclicality of the markets and hold onto cash that can be used in downturns when opportunities present themselves.
How can family investment firms beat out major private equity managers that have deep investment team infrastructure and access to capital from institutional investors? They can and have because family wealth understands the importance of permanent capital, with its long-term yield-generating approach to investing. The pitch from family office investors to entrepreneurs looking to sell their businesses or take on a strategic partner is straightforward. Permanent capital allows alignment with management teams, efficient decision-making and flexible transaction structures. Key for business owners is the shift from trying to force value creation into a pre-determined five years of investing, five years of harvesting fund strategy. With family investment firms, they can have a partner who is interested in growing the business for the next 20 years.
Another major advantage for family firms is a pure focus on investing. Unfettered by the care and feeding of LPs or the time required to raise a next fund, their investment teams are solely focused on the portfolio holdings. When deals are too big for one family investment firm, they find like-minded family offices to co-invest – no different than what happened two decades ago among private equity and real estate managers and what is happening today in infrastructure.
These same selling points work when recruiting talent. Executive recruiters have facilitated a steady stream of talented professionals leaving large alternative asset managers or investment banks to join family investment firms. They are attracted by the lean decision-making structure, the breadth of investment opportunities, the flexibility that ready capital provides in financial structuring, the longer-term commitment to creating value and the single investor focus.
And when family investment firms addressed how to compensate on carried interest within an evergreen fund, the talent began to migrate in earnest. While there are several carried interest models, generally most are based on shares of the overall portfolio, using an annual book value of the assets to calculate share value. Unlike carried interest in a fund, which is distributed based on the disposition of assets, these family office compensation plans allow participants to harvest the value of the shares at their discretion, once the shares have vested.
The flow of talent began to make headlines a few years ago with marquee recruitments such as Morgan Stanley Investment Management COO Michael Levy’s departure to become the first outside CEO of CrowHoldings, and it has continued at an increasing rate each year. Family investment firms have attracted senior talent from major private equity outfits such as Madison Dearborn Partners, Palladium Partners, New Mountain Capital, Kleiner Perkins Caufield & Byers, Battery Ventures, Morgan Creek Capital Management and Quadrangle Group, as well as the private capital or investment banks of Robert W. Baird & Co., UBS, Goldman Sachs, and J.P. Morgan, to name but a few.
With the benefits of permanent capital driving the culture of family investment firms, their rise now and in the coming years may be to the 2020s what real estate investing was to the 2000s, hedge funds were to the 1990s and leveraged buyouts were to the 1980s. These firms – and the patient capital they manage – are creating a sea-change in how value is created.
Cornelia Kiley is a partner at Judson Partners, a financial services executive search firm specializing in alternative investments, real estate, and asset and wealth management.
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