A version of this article first appeared in CNBC’s Inside Wealth newsletter by Robert Frank, a weekly guide for high-net-worth investors and consumers. Sign up to receive future editions directly to your inbox.
Many ultra-wealthy investment firms are keen to buy shares in private companies directly, rather than through fee-heavy and loosely managed private equity funds.
However, cutting out intermediaries can be costly and require hiring an in-house investment team to source your own deals.
But family offices have found a way to have their cake and eat it, too, by making direct investments while backing PE funds.
In this type of transaction, a family office commits a large sum of money in exchange for the right to independently invest additional capital in individual portfolio companies. They typically pay a reduced management fee or performance fee for co-investments, and the PE fund handles the sourcing and due diligence burden.
Such co-investment arrangements have grown in popularity over the past decade, family office lawyers and fund managers told Inside Wealth. This trend is being fueled by family offices seeking more direct investment and PE firms facing funding challenges.
“The ability to share the burden, share the costs, and in some cases rely on private equity funds to source, diligently execute and manage the investment is very attractive to families who want direct investment exposure but don’t necessarily want to build it all on their own balance sheet,” said Scott Beach, head of Day Pitney’s corporate law and family office practice.
By partnering with private equity funds, family offices can acquire stakes in companies they can’t buy outright, said Michael Schwam, a partner and co-chair of Duane Morris’ family office practice.
“At least in the middle market, private equity funds will almost always outbid family offices,” he said. “The vast majority of families we work with realize that they will never be the highest bidder for a room.”
PE sponsors are becoming more active in negotiating co-investment rights as a way to entice family offices to allocate to their funds, said Kevin Schmelzer, co-leader of Morgan Lewis’ private equity practice and family office strategic initiatives. For example, he said, a sponsor might give a family office the right to buy new shares to maintain its ownership percentage when additional shares are issued. PE firms may also provide more detailed financial and operating information about portfolio companies than fund investors typically receive.
However, although family offices invest alongside PE funds, they remain a minority investor. They don’t get the same governance or operating rights they would have if they bought the company themselves.
“These family offices are not negotiating with PE sponsors,” Schmelzer said. “At the end of the day, family offices are still subject to the whims of PE funds.”
Most importantly, family offices retain their own shares and have little power to prevent PE firms from exiting. This could be a major drawback for family offices known for their long-term investments.
“That can cause tension in the final stages of a relationship,” Beach said. “The PE firm will want to hand over 100% of the equity to the buyer if possible, so they want the right to take over the family office.”
But Doug McCauley, a partner at investment advisory firm Cambridge Advisory, says the result is that family offices can deploy capital faster than if they relied solely on finding deals in-house or allocating them to funds.
McCauley expects family offices to allocate more money to co-investments as private markets become more attractive overall. He said some family clients allocate 15% to 20% of their portfolios to co-investments.
He cautioned that families need to be mindful of liquidity and choose fund managers and portfolio companies. He said if a fund invites co-investors to participate in a deal, it could indicate a lack of belief on the part of the sponsor, or the presence of risky assets.
“I don’t think there’s any rationale that the returns will be higher because it’s a co-investment. The lower fees may be the reason for the higher returns,” McCauley said. “It doesn’t make it a bad deal, but it also doesn’t make it a better deal than all the other deals in the fund.”
