While direct investment has been an option for family offices since the early 2000s, their popularity surged between the 2010-2015 period, highlighting the highest growth in direct investment activity in any 5-year period since 1990. The 2020 FINTRX Family Office Industry Report further noted that, on average, 55% of family offices were making direct investments across the globe. We will take a deeper dive into what makes direct investing such a lucrative investment strategy for family offices and what potential advantages it holds over the existing traditional ones.
The drivers of the trend
A recent EY report suggested private market investments accounted for nearly 18% of total asset allocation by family offices and UHNWIs in 2021. These investments were traditionally executed via third-party asset managers. However, an increasing number of family offices, especially single family offices, have begun exploring sophisticated in-house investment infrastructures to pursue these investments directly. Here are the primary drivers behind this trend:
Increased investment control: The elimination of middlemen allows for greater transparency and decision-making capability for family offices on the investments that they make. In addition to this, building an in-house infrastructure for direct investing ensures that the next generation of wealth owners will have no trouble growing their wealth even if they lack detailed knowledge of the private markets.
Attractive risk-adjusted returns: Private market investments typically demand longer downtime from investors due to the inherent volatility that comes with them. Family offices usually have the capability to hold down these investments for a much longer period as compared to hedge funds. Therefore, direct investing can provide attractive risk-adjusted returns as is evident from this insight by IFM Investors.
Interest alignment with family enterprises: Many UHNWIs often prefer investing directly into businesses that closely align with their own family enterprise which is generally not possible through passive investing. For example, a family that holds a Limited Partner role in an industry-agnostic private equity fund will likely not be granted a board position in the companies that the fund invests in. Direct investing will allow the investor to be more ‘hands-on’ with their financial commitments.
Reduced investment fees: The industry standard fees for the top-performing funds include 1.5-2% managerial and 10-20% performance charges. Direct and co-investing allow family offices to minimise these variable costs and generate the maximum possible revenue from their investments.
Increasing co-investment opportunities: Family offices generally have diverse and well-connected networks. These networks can often present co-investing and/or club deals with other family offices which involve lower fees and greater control than LPs but at a reduced risk liability.
Family office direct investment consideration
While direct investing has clear strategic benefits that it can bring to the table, according to the recent Denton’s Family Offices Direct Investing Survey, it is not without its challenges, the major ones being:
- More operational risk: Being complex, illiquid, single asset investments, even a minor error in decision-making can have major implications making this a high risk-high reward strategy, as evident from the fact that 45% of the respondents in the Denton’s survey consider this as a significant challenge.
- Poor access to high-quality deal flows: In order to mitigate the high operational risk that is involved with direct investing, many family offices go the co-investing route. However, owing to the highly private and competitive nature of their operational dealings, it can be difficult to find family offices outside of their immediate networks, who are open to investment opportunities in the same sector.
- Legal Challenges: Startups, especially those that are focused on disruptive technologies, are notoriously difficult to value. Therefore, investing into them requires much more due diligence in the entire investment management workflow, including consistent portfolio selection and performance monitoring by experts. In addition to this, tax and estate planning was also highlighted as a key legal challenge in the Denton’s survey.
Future of direct investments
Direct investing is bound to play an even larger role in the way that family offices invest. Keeping the post-pandemic market volatility in mind, the following are some of the key direct investment strategy trends that family offices need to consider for 2023 and beyond:
- Tilted and Tactical Asset Allocations: While strategic asset allocation(SAA) is often the starting point when considering a portfolio management strategy, incorporating tilted and tactical asset allocations to the mix will allow family offices to optimize returns and take advantage of the short-term movements in the current state of the markets respectively.
- Determining Minimum Standards: It is imperative that family offices that practice direct investing should consider formulating standard due diligence procedures with minimum set standards in order to mitigate operational risks.
- Expanding Networks: In order to find and gain access to higher quality and potentially more rewarding club deals, family offices must expand beyond their gated networks. These include industry associations, equity crowdfunding ventures, angel networks and groups, etc.
Direct investing has seen significant growth in recent years as family offices seek greater control over their investments, providing attractive risk-adjusted returns, increased investment control, interest alignment, and reduced investment fees. However, it brings operational risk, poor access to high-quality deal flows, and legal challenges. Family offices must consider tilting and tactical asset allocations, determining minimum standards and expanding their networks in order to stay ahead in the direct investment game.