**Family Offices Face Risks in Direct Private Equity Investments: A New Survey Reveals Potential Pitfalls**
A recent survey reveals a concerning trend among family offices: while direct investments in private companies are surging in popularity, many are overlooking crucial aspects of due diligence and long-term strategy, potentially jeopardizing their returns. The 2024 Wharton Family Office Survey highlights a significant gap between the perceived advantages of direct deals and the actual practices employed by family offices. This article delves into the key findings, revealing potential risks and suggesting strategies for improvement.
**Key Takeaways: Are Family Offices Underestimating Private Equity Risk?**
- Short-Term Focus Undermines Long-Term Value:** Many family offices are adopting shorter investment horizons for direct deals than their overall portfolio strategy suggests, missing out on the potential “illiquidity premium” associated with longer-term private investments.
- Lack of Expertise and Oversight:** A significant portion of family offices lack dedicated private equity professionals and fail to secure board seats, limiting their ability to effectively monitor investments and influence company strategy.
- Missed Opportunities in Family-Owned Businesses:** Despite the potential synergies, a surprisingly small percentage of family offices invest in other family-owned businesses, possibly overlooking valuable opportunities.
- Network Reliance Over Strategic Sourcing:** Family offices heavily rely on personal networks for deal sourcing, potentially limiting access to a wider range of high-quality investment opportunities.
- Overemphasis on Management Teams:** While management quality is vital, the survey suggests a possible overreliance on this factor, potentially neglecting other crucial aspects of due diligence.
**The Rise of Direct Deals and the Growing Concerns**
Direct investments in private companies have become a prominent strategy for family offices, drawn by the potential for higher returns than publicly traded markets and the avoidance of private equity management fees. The allure is understandable: many family offices, built on the backs of successful entrepreneurial ventures, possess unique insights and experience. However, the Wharton survey suggests many are not leveraging these strengths effectively. The survey, conducted by the Wharton Global Family Alliance, points to several critical shortcomings:
Insufficient Private Equity Expertise within Family Offices
Only 50% of family offices engaging in direct private equity investments employ private equity professionals trained in deal structuring and sourcing. This lack of specialized expertise exposes them to a higher risk of making suboptimal investment decisions and failing to effectively manage and monitor their portfolio companies.
Limited Oversight and Monitoring
The absence of active oversight is a major concern. Only 20% of respondent family offices secure board seats in the private companies they invest in. This lack of direct influence and involvement significantly limits their ability to understand and manage risks impacting the success of the investment, even if they are actively involved in investor governance (which may require board seats which aren’t always taken due to internal policies). This is in stark contrast to private equity firms making these investments for their own portfolio companies, as they frequently take board seats or otherwise participate in strong governance.
Shorter Investment Time Horizons Than Anticipated
Family offices often emphasize their long-term investment strategy, boasting a patient capital approach that aligns with the illiquidity premium inherent in private investments. Yet, the survey revealed a stark discrepancy between stated long-term goals and actual investment practices in direct deals. While 60% claim a decade or longer investment time horizon for their broader portfolio, nearly one third target a mere three to five-year window for their direct deals. This short-term focus compromises the potential for significant long-term returns.
Deal Sourcing Strategies: Reliance on Networks**
The survey highlights an overwhelming reliance on established networks (both personal and family office-based) for deal identification, suggesting a relatively passive approach to sourcing. A significant lack of formal deal sourcing practices is evidenced. While networking has its merits, overly relying may obscure many superior investment opportunities and limit access to otherwise inaccessible opportunities.
**The Missing Link: Investments in Family-Owned Businesses**
Given their extensive experience in running family businesses, one might expect family offices to show a strong preference for investing in similar companies. Surprisingly, only 12% of respondents reported investing in other family-owned businesses. Professor Amit suggests that this may be due to seemingly better opportunities arising in non-family businesses. However, the lack of engagement in the family-owned business sector suggests a potential missed opportunity to leverage existing experience, potentially reducing the risk profile of some investments and allowing the utilization of stronger management advice.
Investment Criteria: Overemphasis on Management Teams**
While a capable management team is crucial for any company’s success, the survey revealed a potentially concerning overemphasis on this factor. 91% of surveyed family offices stated that management experience forms their primary investment criterion. Although essential, this singular focus may overshadow other important factors, creating risks and potentially diminishing their ability to spot strong candidates for investment.
**The Syndication and Club Deal Phenomenon**
The survey indicates a growing preference for syndicated and "club deals," which involve partnering with other family offices or leveraging the expertise of private equity firms. While collaboration offers potential benefits, including access to broader expertise and reduced risk through investment diversification, it also signifies that many family offices are acknowledging their limitations in handling direct deals solo.
**Professor Amit’s Assessment and Future Outlook**
Professor Raphael "Raffi" Amit cautions that the success of this direct private equity investment strategy remains unclear. The current practices revealed by the survey raise significant concerns. "The jury is still out on whether this strategy will work," he notes. He points specifically to the short time horizon, the insufficient levels of internal expertise, and the lack of board seats as significant "puzzling" aspects of the investment strategy. It is vital that family offices carefully assess their resources and capabilities before embarking on direct private equity investments. “It will take a number of years to find out if this will be successful,” he adds, emphasizing the need for continuous evaluation and adaptation.
**Recommendations for Family Offices**
Based on the survey’s findings, family offices should consider implementing the following measures to mitigate risks and enhance the effectiveness of their direct private equity investments:
- Invest in Expertise: Recruit and retain experienced private equity professionals to provide the necessary deal structuring, sourcing, and monitoring capabilities.
- Extend Investment Horizons: Align direct deal investment horizons with overall portfolio strategies, maximizing the potential for long-term appreciation and returns.
- Enhance Deal Sourcing: Implement more robust and proactive sourcing strategies that broaden access to investment opportunities and identify undervalued companies.
- Consider Active Oversight: Seek board seats or more actively participate in the governance of portfolio companies.
- Diversify Investment Criteria: Complement the evaluation of management teams with a holistic due diligence approach that equally weighs product, market, and financial viability.
- Leverage Existing Networks Strategically: Use personal and family office networks effectively, but also consider external resources for expansive deal sourcing.
By addressing these shortcomings, family offices can better leverage their unique position and significantly enhance the probability of successful investment strategies in direct private equity deals. The key is to move beyond the reactive approach currently prevailing in the family office sector and adopt a proactive strategy centered on careful planning, informed decision-making, and thorough risk management.
