Looking to Edge Around Hedge Funds and Private Equity?

Make sure your family office team is prepared for new investment approaches.

Fund structures, such as hedge funds and private equity funds, can be excellent ways to diversify family office holdings. However, it’s important to be aware of lockup periods and related fees. As an alternative, many family offices are considering direct investments into growing companies, as well as separately managed accounts alongside traditional hedge funds. Both options are worth considering, but they require careful planning, new capabilities and their own types of risk management.

Rise in direct investments

Choosing to directly invest in companies instead of through private equity funds is complex and requires skills many family offices don’t have. Nonetheless, there’s a growing trend of family offices, and accredited wealthy individuals, making direct investments.

Reasons for investing directly

There are several reasons why a family office might prefer to invest directly in private companies:

• Control over exactly which companies to invest in and how much to invest in each one
• Ability to set deal terms
• Potential for higher returns
• The ability to use family members’ skills
• Involvement with the companies the family is investing in
• Family members enjoy sourcing and evaluating investment targets

Control and involvement require additional work and expertise. Sometimes, that’s exactly what family members are looking for – the opportunity to put their expertise to work. Or, the family might recruit a skilled operations person with very specific and proven experience in a particular field to assist in this process.

Expertise needed

Before a family office even gets to the point of investment, it must master deal sourcing, review, purchase negotiation and due diligence. This generally means either adding employees with unique expertise in these areas or working with outside consultants (or some combination thereof).

It’s important to develop, acquire or hire expertise and bandwidth in the following steps of the deal making process:

1. Maintaining a good pipeline of deals
2. Evaluating potential deals as volume grows
3.  Conducting buy-side due diligence, from both a legal and accounting perspective (this is a good area to engage a third party who can become a de facto extension of your team and work with you on the other steps below)
4. Identifying red flags on potential investment targets
5. Preparing letters of intent that clearly define potential deal terms based on your due diligence and address industry-specific issues 6. Structuring and negotiating the purchase agreement
6. Choosing the best legal entity and ownership for both tax and liability issues
7. Closing the deal

Address future capital needs

Closing the deal is just the beginning of the investment process. In addition to a plan for involvement with the company, there should be a plan to address its future capital needs. It isn’t uncommon for a company to need additional funds down the road. Is the family prepared to write more checks? If not, will their ownership stake be diluted? If the company does poorly, it’s often time-consuming and expensive to try to recover the investment.

There are many reasons why family offices may want to choose the direct-investing path. Keep in mind, though, that it’s essentially a new line of business that requires new competencies and experience, introduces new risks, requires new processes and controls, and is more complex than it might appear.

Managed accounts as an alternative to traditional hedge funds

In addition to bypassing private equity funds for direct investment, some family offices are taking a new approach to investing in hedge funds. One option family offices are increasingly considering is setting up separate managed accounts, which are large, separate pools of money, invested by a hedge fund manager in the same equities and other instruments as the hedge fund. By using managed accounts, families can negotiate lower fees and have more transparency and control over the timing of the trades and liquidation of positions, should the need arise.

Separately managed accounts usually require $10 million to $50 million or more for a manager to consider taking on the family. Smaller hedge fund managers might be willing to accept less than $10 million.