The Wall Street Journal recently focused on the rise of family offices as significant disrupters of the private equity model. In an interesting article by Anupreeta Das and Juliet Chung entitled “New Force on Wall Street: The Family Office” the authors confirm a trend we have been seeing for the last 10 years. Increasingly, wealthy families are collaborating for advantage. That advantage may be direct investments where fees and carried interest are side stepped completely or it may take a form of uncompensated side car investments where the important family uses its networks, wealth and access to assist private equity sponsors. In return for the extra help, these families are often allowed to invest in “friends and family” vehicles or directly into a specific portfolio company without paying management fees or carried interest. As Ms. Das and Chung observed:
“Wealthy families have always found ways to protect and build their money, and the savvier among them have pursued their own business deals, from acquiring farmland to seeding hedge funds to buying companies. Today their ranks are ballooning, and many, put off by the high fees and sometimes weak performances of Wall Street money managers, are shifting to investments they can pursue directly through family offices.”
In October 2014 I wrote a blog entitled “Family Offices Are a Protected Species” about another advantage a family office has; exemption from SEC registration. As you may recall Dodd Frank requires private equity firms and hedge funds with more than $150 million under management to register with the SEC. This almost always triggers an audit where manager compensation, cybersecurity, valuation of portfolio companies, record keeping practices, governance and self-dealing are scrutinized. The same registration burden, however, does not apply to family offices with a common ancestor even if they hire internal managers who are paid performance compensation. As long as the managers do not own and control the fund they are managing, they can be incented with performance compensation. I guess the logic is that a single investor family office is sophisticated enough to fend for itself and, more importantly, no ERISA governed assets are at risk.
The scale of these disrupters is what caught my attention. According to the authors, the family assets rival the managed wealth within the entire PE asset class:
“Research shows family offices hold assets of more than $4 trillion. That approaches the cumulative $5.7 trillion of private-equity firms and hedge funds, as estimated by data provider Preqin, though there is overlap because family offices sometimes invest in private-equity and hedge funds.”
Secrecy May Be the Biggest Advantage
The authors also note a big advantage family offices bring to the investment world – SECRECY. Many private or public company management teams do not want the world to know who owns them or if; in fact, there has been a change in ownership at all. In addition, we have seen that certain families like the Koch Brothers have become political targets for their activism. Secrecy about where they are investing removes one less possible objection. It also helps disguise investment themes or strategies. I have always believed that the Wizard of Omaha, Warren Buffet, often shares investment wisdom when he is conditioning the market. For example, he’s often quite bullish on investments like U.S. Air and Salomon Brothers while he is an owner but more whimsical once he has exited.
Family Offices Are Not a Real Threat
However, even with these advantages, the family office has yet to dominate private equity. There may be five big reasons:
- Taxation of carried interest
- Career path for younger employees
- Total compensation
- Lack of owner urgency
- Alignment for portfolio company managers and rollover owners
On the first point it is typically hard to compensate family office managers with anything other than phantom equity because a good company may be owned for multiple generations. Without an exit to set value and create a capital transaction the inside manager may settle for the equivalent of stock appreciation rights. Typically, this phantom equity is treated as ordinary income.
On the second point, the family office will never provide the same lateral employment opportunity as a private equity firm in a city with a vibrant practice. For example, Cleveland has a robust PE community where the breakup of a PE firm can lead to multiple new entrants with opportunity to own their own management company, raise capital and recruit managers who are blocked at other firms. That entrepreneurial pull is strong.
The third disadvantage is total compensation. If the family is supplying the capital, the managers may command a much smaller share of the upside.
The fourth disadvantage is urgency. In the PE model in order to raise successive funds you must demonstrate an ability to realize returns in all markets. This means deploying capital, growing companies and having successful exits in all markets. Many PE firms have proven they can repeat the formula over 50 years and as many as 9-10 funds. The family office already has uber wealth and often does not have to deploy capital for self-preservation.
No Second Bite
While a family office can offer immortality for a patriarchal business and continuing employment for loyal employees, it struggles to provide long term gain opportunities for management that has not had a “pay day” as well as owners who want a “second bite” of the apple. The alignment of managers and former owners is a powerful inducement as well as an important risk mitigant that you are buying a business that is running out of gas.
In short, I really don’t know any PE managers who would quit their job to work for a family office. Until that happens the private equity firms will win the recruitment war.
Your Insights Are Welcome
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Rob McCreary, Chairman
March 22, 2017