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In mid-2014 I chaired the 10th Canadian Private Family Office Invitational in Banff, Alberta, where I led a panel discussion on how families of wealth can effectively manage direct private equity investments. In addition to me, the panelists included family office leader, Stefan Erasmus (Werklund Family Office), and private equity fund manager/ direct investing specialist, Irfhan Rawji (Parkland Fuel Corporation).

The conversation focused on lessons learned, best practices and key factors for family investors to consider in making decisions related to these types of opportunities. This post includes a summary of the key takeaways from the various discussion topics featured throughout the panel.

The Diversification Dilemma

Most families of wealth have built their fortunes on entrepreneurial success focused in a particular industry, resulting in a highly concentrated portfolio. And so a common dilemma for these families is: should they look at direct private equity as a means of portfolio diversification, or as a way to enhance the return that they are already earning in their area of expertise? There seemed to be two conclusions from the panel. The first approach is that families should adhere to the “stick to what you know” rule.

The years of experience operating in a specific industry will often forge a material sourcing advantage for the family, where it can then leverage its industry network and knowledge to source and evaluate prospective deals. By sourcing its own deals, this will allow the family to gain a critical first-look at the most attractive opportunities instead of being peddled already overlooked and less desirable investments by brokers or other intermediaries.

The second option is that families should consider “picking one other area” where they have (or can build) a competitive advantage and focus their private equity investing there.

The panelists agreed that families should not spread themselves thinly across a wide range of industries and strategies.

The challenge with any direct private equity investing strategy is the extensive resource commitment required for the due diligence, execution, and ongoing monitoring/ reporting of any direct private equity investments that the family has made or is considering. Unless the family has its own well staffed family office or has employed an advisor with experience in these activities, then it should be careful not to take on more than it can handle.

If a family wants to get broad diversification in private equity, they should consider a fund.

The Importance of Process

The panel also agreed on the importance of process in direct investing. Many serial entrepreneurs have “never seen a deal they don’t like” so they may be quick to add new investments without adequate due diligence and strategic intent. This can have serious implications given the concentrated and illiquid nature of direct private equity investments.

Thus, mechanisms should be put in place to safeguard the family from making any decisions that they might ultimately regret. This can be a tool as simple as the Investment Policy Statement (IPS) that can prevent over-allocation to riskier strategies and a rigorous investment evaluation process, possibly with an investment committee to bring the important “second sober thought” to the decision process.

These management tools and policies will act as a natural way to keep family investors from making poorly thought out decisions and improve the probabilities of ultimate success.

The Exit Plan

In establishing its investment process for direct private equity, the family should also consider including guidelines for an exit plan. Here the family should first determine what its intentions are with respect to its direct private investments. Does it view the asset class as a long-term income investment, or a temporary one with the potential for a high payoff? For instance, the family might prefer the cash annuity it earns from a successful investment instead of realizing its value in the short-term. Consequently, it may not want to be forced out of that investment by a matter of policy that pressures it to sell.

On the other hand, if the family is involved in the asset class chiefly for the possibility of enhanced investment returns, then having an exit plan in place would be crucial. It could be surmised that if the investment thesis is strong, then the exit will come naturally to the family. However, unforeseen complexities can cause even the best investment to be a challenge to exit without the appropriate strategy in place.

Is There a Case to be Made for the PE Fund?

If diversification is the purpose of an allocation to private equity, then the family should consider the indirect route in order to circumvent the resource disadvantage it would face in making direct investments in an industry it doesn’t know. Here the case can be made for investing with a private equity firm that has the requisite expertise. Unfortunately, the current environment for private equity investing makes the already difficult task of finding and accessing the right manager even more challenging.

The availability of affordable credit has contributed to increased competition for portfolio investments. As a result, many prospective investments have gone to auction and sold for lofty valuations, which ultimately limits the potential for further value creation. This underlines the importance of investing behind a general partner that can source its own proprietary deals.

Furthermore, for private equity funds, performance data suggests that there is a wide dispersion of returns between the best managers and the rest of the pack, and it is also the best managers that have the most persistent performance.

The confluence of these factors amplifies the significance of conducting the rigorous due diligence necessary to find the right manager. And of course, because the best managers are in high demand it is now also commonplace for the funds offered by these managers to be oversubscribed.

An integrated advisor with existing relationships in private equity fund investing can be brought in to facilitate an indirect private equity investment. Involving a third party can help advance the due diligence process and also provide the benefits of the ability to leverage existing relationships to gain access to highly sought after funds.

Finally, if the situation merits, what might be the best strategy for a wealthy family seeking to diversify using private equity but lacking the specific industry experience to succeed, is to invest as a general partner alongside a seasoned private equity fund manager. However, the ability to locate such an opportunity will likely heavily depend on the size of the family’s allocation to private equity and its industry relationships.

Tom McCullough

Tom McCullough is Chairman and CEO of Northwood Family Office, which looks after the investments and integrated financial affairs of wealthy families with $10 million or more. He teaches ‘The Management of Private Wealth’ in the MBA program at the University of Toronto’s Rotman School of Management, and is also co-author of the books, Family Wealth Management and Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask.

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