Here’s an “ah-ha” insight for entrepreneurs and an “uh-oh” reality for old school venture capital and private equity firms: Family offices, unhappy with the kind of returns hedge funds have recently generated, are invading private equity with deep pockets and a new set of rules that say preserving wealth is just as important as creating it.
The phrase “family office” is shorthand for advisors who manage ultra-wealthy people’s money. How rich is ultra-wealthy? The Family Office Exchange (FOX)—a network for the ultra-rich and their advisors—says to afford your own family office you’d have to have at least $100 million in assets. FOX estimates there are 10,494 such families in the U.S. This move by the ultra-rich is a sea change and it’s transforming the relationship between entrepreneurs and PE firms in three significant ways:
- Expect longer-term commitments for the right investments.
- There’s an opening for more minority position deals.
- It changes the way PE firms evaluate CEOs.
A New Level of Commitment
Wealthy families have been making direct investments in companies for about 600 years in Europe and half that time in the United States. Their centuries-old pattern is to be growth friendly and take a longer view. As PE investors, they’ll do the math to determine how their capital can be used to grow a business and generate wealth over a range of time periods, in the context of tax and other financial planning strategies.
That’s a strong contrast to the institutional investors that back traditional VC and PE firms. All the “institutionalists” want is an acceptable return in a relatively short time frame so they can declare victory and do it all over again.
Tom Knauff, CEO of Energy Distribution Partners, is a three-time PE-backed company CEO. He’s a consolidator who, in his last investor-backed company, was forced to sell what he had built just as it was beginning to scale. “They settled for a standup double when they could have had a home run,” Tom laments of his previous PE investors. “We felt short-changed.”
One caution is seeking a family office with a tenured team, dedicated to direct investments rather than a family office that dabbles in direct investments. While a family office investing on a one-off basis may have long-term investment horizons, working with a dedicated private equity team can eliminate risks. Family offices that dabble in private equity may not appreciate the governance role they play in the investment or may simply lose interest in the investment.
Here’s the thing about family offices: If you’ve met one, then you’ve met just one. They are all so different depending on generation, how many family members are involved, style and approach. These firms are a growing minority. According to research firm Preqin, about nine percent of PE funds represent family money; that’s double the number that existed six years ago.
Taking a Minority Stake
The CEOs of entrepreneurial companies always worry about losing control after taking on a majority investor. The fear is palpable and drives a lot of insecurity about even doing a deal.
Because a family office-backed PE fund’s objective is as much to preserve wealth as create it, the directors have the latitude to structure minority ownership arrangements, as long as they include consent rights that protect the value of the investment. This includes decisions related to budget, personnel, acquisitions, capital expenditures and selling the company.
We recently completed an investment with a specialty coating company. That investment fit the family office criteria to a tee, including having:
- A tenured, proven CEO.
- An industry that preserves wealth—in this case, discrete manufacturing.
- A predictable revenue stream, including a track record for sustained financial performance.
- A vision and plan for growth that would benefit from specific capital investments and the PE firm’s management expertise.
In exchange for the minority stake, we structured a deal that had less risk for us. We used a convertible preferred instrument that would have allowed us to exit first if the investment hadn’t performed.
The New Entrepreneurial Leader
So far this sounds pretty good for entrepreneurs: lots of capital resources, a long investment view and the possibility of trading a minority position. But that’s not the end of it. Family office investors also expect more of their portfolio company leaders—specifically in how they develop the company culture.
Family offices know the importance of culture because navigating family dynamics is complex and central to their fundamental ability to operate. They know a lot about it, so it’s a hot button.
It’s crucial that portfolio company CEOs demonstrate how they can foster a productive company culture. This is especially important for entrepreneurial companies, where a bad hire can do a lot of damage.
Family office investors are putting their resources behind CEOs who demonstrate an authentic commitment to organizational development and culture—and this trend is going to continue.
If you’re looking for private equity investment but want a longer-term commitment and the possibility of your investors taking a minority position, then be an authentic leader and build your case around how an investment in your company can both preserve and create wealth. iBi
Eli Boufis is executive principal of Driehaus Private Equity, LLC.