Family offices have long known about the possibilities for outsized returns in direct private equity investing; they are now becoming more sophisticated in understanding other aspects of the asset class
For years family offices have invested in the private equity asset class both through funds and directly, however, in recent years, theyhave developed a level of sophistication akin to specialists in the space. Compared to public equity historical yields in the 6% to 8% range, private equity investments yield on average 15% to 40%. The cost of not developing an in-house private equity program has increased and family offices have taken notice. They are now dedicating more time and energy into pursuing direct private company investments as a means to increase asset returns as well as further diversify their portfolio. They seek highly experienced professionals in the field to help them evaluate and structure investments. The advantages of direct private investing, as highlighted below, have become well known in family office circles.
Ownership in private companies is less volatile, largely immune to whims of the public market and more focused directly on the company’s business performance. Private company management teams manage for the long term as opposed to near-term quarterly results which in turn leads to more sound business building strategy and value creation. Investors meanwhile are not subjected to sudden downturns in share prices due to seemingly distant and unrelated macroeconomic events or temporary minor business setbacks.
Protection Through Structuring
Disciplined and focused private investors will understand the fundamentals of the business’ value proposition and operations as well as how to optimally structure their investment. Depending on the situation at hand and considerations of the existing stakeholders, the investor may decide between various forms of debt, equity or some combination of the two. Downside protection in its simplest form can be created through seniority in the capital structure but can also be enhanced through director designation rights, minority protective provisions, and redemptive rights, among other mechanisms.
Control in private company investing can come in two forms. First, through structuring,where an investor is more an active participant in shaping their investment security and economic potential. Second, serious private company investors will seek to have some degree of involvement with the direction of the company and can take a board seat and/or have voting or veto provisions on major strategic decisions or in the event of a material downturn in business performance. Active investors share accountability for the investment outcome alongside company management.
Limited Exposure to Venture Elements
Within the private equity investing universe, growth equity focuses on the middle stage of a company’s life cycle, when product or service adoption has been well established and the company has demonstrated consistent year over year revenue growth. Compared to venture capital investing, this stage is materially less risky. The capital loss ratio for the venture capital asset class in the U.S. from 1992 to 2008, for example, was 35.4%, while for growth equity, it was a low 13.4%, even lower than buyouts at 15.1%.
Business software and services companies can have more predictable revenue streams given longstanding relationships with a portfolio of clients. Clients that are businesses tend to be stickier as compared to individual consumers who can and often do change their minds about the products or services they use. Business to business companies that have experienced management teams, large addressable markets, recurring revenue streams, low customer churn, a diversified client base, and high margins can lead to outsized value creation.
– RJ Lumba