During the pandemic, wealthy families have continued to use their investment pools, known as family offices, to gain access to the type of high-return opportunities once reserved for institutional investors. But they are taking a more hands-on role in those financial decisions.
These family offices have chosen to bypass private equity and venture capital funds — which have high minimum investments and sizable fees — to invest directly in companies, either by themselves or with other significantly wealthy families, a report released on Friday found. And they are taking a greater entrepreneurial role in their investments, which would not have been possible if they had put their money into large funds for other people to manage.
Direct investment in businesses began to rise after the last recession, climbing 206 percent from 2010 to 2015. Last year, it grew 11 percent.
Now, half of all family offices in the world make direct investments in companies, according to the report, which was released by Fintrx, a data and research company, and sponsored by Charles Schwab’s family office arm. That number jumped to 83 percent for single-family offices, compared with offices that serve multiple families, with many of those investments focused on areas where the family had originally made its money.
“Family offices add value in times of crisis,” said Russ D’Argento, founder and chief executive of Fintrx. “That’s a big component of how they stand out and can be different from other fund structures.”
To be sure, the wealthy are able to invest differently in the pandemic from everyone else. Nearly 1.2 million workers filed new claims for state unemployment benefits last week, the Labor Department reported on Thursday. The tally has exceeded one million claims for 20 consecutive weeks, extraordinarily high by historical standards. And millions of Americans are worried about paying their bills and not being evicted from their homes.
For the wealthiest families, however, what has been an economic and health crisis for others is an opportunity to make money by throwing a financial lifeline to distressed businesses. The stock market may have rebounded quickly as investors looked past growing hot spots around the country, but these family offices are betting that the public markets are overvalued and that more predictable and steadier returns are to be had through private investments.
“There’s been an incredible recovery in the stock market, but how do I commit more to the public markets when I’m looking at these valuations and it’s still a rocky road ahead?” said Eric Becker, who made his wealth by investing in health care companies and more recently founded Cresset Capital, a multifamily office.
The interest in direct investments has grown in the pandemic. There was a short pause when the initial stay-at-home orders were issued, but interest has begun to rise again, especially among newer family offices, or those formed in the last five years that still retain their entrepreneurial natures.
“Once the data started coming in and talk about therapeutics began, people started seeing a path toward normalcy,” Mr. Becker said. “Whether it’s two years, a year, six months out, it didn’t matter. They could see that path, whether it was distressed companies or companies that just needed some capital.”
The Fintrx report found that families generally invested in industries similar to those in which they had made their initial wealth. Technology led the way, with tech-funded family offices committing 82 percent of their direct investments to tech companies. Real estate families were second with more than two-thirds of their investments in real estate.
“Families initially invest in the same areas where they have experience,” said Paul Ferguson, managing director of the Schwab Advisor Family Office, which sponsored the Fintrx report. He added that family offices could help preserve private businesses through their investments.
“They have a lot of capital to invest, and they’re in a pretty unique position because of the long-term nature of their investing,” he said. “This is where their patient capital is very important.”
Simply having wealth, of course, does not make someone a good investor. Direct investing has its critics, who say the strategy is far riskier than its proponents admit.
For one, private equity firms have trillions of dollars sitting in their funds and are already looking for deals. So when someone with an investment opportunity approaches a family worth hundreds of millions of dollars, alarm bells go off.
“We’re always wary when someone pitches us an idea,” said Paul Karger, a co-founder and managing partner of TwinFocus, which works with 40 families that collectively have put $7 billion at the firm. “The first question is, how did this Texas oil deal miss everyone in Texas and end up on our doorstep in Back Bay Boston?”
Having sufficient selection options is something that even large private equity funds have to consider; many of them examine hundreds of deals before investing in one. But when it comes to direct investments, Mr. Karger said, he also is wary if professional investors are not part of the deal.
Mr. Karger said his firm advised most families to participate in direct investing through deals in commercial real estate — like apartments — that are easier to value and come loaded with tax advantages. He also counsels his clients to invest in deals through private equity funds and focus on the funds’ performance, not on the fees they charge, which are typically a 2 percent management fee and a 20 percent cut on an investment’s return.
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Updated August 24, 2020
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“There’s a cost to doing something right,” he said. “If you pay peanuts, you get monkeys.”
But Mr. D’Argento countered that family offices had become more sophisticated and had hired experienced investors in the last five years.
“They’re starting to look, feel and act like institutions,” he said. “With that added talent comes the ability to do more deals. It’s less of a cottage industry.”
Another risk in a moment like this, when there are many distressed companies looking for investors, is missing an opportunity to leverage the “family alpha,” or the operating knowledge that a family has in the area from which its wealth came, said Kristi Kuechler, managing director of client relations at Vernal Point Advisors, a multifamily office.
“There are families who have as much knowledge of a sector as a private equity firm,” Ms. Kuechler said.
When those families join with other families who made their wealth in different sectors, they could end up with shared family alpha. Or they could end up with less of an advantage than they think. That’s where the selection of partner families is crucial, particularly now when there are many more opportunities.
“What’s happened after this incredible increase in direct investment is people feel they need to diversify their private investment portfolio as if it were an asset class,” she said. “Now, they’re co-investing alongside other families, so they’re not exploiting their families’ distinct edge.”
That edge in understanding what businesses may be struggling but are still viable is important in the pandemic, she said. Many wealthy families went through their own difficult business cycles at some point.
“It does feel like families want a more tangible investment that they can see on the ground, and that can be a really attractive opportunity,” Ms. Kuechler said. “Families are both quite cautious in investing cash, but they’re also feeling pretty opportunistic with companies that look like they can navigate this particular uncertainty quite well.”
That’s good for a family office’s returns, but it’s just as good for that small business that can be saved by the investment.