Direct exposure: Family offices and co-investment

The Coughlins made their money in logistics, and more than a decade after divesting the core business, they continue to invest in the sector. Coughlin Capital, a California-based family office led by three third-generation siblings, focuses almost exclusively on small to mid-size US companies in transportation, manufacturing and related services. It was a natural point of call for McNally Capital when seeking partners to invest in ITS Logistics.

McNally Capital, previously the investment arm of a single family office, describes itself as a merchant bank that sources direct investments for family offices and high net worth clients. It identified ITS, a third-party logistics provider, as a target and was ready to lead the deal, but wanted useful partners. Two families with national retail businesses - and therefore extensive warehousing and distribution operations - came in alongside Coughlin.

The investors bought a 60% stake in ITS at the beginning of last year with a view to creating an outsourced trucking services provider to companies that no longer want the cost or hassle of managing this function in house. ITS' three founders hold the remaining 40% and are still involved in management.

Some entrepreneurial families believe their experience is superior to what private equity can deliver – Mark Thornton

"They saw the value of staying on and leveraging the network we were able to bring," says Ward McNally, managing partner at McNally Capital. "The families not only help in overall operations - such as issues relating to truck drivers, logistics and fuel costs - but they also open up their rolodexes and make introductions to retailers and other companies that meet the profile of the kind of customer we are looking for."

ITS is an example of a well-conceived private equity co-investment: like-minded peers pooling capital and complementary expertise to fulfill a company's financial and strategic needs. This approach has become popular among US family offices that want to play a more active role in their investments. They might work with private equity firms, but they are also an alternative source of capital - one that is arguably more permanent and value-accretive.

At the same time, in the absence of the requisite skill sets, deals can end in catastrophe. Family offices as direct investors therefore also represent a risk, to target companies and to themselves. These dynamics place Asian groups at an interesting juncture. According to Preqin, more than 70 family offices based in the region are active in PE, a three-fold increase on 2013, but some groups' appetite for co-investment is at odds with their experience. Are they ready to be patient and professional capital?

"US family offices have evolved over a long period of time so they view direct investments as a way to generate better returns, and back businesses where they may have some knowledge," says David Kirby, founder of Kirby Capital Advisors, who works with a range of family offices. "Family offices in Asia tend to have less experience of PE and less awareness of the risk. This means they might move faster, but they are also more opportunistic."

A clearer view

McNally Capital is one of a number of co-investment platforms to emerge in the US, combining established networks in the family office world with deal-sourcing and management services. Their remit is deliberately broad. "It is a function of the fact that once you've met one family you've only met one family," McNally explains. "They have different interests, human resources and financial capabilities, and they have different objectives and strategies when it comes to direct private equity."

The unifying element is a discomfort with blind pool funds. As one family office executive puts it: People made 30-35 fund commitments and built a diversified portfolio; but it was like an index fund of private equity - it delivered the mean, not the risk-return profile that you would expect given the illiquidity and the fees. This came to a head in the wake of the global financial crisis when liquidity concerns prompted many investors to review their alternatives allocations.

It is no coincidence that McNally Capital made the transition from single family office to its current role eight years ago. There has been a similar evolution in other markets, including the Middle East and Europe, and several groups now have resources on the ground in Asia.

Geneva-headquartered ACE & Company started as the direct investment arm of a single family office and began offering co-investment five years ago in response to inbound requests from other family offices. "We realized that the performance attribution of private equity fund allocations stemmed from 1-2 investments. We thought if we could better identify those opportunities, we could increase our return on co-investments," says Marc Syz, Asia-based managing director at ACE.

Two other factors also come into play, both of which hinge on underlying philosophy. First, there is a preference to be hands-on, particularly among the younger family offices where the core operating business from which their wealth derives has not yet been divested. Joining a group that employs a third-party manager to build a company might seem illogical when family members have a track record of doing this perfectly well on their own.

"Some entrepreneurial families believe their experience is superior to what private equity can deliver," says Mark Thornton, CIO of Metdist, a trading company owned by the Bagri family, which previously held a stake in the London Metals Exchange. "I have seen family offices dabble with private equity and get frustrated when they see investments underperforming. They say, ‘Let's go back to building businesses ourselves rather than trusting others who we don't think can do as good a job as we can.'"

Second, families don't like paying fees and therefore balk at the notion of shelling out 2% per year based on capital under management plus 20% in post-deal carried interest. This is a very general statement because attitudes vary.

For example, one Asia-based executive with a European family office challenges the whole notion of co-investing in particular companies alongside a fund. He values portfolio diversification and backs a China manager to pick the 10 best local deals; choosing to double-down on two of these would negate the diversification effect and essentially involve second-guessing a team that is paid to be well-informed on China. The exception is when the family office can contribute something to a deal.

"If this is an investment that has an angle on the strategic side and we bring our own team and do our own due diligence, then that makes sense. If not, how do I know that this healthcare company in Chongqing will do better than this retail company in Beijing? These guys should know," the executive says. Even where there is a strategic rationale, this family office would not want to embark on a direct investment in China alone; it insists on partnering with third parties that have local resources.

Levels of comfort

In this sense, a family office's appetite for co-investment, and its willingness to pay others to provide leadership or guidance, is a function of comfort. While some North American groups are able to write checks of $200 million for direct deals, family offices in less developed markets are comparatively conservative - often expressing an interest in co-investment but ultimately reverting to fund commitments. Others only use third-party managers to get private equity exposure beyond their home geography or core industry.

The likes of McNally Capital and ACE exist in their current form because family groups want direct exposure to private equity but lack the in-house capabilities to source, execute and manage deals. While these groups have principal capital to invest alongside their clients and preserve an alignment of interest, they are also paid for their work. The same goes for Crescent Point and EXS Capital Group, two Asia-based firms that have operated for years on a deal-by-deal basis and regularly work with family offices.

"A lot of people go astray because they think that direct investment is easy. While the actual investing might be reasonably easy, monitoring and exit are a lot harder. A small portion of people's overall asset allocation goes into direct investments, but it takes up 80% of their time," says ACE's Syz.

ACE has a 35-strong network of professionals who work on deals globally. They look at around 1,000 opportunities each year, carry out due diligence on 50 of those, and invest in approximately 50% of companies that make it through to the diligence stage. (According to McNally, most family offices he speaks to that claim a level of sourcing expertise will look at 50-100 deals for every one that is closed; this compares to 150-200 for the traditional sponsor in the US lower middle market buyout space.)

While ACE has people on the ground, every deal includes a specialist partner, typically a management team, another family office or a PE fund. Last year, it became the largest shareholder in financial products comparison site CompareAsiaGroup. The deal came about through a pre-existing relationship with Nova Founders Group - a financial technology investor set up by three former Rocket Internet executives and backed by Richard Li's Pacific Century Group - which seeded the business in 2014.

Syz distances his firm from those that target co-investment purely as a means of minimizing the private equity fee burden. ACE takes a similar approach to McNally, forming clubs of families that can contribute strategically to a company. It is willing to pay for access to the right deal, whether that involves supporting a fund-less sponsor or paying fees because others in a consortium are doing so.

Understanding how Asian family offices fit into this matrix is complicated by the fact that, like their Western brethren, they sit at different points on a broad spectrum. However, one recurrent theme flagged up by industry participants is relative youth: the family patriarch is still very much involved in both the core business and the management of his assets. Indeed, the line between the two may frequently blur. This has positive and negative connotations.

A family office investing in an industry in which it has extensive expertise and can offer synergies on the corporate side is a powerful proposition. As the ITS Logistics example illustrates, this is the kind of specialist local partner that many other family offices look for - and in Asia one sector features more prominently than others. "Everyone has a slightly different strategy, role and team composition, but the one thing all these families have in common is real estate. Since our specialty is doing PE-style deals into real estate operating platforms, we love that," says Eric Solberg, founder and CEO of EXS.

Regardless of the target industry, the presence of a family office with relevant strategic interests can also facilitate a path to exit. In certain cases, the family office - perhaps acting alongside other parties - seeds a company in expectation that the corporate unit will absorb the business once it is fully functioning.

The flip side is that a family office's motivations can be hard to gauge. Sanjay Chakrabarty, a partner at Singapore-based Capital Square Partners, who has worked with family offices on deals, recalls situations in which these groups have been obliged to drop out of transactions because they wanted to be the majority investor. It was no longer clear whether the agenda was financial or strategic.

"As a financial investor I am not going to give majority control to anyone who has a strategic point of view; we would no longer be in alignment and I would be doing a disservice to my investors," he explains. "That is the paradox they have to break out of. On the one hand, family offices can and should invest in businesses they understand and in which they have expertise. But there is a creeping mentality to start thinking like a strategic investor and that conflict has to be managed."

Kirby of Kirby Capital notes that most family offices he deals with in the US are run entirely separately to the core business - different teams, different offices, maybe different cities. However, distance does not necessarily diminish an active patriarch's influence. He draws up the parameters within which the family office operates, even creating thresholds above which commitments require personal sign-off. In addition, the patriarch's children may be employed by the family office; some are highly suited to the job, and others less so.

These challenges are not unique to Asia, but they can be accentuated by the absence of institutional processes. It results in a decision-making system described as "not so much analytical and process-driven, but people-driven," or "more emotional." Breaking this habit is possible but it comes at a price.

"The approach is linked to what generation the family office is in - they ultimately shift to capital preservation, as we can observe in Europe and North American, but when they are young they want to go direct," adds Michael Prahl, a fellow with INSEAD's Global Private Equity Initiative who now is a partner at Asia-IO Advisors, a co-investment platform for large institutional investors. "Making investments in areas they know, they already have assets there and are happy to double down. Going outside of the comfort zone, it is harder to evaluate opportunities. They have to invest in professionals and structures, which is expensive."

Metdist was willing to do exactly that. Thornton, who previously headed up 3i Group's Southeast Asia business and is still based in the region, was recruited to execute a control-oriented investment strategy. His small internal team is augmented by advisors who are brought in to assist with due diligence, assess management teams and assemble five-year development plans. While Thornton says the family places a high premium on finding teams that share its values, decisions are underpinned by private equity-style analysis.

"It wasn't until after I left 3i - having spent 16 years there - that I realized how important our internal processes were. When you go somewhere that doesn't have these processes you appreciate them for what they are," he adds.

Based on his experiences in the US, McNally of McNally Capital is convinced that the family office movement from fund commitments to direct operating company investments represents a systemic shift. Three years ago he wasn't so sure, but the steps taken to build out dedicated investment teams make for a convincing case. Five years hence, McNally expects club deals between families to account for a more meaningful portion of deal flow.

Plotting the future

It is an open question as to how quickly Asian family offices might follow suit. Although there are groups in the region that are of international standard in terms of sophistication, they are few in number. EXS' Solberg believes there is still a struggle between applying local knowledge and connections and developing a professional approach. "The worst family offices hire second-rate PE guys, and they are just run-around guys for a very capricious and whimsical investment committee process," he says. "The best ones hire grade A professional teams and incentivize them as well as or better than PE firms."

Yet it is the pace of progress that is subject to debate, not progress itself. Several industry participants point to an evolutionary process among Asian family offices that has already been seen elsewhere. It takes place gradually, crawling up and along two axes: the first measures the level of comfort with private equity, starting with fund investments and moving into direct exposure; the second tracks generational change and the introduction of professional management.

Henry Lee served as CIO of Hong Kong-based real estate and investment company Nan Fung Group, before launching his own fund under Hendale Asia. He respects families that don't assume they can seamlessly replicate business success in the investment world, but rather identify what can be accomplished in house and outsource other functions to third parties. 

This is likely to happen with increasing regularity as more families recognize the importance of wealth preservation. Looking to create portfolios that are diversified rather than concentrated in particular industries, they find that time-intensive PE co-investment is best left to those with relevant expertise.

"Most Asian families have never thought of investments as a separate business because their operating businesses have done so well in a high growth economy," Lee says. "However, economies are slowing and operating rates of return are dropping with increasing risk. The primary way they can mitigate that risk is through investment diversification globally."

 

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• Topics
• LPs
• Buyouts
• Expansion
• GPs
• Fundraising
• Family office
• LPs
• Co-investment
• Direct investment
• Fundraising
• Asia