Five Factors Complicating Direct Deals Right Now For Family Offices

Family offices are continually evolving. As they grow in number and assets, direct investment models are emerging, and conventional portfolio architecture is being revisited with vigour in the post-COVID environment.

The recent Dentons Family Office Direct Investing Survey reveals various reasons why more family offices focus on direct investments. These include enhanced returns through circumventing management fees and the carried interest of fund investments, alignment with the family’s interests to exert more influence and enjoying greater control and transparency within specific industries and company types.

Despite these benefits, direct investments are not without challenges. These types of investments are often complex, illiquid and risky, and there is also no guarantee that they will outperform funds and publics. What’s more, they require skilled investment management resources to ensure success.

Below are the top factors complicating direct deals as listed by the survey’s respondents. These factors, along with trust and confidence, an often lesser considered factor, warrant careful consideration when formulating direct investment strategies in 2023 and beyond.

Operational risk

According to Denton’s data, 45% of family offices worry about taking on too much operational risk when investing directly. This is a legitimate concern given the nature of operational risk and the fact that even a slight oversight can have significant repercussions. There are, however, ways to maximize operational security and reduce this risk.

Many elements factor into operational risk, which requires careful consideration when assessing direct investments and ongoing monitoring and assessment throughout the investment process. Therefore, it is vital that each potential risk element, no matter how nuanced, is considered and assessed rather than focusing solely on a few significant risks from the operational category.

It is also advised that family offices involved in direct investing formulate a documented operational due diligence process and that minimum consistent level standards are set for review on an ongoing basis. The initial formulation of such procedures may take time and pose additional challenges at first. However, when identifying objective minimum standards across different opportunities, having a structured, well-defined process in place offers a solid foundation for assessment that can be tailored to best practice over time.

Family offices not equipped to carry out operational risk assessments and management strategies in their entirety may consider investing in developing this expertise in-house or securing outside council can save considerable sums long-term.

Access to high-quality deal flow

Forty-three percent of Denton’s survey respondents cited access to high-quality deal flow as a challenge in direct investments. This is particularly relevant in an increasingly competitive environment where family offices are conducting higher value and volumes of deals than ever before, as evidenced by the findings of the recent PWC Family Office Deals Study.

To secure deals, single family offices are reportedly partnering with other family offices and groups on deals. Expanding these partnerships will become crucial, and families must look beyond their immediate networks and build relationships beyond them.

Still, building new deal pipelines is often tricky. While family offices are increasingly looking for new opportunities because they are private by design, it can be challenging for outside parties to discern which families are actively seeking investment opportunities. This causes a disconnect in the deal flow pipeline. It is, therefore, critical for family offices to build a presence within industries of interest. This can be achieved by joining relevant industry bodies and associations, attending conferences, networking events and educationals to build relationships and expand the family office’s footprint.

Control over exit options

While family offices are known to be flexible and offer patient capital, exit options are still considered for direct investments. In fact, forty-two percent of Denton’s survey respondents listed exit strategies as a challenge.

To minimize complications, family offices making direct investments need to understand their total wealth, liquidity and strategic goals across their entire portfolio. These factors, along with the investment timeline, must be clearly defined for the family, the portfolio company and the stakeholders to ensure alignment of all parties.

Due diligence

FINTRX data shows that most family office investments occur throughout early-round funding, with 29.5% of these being made in the earlier seed-stage and venture rounds.

Due diligence is undeniably a necessary step in the investment process, yet, forty-one percent of Denton’s survey respondents list it as one of the top challenges they face when it comes to direct investing, particularly from a legal perspective. When it comes to startups, conducting due diligence in the same way that a family office would on a larger company can cause significant delays and potential missed opportunities.

New ventures are notoriously difficult to value, and much like family offices, each is different. According to Seraf, comprehensive due diligence efforts on startups that require endless hours of investigation into every aspect of the company and drag on for months may do little to de-risk the deals.

Similarly, family offices involved in any direct investment need to consider re-evaluating how due diligence on startups is performed and not subject them to the same approaches employed when evaluating more mature companies. Creating new processes that revolve around identifying risks, obtaining sufficient information to develop an investment thesis, and knowing what needs to be believed for investments to be viable can help execute due diligence in a comprehensive yet more rapid manner.

Trust & confidence

Foreign direct investment is critical to global economic development. Marked declines have been noted as tax reforms, anti-globalist policies and, most recently, the COVID-19 pandemic have taken their toll on countries worldwide.

Investor confidence has plummeted for developed, emerging and frontier countries, with the latter two being hardest hit. However, a return to fundamentals is noted, with investors favoring larger, more stable markets with more predictable political and regulatory structures.

Now more than ever, it is critical for family offices to utilize strategic foresight tools to improve planning strategies and predict potential future exogenous shocks. As a result, contingency and scenario planning, simulations and “war-game” exercise are becoming an essential part of direct investment protocols.

The challenges associated with direct investments are undeniable. Yet, with values alignment, proactive strategy and process formulation, investing the required resources in developing expertise in this area and a little creativity, family offices can continue to reap the benefits of these opportunities for years to come.