Seven Ways Family Offices are Different from Other Buyers of Lower Middle Market Companies

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Like most other institutional investors in recent years, family offices have shifted a significant share of their assets from the public markets to private equity, real estate, and other nontraditional assets.

Unlike pension funds and endowments, however, affluent families have not been content to invest through private equity funds. They are at least as likely now to invest directly in middle market companies.

A 2021 survey by Citi Private Capital Group found that nearly half of family offices have more than 25% of their overall portfolios in direct private investments. The Family Office Exchange (FOX) found that the overall share of assets devoted to direct private equity investments by family offices increased by 50% from 2014 to 2018.

Family offices have an advantage in direct investing that other institutions often don’t: the business experience of the family itself.  Most often, their wealth stems from building the sort of middle-market companies their family offices are now buying into. That gives them insights, connections, and experience that boost the return of deals.

Here are seven ways that family offices are different from other investors in middle market companies:

1. They have a longer time horizon 

While a typical private equity fund is looking to exit its investments within seven years, family offices can hold companies much longer.  They generally are investing with money that isn’t needed to pay any near-term expenses.

“Our family has been phenomenally successful since the patriarch took over the business 50 years ago, and now they are thinking about the next generation and making sure their wealth grows with their expanding family,” says Michael Barnes, vice president of Walnut Ridge, the investment office for the Kanfer family, which owns Gojo, the maker of Purell. “We have much more flexibility than traditional private equity firms because we’ve got no artificial timelines that drive a need for liquidity.”

The long-term perspective also creates an incentive to hold investments so their value can compound without triggering capital gain taxes, Barnes adds. 

2. They contain multitudes

Even the office for a single family typically looks after many distinct trusts, balance sheets and entities, each with its own assets, liabilities and cash flow needs. Moreover, the family office management often must reconcile differing views and goals among family members.

“If you’ve seen one family office, you’ve just seen one; they are all different,” says Peter Braxton, the managing director for investor relations at Akoya Capital Partners. “They all have members with differing passions and priorities. They have different liquidity requirements, active vs. passive investment styles, tax rates, and risk tolerances.”

And more than a few families have at least some of the intergenerational intrigue vividly on display in HBO’s Succession. Nonetheless, Braxton observes that strong leadership from family members and the family office staff can keep at least normal levels of familial dysfunction from impeding investment decisions and potential performance.

3. They either love the industry where they made their money, or they want to avoid it.

Any financial advisor would suggest that a family whose wealth comes from, say, oil wells would be prudent to invest their free cash anywhere but the energy industry. Indeed, some family offices embrace diversification, investing broadly or developing a few themes that may stem from the passions of some family members.

Often, however, families are drawn back to the source of their initial success.

“People will say I still love that industry, and I see more opportunities in it and accretive ways to use my contacts,” Braxton says.

4. They want to be involved after writing the check

One of the appeals of private direct investing is that it gives family members the opportunity to work with their portfolio companies. For the Kafner family, Barnes says, these deals offer both financial and non-financial rewards.

“They are operators at heart and think they can generate outsize returns by investing in the lower middle market, being involved, serving on boards, and digging deep,” he says. “It’s also, quite frankly, what they enjoy doing, and they figure why not get some enjoyment out of the way they invest their money.”

5. They hate paying fees

Another appeal of direct investing is that it avoids the management fees charged by traditional private equity funds. It may seem discordant that many of the world’s wealthiest people are also among the most willing to go out of their way for a bargain. An explanation for this paradox, Braxton suggests, may come from the experience of entrepreneurs. “When you’re in business, you’re used to buying wholesale materials, adding value, then selling them retail,” he says. “I don’t know any successful person who is comfortable always paying retail.”

6. Getting access to deal flow can be a challenge

Many family offices say that among their biggest obstacles in building out a direct investment portfolio is ensuring that they have the opportunity to bid on the most attractive potential acquisitions.

“We’re using investment banks for the majority of our deal flow, and quite frankly, we are more dependent on intermediaries than we want to be,” Barnes says. “So we’ve started a process of reaching out to people who are playing the areas we’re interested in – advisors, experts, board members, former CEOs. And we’re building connections so we can start to meet some business owners who may be getting ready to sell.”

Another channel, Barnes says, is the Axial network. “It helps me cover the long tail of business brokers and investment bankers that I don’t have time to build relationships with,” he explains.

7. They often need a creative way to bring other investors into a deal

While direct investing helps avoid fees and offers family offices a way to leverage their business experience, it presents concentration risk. At today’s multiples, even modestly sized businesses can represent a significant portion of one family’s investable assets.

Family offices have long financed other deals by reaching out to other families, either through their own contacts or through networks like the Family Office Exchange. Another approach is to work with an established PE fund or independent sponsor as a coinvestor. This can help a family increase its exposure to an already successful deal while providing access to additional industry expertise.

“If you buddy up with an institutional private equity firm, you get more alignment of interests; they have the infrastructure and can handle all the mechanics needed to complete complex deals,” said Braxton, who is building a small group of family offices that will coinvest with Akoya. For families that commit to participate and looking at deals, it is offering reduced management fees and the opportunity to own a share of the general partner.

“A traditional GP doesn’t necessarily value the years of experience a family has developed operating their business,” Braxton says. “Here, they actually become part of the GP and can put their experience and contacts to use for the good of the firm and the syndicate.”