A conversation we have been having with family offices recently is about the magnitude and significance of the change when a family moves from being predominately an operator of a business(es) to an investor in businesses. This shift can be sudden in a liquidity event when the whole business is sold, or gradual, as excess cash flow from an existing business is redirected over time into other investments. Regardless, it remains highly important that families understand the new landscape in which they find themselves. Below we summarize our view of the 3 most important factors to keep in mind.
First, families must recognize that they are now participants in an efficient market. When an operating company is owned and controlled out right, the owners have access to several unique market inefficiencies. They likely have sources of non-public information about suppliers, customers and competitors. These sources can be combined in novel ways to drive new product development, operational efficiencies, or even M&A strategy. As an outside investor, this efficiency goes away. In the case of investments in public companies, management teams are highly regulated in the data that they can and cannot share with their shareholder base.
Even in the case of buying private companies, with the number of private equity funds, sovereign wealth funds, search funds, and other family offices actively searching for, pursuing due diligence, and closing on deals in an industry, there are a host of people who are being engaged to find relevant information that can be used to add returns to the business. Because of the number of other bidders and limited information available, this leads to the creation of a market. As such, the potential for out-sized returns (especially vs. a diversified benchmark like the S&P 500) is greatly reduced. The price being paid for the business is highly likely to reflect both the current economic reality of the business, as well as likely pathways for additional value creation.
Second, families must recognize that their capital allocation decisions are infinitely broader now. Earlier in my career when I was moving from an analyst to a portfolio manager, one of the key things I learned was that just because a specific company is the best opportunity in its industry (i.e. the view of an industry focused analyst), the determination a portfolio manager must make is if it is the best opportunity relative to all other competing options (i.e. cross-industries).
For years, a family owned company has had its choices regarding capital allocation nicely constrained. They could either reinvest in the operating business through capital expenditures or M&A, or they could return capital to shareholders through dividends / share repurchase. The reinvestment decision is largely binary. Now, as an investor, the family can consider a global range of options across a plethora of asset classes. This dramatically increases the complexity of the choice architecture – which may necessitate the need for additional team members, education for the family, and new advisors to assist in the process.
Third, families must recognize and resist the story-driven nature of investing. To an outsider, investing appears to be a largely quantitative practice. But I can definitively say that the most advanced math I have ever used in my career is algebra with an occasional bit of statistics thrown in. Instead, investing at its core is the analysis of a situation and then the creation of a narrative about the opportunity and future potential ahead. Whether in equity research or investment banking, this is the fundamental task that those professionals are engaged in.
This matters to families because those employed in the production of financial products are really good at telling stories. They can craft narratives that appeal to your emotions, greed, hubris, etc., in order to get a transaction done, simply because they are ultimately compensated by their ability to get someone to act. As such, families must be on-guard as they evaluate those stories to find the true sources of long-term opportunity. This is best done by insisting that investing be executed in the same way that the family ran its manufacturing facilities – in a process-oriented, methodical and measured way which will help mitigate the emotional appeal of a great story.
Families who can keep these three factors: market efficiency, trade-offs, and stories, in mind will begin their journey as investors at a much greater advantage vs. their less aware peers. Building the correct governance structure around the investment process will further reinforce this awareness and mitigate any potential ill effects.