For the last four weeks, we have been working through a series exploring the trend for family offices to engage in private equity deals directly, aka “direct deals” vs. allocating to traditional private equity fund managers. While there is much that makes intuitive sense about such an approach, as the great Yogi Berra remarked, “in theory there is no difference between theory and practice – in practice there is.” The prior 4 posts on this topic have meant to elucidate many of these key points of difference between theory and practice. To recap, we considered the family’s choice to become a buyer of businesses, the competition for doing deals, identifying potential targets, and the challenge of knowing what price to pay. Today in our final installment, we consider two remaining, but crucial dynamics of direct deals – the choice to exit and the challenge of portfolio management.
If in our last post we concluded with the completion of the transaction and the price paid, we have admittedly skipped over the challenge of operating the newly acquired business. Certainly, a family that has been a long-term operator of a prior business(es) likely has some operating chops within its human capital. Nevertheless, by entering an operating business vs. starting from scratch, there is an element of building the airplane, whilst flying it post acquisition. The family must rapidly climb the learning curve for the industry, its new business, and its new employees. The way the family has always done things operationally may or may not make sense within the context of its new portfolio holding. Whether to cut costs, grow organically or inorganically – there are a host of new strategic decisions to be made where the family is operating from a much more limited information set vs. the family’s core business. The more the family can bring a transferable ‘management system’ to its new business, the better able it will be able to navigate an unfamiliar landscape.
Then of course comes the most difficult of decisions – knowing when to exit. We have written in the past on a framework for thinking about when to exit in the context of public market investments (here). And much of that analysis applies to private holdings. The great difference for a family office owning a business is the potentially unlimited time horizon permitted by the family vs. understanding the conditions under which an exit makes the right strategic choice. This is not unique to families, management teams of public companies are often challenged to know when the right time is to buy back their shares using share repurchase which is analogous to knowing when the time has come to sell.
No doubt a foundational element of such a choice is having a robust corporate governance structure in place. A high-functioning board replete with outsiders can bring its considerable expertise to bear in helping the family consider when the business’s strategic position has changed, and an exit is the best choice to harvest value. Similarly, thoughtful outside advisors can help when a proverbial too good to be true offer is slid across the desk.
Living in Nashville, there is no greater example of a family that has figured this out than the Frist family which founded and has owned Hospital Corporation of America multiple times. The family’s leadership has an acute sense of cycles of the business and has been able to buy back and take public the company multiple times – each time sizably increasing the family’s financial wealth.
Most likely a family who has embarked on a path of direct business ownership will choose to own more than a single asset. The shift in mindset from an owner/operator of a single business, to managing a portfolio of businesses should not be taken for granted. Within a portfolio, the family must consider how much capital to commit to any single deal. How do they handle oversight and governance at each portfolio holding? Are there enough people within the family who can credibly manage and / or oversee a diverse portfolio of holdings? Additionally, having a clear policy articulated for how businesses retain or distribute capital is important. One of the genius insights of Warren Buffett and Berkshire Hathaway has been the ability to reallocate surplus cashflows away from businesses that do not need further reinvestment capital to deploy into businesses with higher reinvestment potential. Families should study and adapt this approach for their own holdings.
So, what the message after all this? Let us consider the upside first. As we highlighted last week, the owner effectively earns the return on invested capital (after adjusting for the impact of leverage) of the business. A sensibly purchased, professionally managed and nicely growing business can present a family with an attractive way to compound capital over long periods of time in a highly tax efficient manner. The sizable cost of management fees and performance fees, even despite a preferred return, mean that private equity sponsors reap a sizable amount of the reward of any potential investment. The desire to go direct is understandable and makes sense.
Yet the path from pure liquidity (unallocated cash in the bank) to the El Dorado of private equity-esque returns is neither simple, nor linear. Sadly, in our experience, many families and family offices are formed and begin operation with a sizable degree of naivete about the difficulties they face. And understandably that is the place where all investors must begin. The question is whether the family will move beyond such a place of naivete, what we have termed the strategy of “only doing good deals,” to the place of being a serious investment contender.
If the family is serious in pursuing such a path, they must be highly intentional in their choices. They must recognize the limits of their own expertise and partner with outsiders where appropriate. They will have to understand new compensation dynamics as they compete for investment talent. And they will have to learn to think like investors, not just operators. Investments must be held to high standards, and management teams accountable for delivering performance. With such intentionality and a good dash of luck, the family may find itself successful in its newfound endeavors.
Disclaimer: This does not constitute investment advice or an offer to buy or sell any securities. It is provided for informational purposes only and represents the author’s own opinions