Direct investing in private equity by single family offices has its challenges that need to be clearly understood, argues the author of this article.

The following article is by Rupert Phelps, who is the director of family office services at Savills, the real estate firm; he works with substantial investing families in the UK and Europe. The article was originally published by Somers Partnership, which is a specialist wealth management recruitment firm. This publication is grateful for permission to republish this item and invites readers to respond with their views.

The intellectual thesis for single family offices to engage in direct private equity club deals with like-minded families is compelling. The common cry from SFOs is that “they want more control over where their money is put to work” and so this argues against committing to blind pools. But many single family offices are sceptical and there is wide acknowledgement that there are few examples of it happening successfully and many investments remain too early in the cycle to judge.

In principle, substantial families may well be more predisposed to have the contact, involvement and control that come with direct investing. They may also see this as a way of leveraging their reputation, expertise and network, yet there is little evidence of club deals amongst “like-minded” families. Furthermore, since one key driver for a family to go direct is control, it must be appreciated that including other investors will add different agendas, risk appetite, and timeframe.

One principal of a London-based SFO remarked: “Direct private equity for SFOs has grown in significance in the last three or so years, not least because it is perceived to have a natural governance and scale fit (since small tickets are not worth the resources used in due diligence) with the largest investing families, but the actual dangers of this approach to investing are vastly under-considered, and, whilst it is more talked about than done, beware!”

One educative advantage sometimes cited is that a limited partner SFO might place a next generation family member as their representative on a portfolio company’s board, yielding vital early financial experience (and only direct private equity will allow this). The dangers are, however, substantial. Deal origination, screening, due diligence, and then ongoing administration and monitoring is a skilled process that even $1 billion-plus SFOs are unlikely to possess in-house, and clubbing together with other similar families (unless one is a deca-billion outfit which can resource such broad in-house investment expertise) could compound problems but not deliver a solution.

There is also the inherent danger of group-think and similar culture leading to a lack of suitable application to the required work on the way in, and potentially lack of suitable control during the holding period. On these points, specialist private equity advisors have a compelling case to make for "using the experts". Another argument used in favour of the pooled approach is that direct private equity leads to concentrated positions in a few portfolio companies, rather than greater diversification.

Perhaps the most compelling way to sow a seed of rightful scrutiny is to ask the question, why is my family being offered this co-investment? If it is genuinely attractive and high quality, surely it would already have been taken or allocated by the existing general partners and their closer associates? Consider another danger endemic in SFO direct private equity investing: often the origination of such deals is though social networks (the bar at the club), which can add to excitement and appeal but vastly increase the likelihood of buying into a “dog” that has already been touted round more expert potential LPs who have chosen not to invest.