Asset Class Diversification: A Family Office Perspective on Direct Investing

There is a growing trend in which Family Offices are directly buying or investing in private companies, as opposed to allocating capital at arm’s length to managers of private equity funds. The trend is nascent but could become more widespread in the coming years, says Gene Lee, Managing Director of Cove Point Holdings, a Family Office and Member of the Axial Network, who in our recent interview touched on how to stand out from private equity firms, source viable investment deals, close transactions quickly with no leverage, value a company for the long run, and work with existing management as a Family Office business buyer.

Anthony: How prevalent is direct investment – buying companies – by Family Offices as opposed to 3rd party asset allocation?

Gene: “We (Cove Point Holdings) are looking to acquire businesses directly and own them outright. On the family investment side, more and more people seem to be going the route of acquiring businesses directly or investing in a minority stake of a company and having the infrastructure to do so. Historically, most Family Offices have operated more like traditional asset management businesses that hire investment advisors or officers to construct a portfolio of public securities and private investments – for example, placement in private equity and hedge funds. This is probably what the lion’s share of Family Offices do, but more are starting to take a more active approach of looking for companies to buy directly and own outright in their portfolios. There’s now small penetration, but it’s [a trend] that will probably continue to emerge over the next few years.”

Do you use leverage to complete transactions?

“No, we don’t use any debt to finance the acquisition of a company. We are an all cash buyer that uses 100% equity capital that is available for immediate investment. While we have a solid understanding of debt financing alternatives in a leveraged buyout, we don’t believe that it’s prudent to acquire smaller middle-market businesses with significant debt as part of the capital structure. Financial debt in a smaller middle market business can be very risky and limit the operating flexibility and growth prospects of a business. We don’t believe that it makes sense to compound the operating risk of growing a smaller company and the risk from an ownership transition with the risk of a leveraged capital structure that could have bad consequences for a company if it misses a beat. Leveraging up a company too much puts owners, management and employees at risk. Also, on the one hand [not using leverage] creates an advantage over traditional private equity buyers who might not be able to get financing, plus we can also move much more quickly in executing a transaction without debt financing contingencies or risks. But that also means we aren’t pricing our offers around leveraged returns, so we may not be able to pay as much. I work very closely with the family [whose money it is], and we’re constantly reviewing and evaluating acquisition opportunities together. We try to be careful and disciplined about how we invest. If we don’t believe that a deal has a reasonable valuation, we won’t do it. We’re looking to partner with owners and managers who share our conservative approach to capital structure, and we’re trying to acquire solid businesses at a reasonable valuation.”

You mentioned working very closely with the family. How is direct investing as a Family Office different than traditional private equity transactions?

“A Family Office generally has the flexibility to change its investment criteria and approach as it sees fit whereas private equity institutions are more limited by their investment mandates. Family offices generally don’t have limitations with respect to the types of securities we can invest in, transaction structures, industries, startup vs established businesses, etc. That said, we (Cove Point Holdings) happen to have a focused investment strategy and are looking to acquire established companies in the US, and we have a bias for industrial manufacturing businesses. But, a primary difference and benefit associated with private family ownership is that we generally have a longer and more flexible investment horizon. Unlike a private equity fund that might have a five-year investment horizon and a ten-year fund life and who needs to exit investments regularly and return cash to their investors in a relatively short period of time, we have the ability and desire to hold and grow companies for the long term. We look for good businesses that generate attractive cash-on-cash returns, and we’re looking to partner with management teams for the long-run. We have owned businesses for more than twenty years, and we take that same long-term approach to investing when we evaluate opportunities currently. I believe that this ability to have a long-term investment approach has a meaningful and beneficial impact on the development and growth of a company. The strategic decisions that we make with our management teams for our companies are primarily based on determining what’s best for the business in the medium and long term. We have no incentive to make decisions that might provide a short-term pop but creates longer-term losses or risks for the business. For private equity funds that need to exit their investments and are highly motivated to maximize their own financial gain, their approach and financial incentives aren’t always the same. Sometimes the financial incentives of a private equity fund manager are at odds with the longer-term objectives of a company. And, exiting an investment at the wrong time through a sale of the company or a public offering can be pretty disruptive events.”

I imagine it must be more difficult to source deals as a Family Office without the analyst team and resources available to private equity. How do you find viable investment candidates?

“It takes a significant amount of time and resources for a Family Office to build and sustain a strong network from the ground up. It’s all about building and leveraging relationships productively, and the Axial network has become an integral part of that strategy – we bought a company on the network in 2010 – helping us both stay connected and meeting with new companies, investment banks, and sources of opportunity. We look at hundreds of opportunities per year, sign confidentiality agreements on approximately ten percent of them, meet with close to twenty percent of that group, then bid on a handful of them. If everything goes right, we’ll acquire one business a year.”

What do you do with existing management of a company you buy?

“Management is absolutely key. Our strong preference is to partner with the existing management team or key executives who want to stay on to run the business. If we need to bring in an outside manager, we can do so. But, our bias is definitely to work with an existing team. There are times and situations when you have to replace a management team, but this can very disruptive and set a business back quite a few years. Oftentimes most private equity firms and Family Offices alike are very management friendly; they give management significant options or equity stakes to align economic interests and to provide attractive financial incentives. We give management a significant amount of operating flexibility while providing appropriate controls to ensure that we’re aware of how the business is performing and that we’re involved with important strategic decisions. We speak to our management teams regularly, and we have very open dialogue around operating and strategic initiatives. Because we (Cove Point Holdings) have a more concentrated portfolio than most private equity funds, we’re able to spend more time with our management teams and add value where appropriate. We’re closely aligned with management, and we’re obviously highly motivated to ensure that management is successful in running and growing the businesses.”

What is your outlook on the market for deals right now?

“The deal environment seems to be getting healthier. The financing market is more difficult but that’s better for all-equity investors like us. Valuations are still high but starting to become more reasonable. The volatility and difficulty in the public markets are probably related to this. The underlying economic environment seems to be okay. The companies that we’re generally seeing are not always doing great, but they’re not doing horribly either. For us, we continue to be comfortable acquiring businesses in this environment, especially because we don’t use any financial leverage. I’m not sure that we’d feel quite as comfortable if we had to do a leveraged acquisition when there’s meaningful risk of a recessionary economic environment. So, overall, I’m optimistic that there will be some good opportunities for us in the year ahead.”

A few weeks before my interview with Gene, Ramsey Frank of JLL Partners made the point at the Yale Private Equity Conference that environments like the current one in which leverage is hard to find naturally benefit those investors who don’t rely on it in their business models. Family Offices, such as Cove Point Holdings, that don’t use any debt financing are able to mitigate execution risk for sellers and close deals expediently. These traits, along with investing with a commitment to the long-term success of a business (and thus the ability to perceive more intrinsic value than shorter term buyers can) and sourcing deals through online networks and old relationships, place Family Offices in a perfect position to continue the trend of buying businesses outright and perpetuating wealth for future generations.