Family offices are private wealth management firms that serve ultra-high net worth individuals and families. In recent years, there has been a growing trend of family offices bypassing third-party fund managers to make direct investments into companies and assets. This direct investing approach has its unique pros and cons compared to the traditional strategy of investing through external fund managers. In this article, we will explore the key considerations around direct investing for family offices.
Direct Investing Allows More Control and Customization for Family Offices
One of the main benefits of direct investing for family offices is greater control and ability to customize investments. By directly selecting companies and assets to invest in, family offices can fine-tune their portfolios precisely to their specific goals and preferences. For example, they may want to have a direct stake in certain high-growth startups or local real estate projects. Direct investments also allow closer involvement in deal terms and corporate governance. Family offices can negotiate preferred stock terms, board seats, and other special rights not typically available through third-party funds. Hands-on oversight is easier with direct deals compared to reliance on external fund managers.
Direct Investing Requires Building Internal Capabilities
While direct investing provides more customization and control, it also requires family offices to build internal teams with strong deal sourcing, evaluation, and post-investment management capabilities. Assembling the expertise across private equity, venture capital, real estate, infrastructure, and other areas takes time and investment. Smaller family offices may lack the scale to justify developing specialized internal teams. There can also be a steep learning curve when family offices first start doing direct deals without an existing portfolio of fund investments from which to learn.
Fees Are Lower but Operational Burdens Are Higher
Avoiding the typical 2% management fee and 20% carried interest charged by third-party funds is an obvious cost advantage of direct investing. However, the expenses associated with building an internal direct investment program can still be significant. Deals need to be structured, negotiated, and monitored, requiring dedicated staff and advisors. Legal, accounting, travel, and other costs add up for direct deals. Still, overall costs are typically lower compared to paying external fees, especially as assets under management grow larger.
Direct Investing Involves Less Diversification
While diversification is still possible, direct portfolios are more concentrated by nature compared to fund investments. Top fund managers make investments across hundreds of companies and assets, while even large family offices may only have the capacity to directly invest in dozens. This concentration introduces portfolio risks that require careful monitoring. Smartly constructed fund portfolios provide embedded diversification that direct investors must create themselves.
Fewer Liquidity Options with Direct Investing
Direct investments into private companies and assets are inherently illiquid long-term commitments. While fund stakes typically permit redemptions based on net asset value, direct investments cannot be exited until a private company acquisition, IPO, or asset sale occurs. This illiquidity needs to be accounted for in financial planning and cash management. It also makes rebalancing more challenging compared to fund investments.
In summary, direct investing provides family offices greater control and customization over their portfolios. However, it requires major investments in internal capabilities and accept less diversification and liquidity. Weighing these key pros and cons allows family offices to take a strategic approach when deciding between direct vs fund route for making investments.