The report notes that a global economy roiled by geopolitical, economic, and regulatory transformations in 2023 will undoubtedly present challenges for family capital, but well-positioned planning also will allow dynamic opportunities to be captured.

The following article comes from Dentons Family Office, part of global law firm Dentons. Family Wealth Report published an article about the group’s Direct Investing Survey Report here. In this piece, the firm delves into more detail about the report. This is an example of the in-depth coverage that FWR is able to provide through its work with Dentons and other parties. 

Introduction 
Family offices have traditionally invested indirectly through funds and investment managers. However, a trend in recent years toward direct investments by family offices – whether in real estate, infrastructure or private equity – has continued unabated. The ability to make direct investments can be very attractive to family members and those running family office investment portfolios. However, as directs can be complex, illiquid, risky single-asset investments, with no guarantee of outperformance over funds or publics, they require skilled investment management resources for success.

The new year presents a unique set of challenges for family offices when it comes to directs. On the heels releasing the 2023 Dentons Family Office Direct Investing study, we explore key risks to be navigated in the current climate.

The challenges of direct investing for family offices
While direct investments can offer family offices access to good opportunities and the ability to influence how an investment is managed, they can also be challenging, requiring time and expertise. From determining market and regulatory intelligence to identifying suitable opportunities, agreeing to terms, then managing the direct investment through to exit routes and realizing gains, direct investments can be very demanding.

We see nine hurdles family offices face when going direct:
--   Operational risk; 
--   Deal flow quality;
--   Control of exit options;
--   Time management;
--   Ability to conduct thorough due diligence;
--   Fees and costs;
--   Legal and regulatory issues;
--   Alignment with family mission and portfolio goals; and
--   Investment amount requirements.

In our survey, we found that family office size is an important factor in what they see as the biggest direct investing challenges. Large single-family offices (SFOs) and family enterprises (FEs) with over $1 billion in assets are more likely than smaller ones to see obtaining high-quality deal flow (51 per cent) and having too much operational risk (54 per cent) as the biggest challenges. It may be the case for larger SFOs that deal flow is a critical issue because more in assets needs to be allocated to suitable opportunities. In contrast, for SFOs and FEs with less than $250 million in assets, having control of exit options is the biggest challenge (41 per cent), followed by managing fees and costs (32 per cent). Small SFOs and FEs are also more likely (13 per cent vs. 6 per cent overall) to find high-minimum-investment amounts a challenge.

From a legal perspective, the biggest challenges of direct investing are due diligence issues (66 per cent). Structuring investments is also an obstacle for families (43 per cent), while 40 per cent say that tax and estate planning is a difficulty. While there are regional differences on legal challenges, overall, family members (57 per cent) and smaller SFOs and FEs (62 per cent) are more likely to see tax and estate planning as a key legal hinderance. For the largest SFOs and FEs, over half (51 per cent) put litigation risk as one of the most arduous aspects of direct investing.

Avoiding pitfalls on the path to going direct
Family offices are typically quite different in their objectives, design, operations and impact on their environs from other types of business and institutions as their creation often results from the sale of a privately held business or similar liquidity event.

Henry Brandts-Giesen, a partner in Dentons’ New Zealand office, has found that for many families, the business exit and the ensuing transition from predominately owning and operating a commercial enterprise or real estate to passive, indirect ownership of a portfolio of less familiar asset classes is challenging, both conceptually and practically. 

This is because some wealth creators and stewards expect higher returns and prefer more direct ownership and control than a portfolio of listed securities and managed funds can provide. They may crave the stimulation and potential for outsized ROI that directly owning and operating a business offers, and therefore favor direct investing after an exit.

Henry observes that while that approach may fulfill the natural human instincts of entrepreneurial family members and boost financial returns in the short term, it can defeat many of the purposes for which the family office was set up – for example, diversification, liquidity, reducing key-person risk, smoothing out returns, downside risk protection, and liberating the family to do other things. Direct investment may also be inconsistent with the family office’s investment governance structure, investment policy statement and the views of hired investment advisors. 

However, it need not be that way, and directly held investments can be a high-performing component of a responsible family office asset allocation strategy. With a clear strategy, advice, research, systems, processes, protocols, and procedures in place, many of the aforementioned issues can be managed. Engagement with, and sharing intelligence among, other family offices and sector experts is a good starting point.

Global M&A in 2023
The global M&A topography has become increasingly jagged, as recession, inflation and geopolitics place a pause on transactions. But that same lull appeals to visionary companies and financial sponsors eager to take advantage of decreased valuations. In a recent Dentons global M&A survey, the shifting tides of cross-border M&A, over a third of executives in the US and Canada and 40 per cent outside North America expect the volume of near-term cross-border M&A to increase compared with the prior year. Within the realm of acquisitions, the technology, media, and telecommunications sectors are currently seen as most attractive. However, these visionaries remain alert in managing cross-border and growth-capital investment risk as inflation and stricter protections on foreign direct investment may negatively impact their investment strategies.

On an overall positive note, two-thirds of respondents based outside of North America cite the US as being one of the most appealing regions for buy-side, cross-border M&A activity, leaping ahead of other markets. Conversely, US and Canadian respondents emphasize opportunities in Eastern Europe (47 per cent). Christopher Rose, a corporate partner who advises on cross-border transactions from Dentons’ London and Dubai offices, observes that families in Africa, Asia and the Middle East/North Africa are increasingly seeking to diversify their wealth beyond their family businesses.

These family enterprises, concerned about keeping all their “eggs in one basket” (or in one business, one country or one currency), are increasing their exposure to equity, venture capital and real estate, mainly in Europe and the US. It is not surprising that the main drivers of cross-border M&A transactions in the coming months will include expansion into new growth markets and scaling up to become more competitive. 

Adding to the complexity of the current business landscape, executives and family enterprises anticipate that guidelines involving ESG (environment, social and governance) and sustainability principles will heavily impact cross-border M&A decisions going forward. However, addressing the ESG agenda need not be a daunting task, as investors can work on closing the gaps in ESG strategies and cultures between the buying and selling entities.

Trends to consider in regulatory, legal, and political affairs 
The impact of current geopolitical disruptions, tumultuous economic markets and stepped-up restrictions imposed by regulatory authorities are directly affecting family office investment dynamics. The war in Ukraine was a defining geopolitical challenge in 2022 that continues into 2023, as tensions spiral between Russia and the West. Additionally, the left-leaning governments of Latin American countries that dominate the world’s supply of certain agricultural products and the extraction of green minerals will impact global markets. The global rise in inflation may lead to political instability in certain countries. 

It is also a fact that our globally connected economy is locally driven. As China and the West continue to decouple their economic strategies, we will experience a seesaw effect in trade policies. The change in the composition of the US Congress, post the midterm elections, and in the regulatory framework relating to valuation, securities lending, special purpose acquisition companies (SPACs) and cyber security disclosures, among others, as well as the uncertain outcome of the US debt ceiling negotiations will evoke concerns globally. Regulatory gyrations also abound as the UK comes to terms with the implications of its vote to leave the EU. 

As noted by Mike McNamara, a partner based in Washington, DC and former CEO of Dentons US, during this period of geopolitical and macroeconomic uncertainty, families are navigating investing choices with far more sobriety about objectives and the need for adherence to a structured plan. Across families and executives worldwide who have shared their front-line perspectives on the direct-investment climate, private market opportunities – appropriately accessed, presented, valued, structured and diligence – are playing a growing and competitive role in a diversified portfolio. More than ever, family offices and their partnering organizations need to leverage broad internal and external expertise to deploy liquidity, maximize downside protection and create value amid rapid change.

On the environmental front, we anticipate that ESG regulations, and growing controversy around the form of ESG mandates, to ramp up in many regions, improving sustainability and reducing greenwashing while also confronting uneven government mandates. 

Bankruptcy and restructuring activities 
Over the past three months, three trends appear to be dominating the distressed-asset markets connected to central banks’ higher interest rates. 

First, crypto asset investors have been shocked by major organization chapter 11 filings and insolvency proceedings. Tania Moyron, head of Dentons’ US Restructuring, Insolvency and Bankruptcy team notes that the market expects the current wave of cryptocurrency bankruptcies to intensify into a monsoon, as these proceedings have called into question the basic value and meaning of ownership and possession of crypto asset investments, loans, and deposits. A new asset class once favored in the market has fallen from grace, with uncertainty in most quarters as to how the traditional and orderly restructuring processes will apply and be executed given crypto’s unique characteristics. 

Second, distressed healthcare systems and hospitals continue to reveal structural and labor force shortages that are no longer disguised by large government subsidies and pressure-related tax-exempt bond values. 

Third, investors in companies and asset pools dependent on retail consumer demand, including residential mortgage lending, hotels, retail stores and aircraft, can expect to face operator demands for concessions. For example, the aircraft industry is being dominated by an Irish leasing company and international airline reorganizations, presenting challenges to airline carriers based mainly in Europe, Latin America and Asia. Residential mortgage lending appears to be impacting predominantly the US and UK markets. A broader global issue lies in the retail sector where inflation is already jolting economies worldwide. These trends will make for an active distressed asset investment environment in 2023. 

Conclusion
A global economy roiled by geopolitical, economic, and regulatory transformations in 2023 will undoubtedly present challenges for family capital, but well-positioned planning also will allow capture of some dynamic opportunities. Family offices attentive to the factors driving global volatility will be in a better position to determine when to avoid risk and when to embrace it. Robust diligence, creative investment vehicle architecture, and strategic engagement grounded in the confidence of executing against an advised plan is already allowing family offices' investors to navigate the new investment climate.