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2023 Primer On Risk Management For Family Office Direct Investments

Dentons February 13, 2023


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. 

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.

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