For the past several years, Family Offices have increased their appetite for direct investments and co-investments with other Family Offices and private equity funds. On February 21, 2020, Forbes reported that going direct was an “undeniable trend” and focused on the 5 Reasons Why Family Offices Are Focusing on Direct Investments which included greater control and decision-making ability, better value and interest in alignment and return, reduced fees and expenses, the strength of Family Office networks and the ability to make an impact. UBS reported in their Global Family Office Report 2019, that private equity outshined other investment classes with an average return of 16% on direct investments and 11% for fund based investments. Many of the direct investments that were made by Family Offices were also made with other Family Offices and private equity funds. In many cases, a Family Office simply piggy-backed the due diligence efforts of another Family Office or private equity fund to make an investment alongside other investors. Private equity funds have also offered definitive co-investment rights to limited partners giving them the opportunity to double down on their investment in a particular portfolio company.[1]
While co-investments with other Family Offices or private equity funds may make financial and business sense, Family Offices and private equity funds that partake in those activities should be mindful of the risks associated with pooling capital with others. The first set of issues to consider are the regulatory issues related to wheeling and dealing in the private capital space. Any person that is in the business of raising capital generally needs to be registered as a broker-dealer with the Securities and Exchange Commission (SEC) or applicable state agency, or be exempt from those registration requirements. While private equity funds can raise capital for their own fund by relying upon Rule 506(b) of Regulation D that exemption doesn’t necessarily allow them to help raise money for other companies. To the extent that a private equity fund manager regularly solicits others to co-invest along with their fund, they may be required to register as broker-dealers. The same is true for a Family Office that regularly solicits other Family Offices to make co-investments. The rules that require registration as a broker-dealer are broad and encompass anyone that is engaged in the business of effecting transactions in securities. Unfortunately, there is not a lot of clear-cut guidance on what it means to be engaged in the business of effecting transactions in securities. Registration issues for private equity funds, however, have continued to surface over the last decade as a result of the SEC’s enforcement actions against private equity firms.[2]
In addition to the broker-dealer registration issues, Family Offices need to be concerned about maintaining their Family Office Exemption if they want to remain exempt from the SEC’s Investment Adviser registration requirements. To the extent that a Family Office engages in a transaction where they pool money with other families and further take the lead on managing that money, they might blow their exemption as a Family Office because they are now managing other people’s money. While Family Offices may like to control their underlying co-investments, they need to assess whether or not that control blows their Family Office exemption.
In addition to the regulatory issues, Family Offices need to be concerned about the anti-fraud provisions of the securities laws. All securities transactions, even exempt private ones between families and private equity funds, are subject to the anti-fraud provisions of the federal securities laws. Any false or misleading statement in connection with the sale of a security is subject to civil and criminal liability. That liability is typically assessed on the person promoting or selling the security when the deal goes south. If your Family Office is the one that promoted and solicited other Family Offices they could be the one held liable for making the false or misleading statements. In general, people go after the guy that sold them the security or lured them into the deal.
Given the risks associated with bringing people together to participate in co-investment opportunities (which are securities transactions), Family Offices should consider employing intermediaries such as broker-dealers and Registered Investment Advisors. For example, using a broker-dealer to help put the deal together can help alleviate both the registration risk as well as the risks related to information that was not properly disclosed. Broker-dealers are required by FINRA to conduct independent due diligence on transactions and to make sure investors receive all pertinent information related to the sale of a security.
Unfortunately, Family Offices have not had good experiences with traditional broker-dealers in the private capital space. Family Offices see a broker-dealer sponsored deal as a high commission, high risk deal, where cash-on-cash returns are few and far between. Generally speaking, there is a crowd of broker-dealers that peddle high risk deals to unsophisticated accredited investors who invest $25,000- $250,000 in a deal. While Family Offices might do a deal with the underlying companies that a broker-dealer is promoting, they typically won’t do the deal on the terms being offered by the broker-dealer. Family Offices simply don’t like to invest in a deal with a 100 other investors, and if they are writing a bigger check, they want to negotiate a better deal. They also don’t like to invest in bad deals. The SEC also spends a fair amount of time regulating and investigating bad deals being promoted by broker-dealers. The SEC recently adopted “Regulation Best Interest: The Broker-Dealer Standard of Conduct” which was made effective on September 10, 2019, hoping that broker-dealers will start recommending products that are actually in the best interests of their clients, and ahead of their own financial interests.
Instead of waiting for the high risk, high commission, deal of the week from a broker-dealer, Family Offices could use broker-dealers to source and structure good deals. Broker-dealers can also help Family Offices properly effect the underlying securities transactions that result from pooling money with others. Broker-dealers that structure private equity transactions for Family Offices, however, should refrain from promoting syndicated retail deals, or they will lose the trust of a Family Office. Unfortunately, Family Offices generally don’t involve a broker-dealer in private equity transaction because they tend to think that a broker-dealer that is neither bringing the deal to the table, or the investors to the table, has no role in the transaction. Family Offices that solicit other Family Offices to invest in a private equity transaction, however, need to remember that if they are taking on the role of a broker-dealer (someone who promotes the sale of securities), they might need to register with the SEC. Rather than run the risk of having to register as a broker-dealer, Family Offices should instead just hire one to assist them with their co-investment transactions.
Another regulatory route for a Family Office to consider is to join an existing Multi-Family Office that is registered with the SEC as an Investment Adviser. Registered Investment Advisers can help Family Offices structure co-investment transactions with other families in an advisory capacity. Investment Advisers can also participate in those investments in certain pooled investment vehicles with other qualified clients. If the investment adviser already has established relationships with existing Family Office clients who are interested in making private equity investments, they can assist those families in finding and vetting private equity opportunities.
Many large private equity firms are now required to register as Registered Investment Advisers with the SEC because they are advising multiple families and funds on their private equity investments. Some private equity firms have started to take on additional Family Office clients who regularly co-invest along with their primary funds. Some of those may be existing limited partner investors, while others are just relationships with other Family Offices that help them fill the funding gaps in a private equity transaction. In some cases, these funds would rather work with a handful of large Family Offices that other competitive private equity funds.
Unfortunately, most Multi-Family Offices are not otherwise well equipped to provide private equity advice. While they understand public investment vehicles and private investment funds that invest in public investments, they have generally stayed out of the private equity arena. A Multi-Family Office that proactively develops private investment capabilities, however, would be a welcome addition to the direct investment and co-investment space. Unfortunately, this is easier to say then do, because the private equity arena can be an overwhelming space. While there might be 6,000 or so public companies in the United States, there are likely over 6,000,000 private companies and getting your hands around private investment opportunities can be challenging to say the least. Multi-Family Offices that take on the challenge, however, can help bring the world down to size for single Family Offices who have otherwise tried to tackle this challenge alone. Helping Family Offices evaluate private equity fund managers would be one thing to consider, and then helping them find good private companies to invest in would be another. The bottom line is that this is not a task for a boy and his dog, but rather for investment teams who are well heeled in the private equity space. Investing in those teams without offering them the traditional 2% management fee and 20% profit interest can be challenging for a Multi-Family Office, but still possible.
While Family Offices continue to explore ways to invest in private companies, the SEC is also considering ways to make the existing regulatory scheme easier for investors and companies.[3] For now, however, it’s important to understand the game you are playing, and the rules associated with that game. If you are playing a match making game, register as a broker-dealer; if you are providing investment advice to others, register as an investment adviser; if you are just out there investing in private deals on your own, good luck. Family Offices, Multi-Family Offices, broker-dealers, and Registered Investment Advisers, that respect everyone’s role in the game, and who come together to provide creative ways to play the game going forward, will likely yield a better result in the private capital world.
[1] See Co-investment: An Effective and Better Way to Invest for LPs and Family Offices, May 24, 2019.
[2] See Keeping Current: SEC Enforcement Heightens Concern over Broker-Dealer Registration for Private Equity Firms, American Bar Association, July 20, 2016.
[3] See SEC Seeks Public Comment on Ways to Harmonize Private Securities Offering Exemptions, SEC Release 2019-97, June 18, 2020.