No private equity please! We're very rich

The majority of very wealthy investors prefer to directly invest in companies ... sidestepping the private equity bandwagon.

Summary: Ultra-wealthy families increasingly prefer direct deals over private-equity funds. One top US law firm has set up a special practice to advise families on structuring direct investments. Families typically invest in industries similar to where they made their fortune, or in the exact opposites.

Key take-out: Rich families making direct investments say they can leverage their experience and achieve outsized returns.

Key beneficiaries: General investors. Category: Economics and investment strategy.

When it comes to investing in private companies, the super-rich are increasingly taking matters into their own hands. They’re shunning private-equity funds and investing directly in private companies, drawing on their own entrepreneurial experiences and their network of similarly successful business owners.

A recent survey by McNally Capital, a Chicago-based advisor to family offices, found that 77% of ultra-wealthy families prefer direct deals over private-equity funds, up from 59% in 2010. The survey covered 100 families, with a median net worth of $US1 billion. The overwhelming reasons cited for investing directly in private companies were to “leverage my experience and knowledge” and “achieve outsized returns.”

Bob Casey, senior managing director of research at the Family Wealth Alliance, cites another reason. “Private equity funds and fund of funds are increasingly seen as overpriced, lacking transparency, liquidity, and control, among other shortcomings,” he says.

According to the study, 52% of the families plan to complete at least two private deals this year and they’re eyeing 20%-plus annual returns for these investments over the next five to 10 years.

It’s clearly a rarefied realm. The most active families have investable assets in excess of $US500 million and allocate as much as 20% to private companies, says John Rompon, managing partner at McNally Capital. The investments are, generally, in the $US25 million to $US70 million range and involve companies beyond the startup stage.

The pickup in the activity is catching the attention of some heavy-hitting advisory outfits. Top-notch law firm McDermott Will & Emery has set up a special practice to advise well-heeled families on how to structure direct investments in businesses. The new operation is an outgrowth of the firm’s work in estate planning and structuring of private-equity deals.

Structuring a direct investment for a family can get complicated, since the deal often must fulfill the goals of multiple generations. McDermott partner Mark Selinger recently helped a family structure a $US40 million private-company investment as four different investment tranches, each siphoned into four separate family trusts.

One trust holds debt issued by the company; it provides a set interest rate for the current generation. The second holds convertible debt, with a slightly lower interest rate and a capped rate of return if the company were sold. The remaining two trusts hold preferred shares, with no current interest rate but significant upside potential should the company be sold or go public. These two share classes are longer-term investments by nature and are meant to support future generations. “Here you’re looking for the next Apple that, if it hits, you’re generating a lot of money for the grandchildren,” Selinger says.

The families typically have one of two investment philosophies, he says. They either make investments similar to the industries in which the family made their fortune – like the Midwest oil and gas family buying local pipeline operators – or the exact opposites, such as the former food distributor entrepreneur who currently has a portfolio of nine companies in the tech and medical device space.

The idea is to fill the void where mid-market private equity doesn’t usually look, says Selinger. It’s a sweet spot after the venture stage but well before a public offering or sale. These companies, especially in the tech space, are just beginning to generate revenue so there is far less competition for deals, Selinger says.

Families involved in these investments often invite other clans to join. The McNally survey found that 89% of families taking a controlling stake in a private company would accept co-investments from other families, versus 50% who would accept an investment from institutions.

Rompon points to a McNally Capital-facilitated investment partnership of 11 wealthy families called the Cleantech Syndicate, with a collective net worth of more than $US30 billion. “These families are either active investors in clean tech or have made money in non-renewable energy, and are looking for either a natural hedge against their existing oil and gas investments or are looking for some moral redemption,” he says.

With ventures like that, direct investing could soon start to change the world.

This article has been reproduced with permission from Barron's.

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