Bypassing Equity Funds, Wealthy Families Try Direct Investing

July 2, 2010
Bypassing Equity Funds, Wealthy Families Try Direct Investing

By PAUL SULLIVAN

The 2008 financial crisis had several unexpected outcomes, but one of the surprising ones was an increased willingness by wealthy families to invest directly in private companies and forgo private equity funds.

Direct investments are not going to replace private equity funds any time soon, if for no other reason than such investments are only for the very rich. Advisers suggest a net worth above $100 million to even contemplate individual, private equity investments.

Still, the world of private equity was shaken in the financial crisis, when many individual investors found their private equity investments to be a burden rather than a boon. Many either had to sell other assets to meet the demands for additional capital from private equity firms or they had to sell their stakes in the funds at steep discounts to get out early.

Though this was all laid out in the rules of the funds, a bigger issue had been raised: the investors’ lack of a voice in how private equity funds operated.

Specifically, the problem was that people with hundreds of millions of dollars were investing alongside endowments and pension funds with billions of dollars. And for probably the first time in their adult lives, these very wealthy people were being drowned out by significantly larger institutional investors.

That’s where Ward McNally, managing partner at McNally Capital, a private equity adviser, comes in. In 1997, his family sold its interests in Rand McNally, the map maker, and he began managing his family’s fortune. Shortly before the market crash, he started a company to advise his family and others on investing directly in private equity, a move he attributed to his own bad experience.

While his family had had success investing in private equity deals on their own and not within a fund, members watched in shock as three of the six units of Rand McNally that had been sold to private equity firms went bankrupt after the firms saddled the units with debt. The three that thrived had all been sold to competitors who integrated the units and ran them profitably.

This was an ah-ha moment for him. He saw where wealthy families could reprise their age-old role of investing directly in private companies and bypassing funds.

“We encourage our families to make direct investments in the area in which they made their wealth,” Mr. McNally said. “That knowledge is an incredible advantage. They can create a network of value for the company.”

At the root of the shift toward individual private equity investments is the families’ desire for control and to know exactly what was happening with their investments. But the bigger issue may be frustrated expectations. “If private equity funds kept producing outsized returns, this shift might not have taken place,” said John Rompon, managing partner at McNally Capital. “The attitude changed when distributions dried up and investors had to meet capital calls.”

A survey last month of 62 families advised by McNally Capital — with an average net worth of $250 million — showed an increased interest in single-company private equity investing. Nearly two-thirds said they now preferred to make direct investments in companies rather than using private equity funds.

Yet that same group acknowledged the risk associated with doing this: 78 percent had two or fewer people dedicated to evaluating private equity deals, and 63 percent heard about deals from friends and family members — eerily similar to how Bernard L. Madoff attracted investors.

“One thing we have found is families are insular by nature,” Mr. McNally said. “Families have a reach that exceeds their grasp. They want to accomplish more than the resources they have.”

This is the downside for direct private equity investing. Yet by directly investing, families can hold an investment for as long as they want and are not bound by fund documents that say when they have to sell an investment.

Investing directly is also a way for families to capitalize on the reputations they have from building their companies. “They want their dollar to be worth $1.06 to reflect the added value they bring to the deal,” Mr. Rompon said. “It is not reflected when you invest in a private equity fund. We try to help them be anything other than an A.T.M., which is how they feel every day.”

How popular is this approach? A recent study by Coller Capital, a private equity investment firm, said 41 percent of all private equity investors planned to increase their direct investment in the next three years.

And Dale Miller, head of wealth management solutions at Credit Suisse Private Bank, called the move to single investments an “emerging trend” that is part of clients’ overall desire for control.

“Clients are interested in being active,” he said. “On a net worth basis, clients with greater than $100 million are interested in direct investments because they can achieve diversification on their own.”

The big risk is too much enthusiasm, even when the investor knows an industry well. Theodore Beringer, a managing director at the Beringer Group, an adviser to family offices, said people making single investments needed to show restraint and properly value the company.

“You have to have discipline,” he said. “Say your limit is $15 million and you have two deals that are $12 million, you can only take one.”

But you would have complete control over which one.