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Direct decisions

When controlling investments is more than ever nine-tenths of the law, should family offices follow the direct approach?

Ask Geoffroy Dedieu how family offices should invest and you’re likely to get a long and passionate response. Dedieu, who heads the UK-based family office of one of Nigeria’s wealthiest individuals, Theophilus Danjuma, reckons not just family offices, but all investors should invest directly in underlying assets when they can.

“Direct investing means that layers of fees are removed, such as paying for managers and consultants to build their capabilities,” says Dedieu. “It also allows for better cost control and higher-quality risk monitoring.”

Such is his conviction on the issue that Dedieu has written to leading financial publications about his quest. In a letter to the Financial Times last year he said: “Why do you still invest in funds? Why are most of us still buying mostly funds? Isn’t it time that managers of such endowments, pension schemes and family trusts got their bottoms off their comfortable chairs and actually did a bit of investing?”

Whether they are listening to Dedieu or not, there is a growing amount of evidence showing that family offices are dropping funds and investing directly. Disillusioned with manager performance and annoyed with multiple layers of fees, many of which lack transparency, single family offices almost doubled their direct allocation to private companies and real estate between 2009 and 2011, to 11% from 6%, according to a study published by the Wharton Global Family Alliance last October.

The same study found that families don’t like funds of funds, which dropped to almost nothing in their portfolios in 2011. Professor Raffi Amit, chairman of the WGFA, reckons single family offices’ distaste of funds of funds is tied up with trust – or rather lack of it. “They have used funds of funds because they trusted these funds would find and monitor good managers, but this has not proved to be the case,” he says. “They are also concerned about conflict of interest.”

Private equity funds are also being dumped, says Amit. “Private equity firms have not performed as expected, which means the two and 20 split [charging fees of 2% of assets and a 20% performance fee] no longer looks like a good deal to many family offices.” Another factor behind this move away from private equity is that newer funds are underperforming. Private equity research consultancy Pitchbook has found that private equity funds in the US that made their first investment in 2008 are producing returns 27% lower than those that made their first investment in 2003.

John Rompon, managing partner of family office private equity investment adviser McNally Capital, says the 350 or so family offices in his firm’s network generally favour direct investment. He says because of their size they can take the risks that come with direct investment. Also most of them have made their fortunes in industries where they made or sold something tangible, providing them with industry expertise they can leverage to make direct investments.

“This means, for example, that even if they made their fortune in food distribution but signed a non-compete agreement when they sold the family company, they may use their supply chain knowledge to invest in distribution businesses serving other industries,” he says.

Chris Crosby, vice-president of Dobbs Management Service, the Memphis-based family office of John Hull Dobbs’ family, describes his office’s approach as “controlled direct investing”, developed over many years of managing direct investments.

Crosby says the family has made the decision to have as much as two-thirds of its money deployed directly, but also believes that family offices need to have plenty of experience before they make such a big commitment to direct investing. “We feel the best approach is to find good businesses and back the management of those companies. A combination of private equity funds and co-investing as a minority investor is probably a reasonable initial approach until you are comfortable doing it on a direct controlled basis.”

But Crosby says what’s more important than direct investing in terms of making money is asset allocation. “About 80% of the rest down to the manager.” And the more you go down the direct investing route, says Crosby, the more you need to know the people in charge have the knowledge and resources not just to do the deal, but also to manage the portfolio.

In any discussion of the merits of direct investment, the conversation quickly turns to whether there is sufficient investment expertise available to single family offices to make good investment decisions in-house.

Such concerns are the main reason why Okabena Company has kept faith with fund managers, says chief executive Christine Galloway. “We have chosen not to do direct investing because of the resources that would be required to do it effectively.”

But Dedieu says family offices can afford to hire expertise to make direct investment decisions. “Expertise can be hired if family offices really want to get to grips with securing good returns and paying less for it.” He adds that it is possible for single family offices to recruit top investment professionals, even though they may not be able to offer the same levels of remuneration and career progression as a fund manager.

“There are benefits to being part of a single family office. For one, it is a permanent source of capital and generally the focus is on longer-term investing. You don’t need to go out and raise funds as well as deploy the funds and manage the companies. Private equity funds could pay more, but in terms of stability and balanced lifestyle the single family office wins out.”

But he admits that funds can provide a better investment option for very specific and rare assets or unique, non-reproducible investment strategies. For those single family offices that remain determined to use fund managers, Dedieu’s advice is to ask these managers to account for every penny of their fee.

“Demand full transparency on costs down to each security or asset line and understand your costs down the entire value chain, not simply the management fee and performance fee. That includes full disclosure on the fund’s own internal costs,” he says.

Graham Reeve, managing director of Melbourne-based Myer Family Office, points out a big potential pitfall of following a direct investing approach, namely that benchmarking performance of direct investing can often prove difficult.

“If this comparison [between in-house direct investment and an out-of-house fund] is not undertaken regularly, one can be fooled into thinking that internal direct investment is better,” says Reeve. “There must also be a strategy to ‘sack yourself’ if the results of direct investment are not better than or at least equal to the alternative.”

Reeve accepts that family offices may have very clever investment professionals in a particular field, but says that in the event that the expert loses their edge or leaves, the direct investment strategy should be reviewed.

When asked whether there are specific situations or market conditions where funds are a better investment option, Reeve says internal investment may be more difficult in complex or large markets where an internal person or small team may just not have the resources to process all the information. “The same may also happen in small, unresearched markets – will an internal team have the time to do the specialist research?” he asks.

While this may discourage some family offices from pursuing a direct investment strategy, it does not mean they cannot take steps to ensure the fund managers they work with are pulling out all the stops, Reeve adds. Ensuring that the manager has a large proportion or all of their personal wealth in the fund can help to reassure investors they are getting good value. Ulrich Burkhard, chief executive of Switzerland-based Marcuard Family Office, says some families obviously enjoy the involvement of direct investing because it appeals to their entrepreneurial spirit.

Burkhard says teaming up with a multi-client family office that provides co-investment opportunities or club deals is an option, as selecting management, capital funding, dividend policy and all the potential upside. However, the focus needs to be on managing execution risk.”

Gero Bauknecht, president of private investment company Bauknecht Capital, also warns that family offices that wish to invest directly should be careful not to be over-confident in their ability to attract the right deals. “Family offices should be aware of their limitations – it is tempting to always assume you have the requisite experience. Often people want to do direct deals because they have had bad experiences with fund managers in recent years and see other single family offices investing directly.”

But the decision on whether to invest directly should ultimately boil down to whether the family office can generate a better return than a fund manager, says Terri Chernick, chief investment officer and third-generation family member at The Koffler Group. “We manage our real estate investments in-house because we find our returns are better than what we can get from anyone else. But for all other asset areas we outsource as we could not retain the talent to be the best in class in other areas,” she says.

The rise and rise of direct investing
The appeal of direct investing has grown with the disillusionment of financial service providers that accelerated sharply with the onset of the financial crisis in 2008.

Many family offices had a nightmare with funds of funds products during the financial crisis, when they found themselves paying excessive fees even when the performance of the funds had fallen off a cliff. Their anger was heightened when they were stopped from getting their money out because of redemption restrictions.

So, as a result, direct investing has flourished. A lot of this has been channelled through passion investments like art, wine and classic cars. But family offices have also piled money directly into companies, buying minority and majority stakes. Club deals, investing with other family offices, and co-investment arrangements, like investing directly with private banks, have also shown a big uptick in recent years.

But indirect options like funds of funds are fighting back, offering better transparency and fee structures to entice investors back.

A factor to consider about the merits or otherwise of direct and indirect investing is that they are not mutually exclusive. In reality, most family offices will combine both options a bit like asset allocation, investing directly into asset classes they are familiar with while choosing indirect investment for assets with which they are not familiar but to which they want exposure.

The obvious difference between the two approaches is that direct investing involves direct contact with the market or company, whereas indirect investing is conducted through financial intermediaries.

The former approach places the onus on the family office to identify suitable opportunities (albeit often with the assistance of advisers), to decide the level of investment in the asset class and manage the portfolio.

By removing the intermediary, the direct investor removes a layer of cost. However, they also assume responsibility for the performance of their investment. Successful direct investing depends on understanding financial markets and their fluctuations and on the investor’s ability to know when to buy and when to sell.

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