Yields are up dramatically and the vast majority of family office principals plan to maintain or increase deal flow. As they struggle with execution, is the end of this winning streak in sight?
Another bullish year, unpredictable politics, and a growing fondness for direct deals all formed part of the family office landscape during 2016. So how are family offices structuring their portfolios as the economy enters the later stage of a record cycle?
Expansion across the global economy saw family offices rewarded for the bolder approach they took during 2016, achieving an average return of 7% up from 0.3% the year before.
The turnaround was partly driven by strong performance of equities and private equity, which respectively make up 27% and 20% of the average portfolio, a share which looks set to grow according to indications from participants.
But Shiraz Poonevala, director of investment at GP Group, says improved returns are more to do with better year-on-year performance across all asset classes, rather than the way family office portfolios morphed during the year.
“As they say, a rising tide lifts all ships,” Poonevala says.
A series of arbitrages between global markets and a dramatic geopolitical landscape also put some investors in a particularly favourable position, says Simon Foster, chief executive officer at TY Danjuma Family Office.
“For example, the currency movement associated with Brexit,” Foster says.
“For us, even though we are a UK-domiciled family office, we traded away from the pound when it was on high before the Brexit vote, given the uncertainties, and into US securities. With the movement of cash we were able to pick up some good returns by riding on the right side of geopolitical movements.”
The Global Family Office Report 2017(GFOR) historically has shown a growing thirst for direct deals among family offices. More than 90% of respondents for this year’s report say they plan to maintain or increase allocations to direct venture capital/private equity, and co-investment deals.
But such deals were being stifled by execution challenges: In reality, within the private equity asset class, co-investment allocations fell 6% year-on-year, and active management fell 4%, while the use of funds increased 8%.
Foster says over the last five years, direct private equity has been a hot topic in the family office community.
“Everyone is talking about how good it is. The problem is, it is difficult to do,” he says.
“Maybe part of what we are seeing [with the increased use of funds] is: There has been such a drive, and now some have said, ‘you know what, enough of this, maybe we’re better doing it through funds than doing it ourselves’.”
“A lot of people have said they want to head into private equity but in order to be successful as a family office in private equity, you need to have the right team, the right people, and the right deal flow.”
Josh Roach, chief investment officer at Lloyd Capital Partners, says while there are good reasons to do direct deals, “there are even more reasons not to do directs”.
“A family office (FO) really needs to be committed to building-out its platform and budget. You are basically building a private equity platform, but the cost to build-out cannot be monetised across lots of [investors], you only have one client to absorb those costs. So to make it all work out, you need really good returns on the direct [deals].”
Just 28% of respondents say it is easy to obtain external professional advice when doing private equity deals, though 65% are confident they have the right in-house skill-set to invest directly.
Roach suggests family offices partner with another family office with direct deal experience.
“We co-invest with other FOs, we share diligence responsibilities,” Roach says.
“There will be new co-operative co-investing models emerging soon that will effectuate this dynamic. In effect, you’ll see a larger FO be willing to partner with a smaller FO with the idea to help scale the industry, disintermediate private equity funds, and transfer knowledge on how to build out a direct deal team.”
But while the family offices surveyed are keen to co-invest—49% want to do more co-investing, and 44% want to maintain their current co-investing activity—they cite challenges including difficulty identifying attractive deals, doing due diligence, and aligning their values and objectives with potential partners.
Foster says while co-investing has a place within family offices, he has reservations about two FOs getting into bed together, if both parties are “just the money”.
“If that is the case then who has the technical expertise about the industry? My view is that you need to know if you are the financial muscle or the technical expertise. My advice is: Find out which you are and try and find the counter party.”
Meanwhile, hedge funds and direct real estate were among the family office classes seeing a gradual decline in take up.
Despite being a laggard in terms of performance during 2016, real estate remains popular, accounting for 16% of the average portfolio. North American family offices are less exposed to real estate—10%—which partly explains why the continent marginally outperformed other regions, with a 7.7% average return.
Hedge funds account for 6% of the average portfolio, down 1% as hedge fund managers failed to deliver high returns to justify their high fees.
Foster says his approach to hedge funds is “use them thinly, at best”.
“We target LIBOR plus 200 basis points (+2%). With hedge funds, we would have to be taking risk equivalent to 4 or 5% because of the fees charged by fund managers and similarly with discretionary mandates. By doing an in-house fund structure, we achieve the same returns but take maybe half the risk we would in an outsourced environment.”
With the current bull market nine years old and one of the longest in history, Susan Ward, managing director of UK global family offices at UBS, says the fact the cycle is entering a late stage is “clearly on people’s minds”.
“As we start to think about where we are in the cycle, some of those more illiquid high-yielding assets may be vulnerable to a downturn,” she says.
“That is not to say we are at the end of the cycle. There are expectations of continued growth both in North America and in Europe—particularly if Trump gets through some of his proposed tax reforms.
“But we are moving towards a late stage [and] we have begun having conversations with clients around tail risk. Clients are asking how they should position themselves and what insurance they should be thinking about over the next 12 to 24 months.”