Traditional family offices examine alternative capital arrangements for a number of reasons, many of which focus on accessing a wider range of attractive investment opportunities and recruiting and retaining talented investment and operating professionals.
These goals are increasingly important in the current competitive market for direct private investment and the emergence of alternatives to traditional private equity models. Family office motivations typically include:
- Mitigating family capital investment constraints (e.g., available capital, concentration or diversification limits, timing of capital deployment and pacing requirements) that potentially limit actionable opportunities. Outside capital often enhances flexibility regarding scope and timing of potential investments;
- Maintaining competitiveness with long-term hold private equity sponsors that increasingly encroach on the territory of this traditional family office investment strategy. The ability to invest in more in-scope transactions promotes family office strategies to a wider audience;
- Using upscaled assets under management to create competitive compensation packages that will recruit and retain key investment personnel. Stability and cohesion of personnel is critical for achieving family office objectives, and higher cash flows generated by upscaling the firm can help level the compensation playing field;
- Enhancing profitability and investment returns by reducing exposure to third-party managers where fees and carried interest may be charged. Larger investment checks lead to greater demand and more leverage in the process;
- Decreasing dependence on strategic relationships and co-investment opportunities for transaction sourcing;
- Building a broader network and enhancing name/brand recognition. Increases in deal flow and a widening investor base create new opportunities for capital raising, capital expansion and building out internal operational expertise; and
- Converting an attractive long-term track record into a competitive marketing advantage for new assets, as many first-time fund sponsors lack credible long-term performance. Prior relevant experience is hugely important in attracting third-party capital, and many family offices are sitting on significant untapped value in their track records.
What are the Alternatives?
Alternative family capital arrangements typically are aimed at increasing the total pool of capital available for investment. There is no one-size-fits-all approach, as each family office has unique circumstances, priorities and sensitivities. However, common approaches include:
- Offering co-investment opportunities without compensation to a network of other family offices or other market relationships;
- Raising a commingled fund that seeks committed capital investments from third-party investors with the family as a significant anchor investor in the fund (or co-investor alongside the fund);
- Managing third-party accounts for one or more strategies in which the family office also participates (e.g., a public markets strategy or a fund of funds); and
- Utilizing special purpose acquisition vehicles or majority-owned public vehicles to raise third-party capital for control investments.
How to Structure?
In light of the wide variety of possible structures, family offices give great consideration to tailoring the structure of the new alternative family capital enterprise for the particular needs of the family. In many cases, the primary consideration is the extent to which the new enterprise involving third-party capital will be (i) integrated with or (ii) separate from the family office structure. Although the options appear simple enough, choosing between them implicates differing operational, legal, tax and regulatory goals, as well as potential family concerns regarding reputation, privacy and control.
To illustrate the complexity, consider that an integrated approach may have tax efficiencies and promote greater continuity with historical practices: however, integration also raises the potential for tax or regulatory scrutiny and heightens family privacy concerns. For example, the Investment Advisers Act of 1940 regulates a wide variety of asset managers. The Advisers Act’s compliance directives are not well-suited to regulate families managing their own wealth, and traditional family offices typically rely on an exemption from investment adviser registration under an SEC rule. However, this rule is narrowly tailored and substantially restricts the ability of family offices to manage third-party capital. As a result, family offices expanding into alternative capital arrangements generally must reckon with Advisers Act registration and compliance as it pertains to the new venture, or seek another available exemption.
Related and sometimes thorny questions also tend to arise, including:
- Is the family office large enough to establish ownership and control of the new venture distinct from that of the family office in a manner that will satisfy Advisers Act and other regulatory considerations?
- To what extent will family principals wish to exercise governance or voting rights over the enterprise and its investment activities?
- To what extent will family principals wish to be involved in the ongoing operational oversight of investments post-acquisition?
- Will the enterprise oversee any historical investments made by the family, or will portfolio management services be limited to investments made within the new strategy or structure?
- Will the new enterprise complicate or limit the investment scope or allocation for exclusive family office investment activity?
- Which entity will employ key personnel?
- Will the new enterprise stand apart from the existing family office from an operational standpoint, or will there be any shared services or other linkages to legacy operations? For example, will the economics of the new enterprise support separate accounting, information technology and benefits services?
- Will the family's capital be invested alongside third-party capital? If so, how will the family's capital be treated relative to non-family capital?
There are good and established paths for navigating the expansion into alternative capital arrangements and the related changes, but careful and considered planning is critical. The unique dynamics of each family office will require sophisticated and thoughtful solutions to these questions, with input from not only family principals and family office personnel but also outside counsel, accounting professionals and other experienced consultants. With forethought, family alternative capital arrangements can be additive to a family’s legacy investment philosophy and approach, without creating a Frankenstein’s monster for all involved.
Ryan Swan, Ryan Harris, Josh Westerholm and Jeffrey Kaplan are partners in Kirkland’s Chicago office; Brad West serves as the General Counsel and Chief Compliance Officer for Pritzker Private Capital.