The New Kids on the M&A Block

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By Mark S. Selinger, Esq.  

McDermott, Will & Emery, New York, NY

In the past decade, family offices and single family investment vehicles have emerged as competitors to private equity (PE) funds in making direct investments in a wide range of industries. As these entities have evolved, from passive PE limited partners, to co-investors alongside PE funds, and now into competitors for mid-market deals, they have introduced an important new category of investor into the M&A market.

Ironically, in the early days of private equity, high net worth (HNW) investors formed the backbone of many mid-market PE funds. But as more institutional money went into PE, these HNW investors became a less important part of the PE limited partner universe, and several of these investors began looking for alternatives.

The trend was accelerated by developments arising out of the Great Recession. The drying up of credit for nearly two years slowed exits to a trickle - but limited partners were still required to pay the PE fund's yearly management fee (which in the past may have been paid out of a fund's distributions). And both the illiquid nature of limited partnership (LP) investments and the restrictions on transfer that are standard in most fund partnership agreements - provisions that did not seem problematic when membership in the best PE funds was like access to a hot private club - began to rankle at least some HNW investors.

In the past, these investors, even if they were unhappy, typically re-upped for the next fund series - where else were they to go, if they needed to diversify their alternative investment portfolio, and get access to the best talent and deal flow? But within the last few years, for some, the answer to that question became - "Why don't I do this myself?"

There have always been HNW families who made direct investments, or were significant co-investors in PE fund deals.  But to do direct investing right, you need to have the infrastructure, and the team - and neither come cheap or are easy to build.  But as PE returns slackened off, some large PE fund investors decided to take the plunge, either by beginning to make direct investments out of an existing structure (often, a family office) or by establishing a fund or fund-like investment vehicle.

One thing that changed in favor of HNW direct investing is the availability of talent. In the past, there was simply no way to lure a young PE manager away from the promise of riches offered by even a mid-market PE fund. But, especially in the mid-market, the Great Recession brought for many, reduced (or at the very least, delayed) returns, and the prospect of raising the next fund became even more daunting. In this environment, a well-funded single source of capital, especially one known to the fund manager, became all the more attractive.

The U.S. Securities and Exchange Commission (SEC) gave the emergence of direct investing by HNW families a push in 2011, when the final investment advisor registration regulations eliminated most of the exemptions available to all but the smallest funds, keeping just one primary exemption from registration - the family office exemption.

Combined with the tax benefits of operating as a family office, the HNW family direct investing has blossomed.

The investment vehicles being utilized by HNW families to do direct investing may look to the outside world much like PE funds, but the story these "family funds" tell to prospective investee companies serves to differentiate them from PE funds. Unlike PE funds, there is no "requirement" to look to exit within the usual three to five years for a PE investment.  And often, the patriarch of the "family fund" is a former operator/entrepreneur, whose story may sound familiar to many founders.  Lastly, the family fund generally operates without the structural constraints (e.g., limits on how much can be invested in one investment, governance and informational requirements, limitations on investing into certain investment areas) contained in many PE fund documents.

To be sure, family investment vehicles lack some things that successful PE funds have - name recognition, an LP network, and most importantly, a track record. But hiring away a successful manager from a well-regarded PE fund can help overcome the track record obstacle, and a prominent family backer can outweigh the name recognition and networking connections of all but the best known PE funds.

As family investment vehicles mature, they will likely increase their reliance on outside managers, and begin to develop compensation structures and track records that will make them even more competitive with traditional PE funds. It appears likely, then, that as PE funds survey the competitive landscape over the next five years, they will likely find that the seat next to them at the bidding table is filled not by another PE fund or strategic investor, but by a family investment vehicle with deep pockets and a growing appetite for deals.

For more information, in the Tax Management Portfolios, see Needham, 735 T.M., Private Equity Funds.

© McDermott Will & Emery 2012. Reprinted with Permission from McDermott Will & Emery, Inside M&A Summer 2012.