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Family offices pouring money into PE should proceed with caution, experts say
21/12/2018 , Alexandra Newlove,

Family offices are set to increase their private equity allocations by more than 70 percent by 2019, according to new research from buyout firm KKR and research provider Campden Wealth.

Wealthy families and other private investors have been wooed by impressive returns in the sector. The 76 family offices surveyed by Campden said their private equity allocations (totaling $51 million on average) returned 14 percent in 2017, and the average predicted return for 2019 was 18 percent.

The families also said they planned to increase their allocations by 73 percent, to an average of $88 million. This included capital allocated to funds, direct deals, and co-investments.

John Elder, of Family Office Advisors, is an independent consultant who specialises in helping ultra high net worth families with their investment and reporting strategy, including direct deal opportunities. He says while returns make up part of the picture, families were also attracted to the higher degree of control which often came with private equity deals, together with the longer-term nature of the investment.

Hedge funds have fallen out of favour in recent years on generally mediocre performance, equity markets may be deemed expensive, and bond yields were low.

“All these things have morphed into people looking at and investing more in private equity,” Mr Elder said.

However, he pointed out that while many wealthy families had always invested directly, much of the buzz around private equity was a result of professionals involving themselves more in the family office space, as well as many family office structures becoming more formalised.

Many families felt “bruised and battered” by the global financial crisis, leading to a new thirst for DIY investment opportunities. Private equity in its various forms then became even more attractive as family offices obtained more in-house computing power thanks to technological advancement, and with this an increased ability to manage investments in-house.

Whilst direct private equity can often look attractive as an option, Mr Elder says one must be careful: many families do not have the in-house resource or expertise to source good deal flow or properly analyse it.

“I often speak with families looking for direct deals who will look at well north of 100 opportunities for each investment they make, a huge commitment of time and effort.

“That is why pooling resources with other known and like-minded families to look at and execute co-investment opportunities is an attractive and efficient option. Typically a family will bring an opportunity to the group and offer co-investment alongside.”

Families may also use private equity firms to gain access to deals and negotiate direct co-investment alongside the PE company as a way of gaining direct exposure and due diligence on specific investments they like within a fund. The PE fund would then effectively monitors the asset on behalf of the family.

KKR member Jim Burns said post-GFC some were wary of locking up capital for ten years or more in private equity.

“However, as the world healed in the years following the financial crisis, private equity reasserted itself as one of the most compelling asset classes in which to invest,” he said.

The Global Family Office Report 2018, also from Campden, showed that on average, the more than 300 families worth more than $100 million surveyed dedicated 14 percent of their capital to direct PE deals and eight percent to PE funds. The average leverage on these investments was 35 percent.

A third of family offices in the Campden/KKR study said they struggled with deal flow, and Mr Elder said this was a top concern among the families he knows and deals with.

“Markets are awash with capital looking for the right investments,” he said.

A 2018 report from Bain & Company estimated PE firms have raised more than $3 trillion over the last five years, while the Boston Consulting Group (BCG) estimates there are nearly 2,300 PE funds in the market, seeking to raise $744 billion, a 25 percent increase from 2016.

BCG also reported that in 2017 there was an estimated $1.7 trillion in unspent capital, known as “dry powder”.

It’s figures like these that cause Fahad Kamal, chief market strategist at Kleinwort Hambros – Societe Generale’s UK private bank, to describe the amount of leverage accumulating in the private equity market as “a tremendous worry”.

“Ten years ago a PE house that would raise a billion dollars was considered a very big fund. In the last 12 months Blackstone raised $125 billion,” he says.

“Why? Simply because we’re living in a low return world where the returns from traditional asset classes are going to be less than expected in the past. PE, which is a very nascent asset class, has looked really good over the last 10 years. The returns have been 20 percent a year for some of the [top performing] funds, and money is rushing there because people are hugely biased towards recent events.”

According to Campden and KKR, family offices reported that 91 percent of their PE allocations either met (53 percent) or exceeded (38 percent) their expectations in 2017. More than half (53 percent) of all private equity fund investments are put towards growth capital deals, while 28 percent go towards leveraged buyouts and 19 percent towards venture capital.

But Mr Kamal said he would be “very surprised” if the PE market continued to generate similar returns in the coming decade.

“The number of good quality companies is less... More importantly, you’re competing with lots of other cash and raising valuations,” he said.

"The inflows into PE, the amount of M&A out there, and the amount of deals out there - not just LBOs but strategic buyers - that is something that could potentially upset the apple cart."

Mr Kamal said the thing that did give him “a degree of comfort” was that if there was a sudden collapse in the market and several funds went out of business, it would narrowly hit the owners, rather than devastating the wider economy.

“Nonetheless, the point remains. PE is an exact example of where things are getting really overheated.”

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