The Rise of Permanent Capital: Single Family Offices and Direct Investing

May 31, 2019

Over the last 15 years, the number of billionaires increased by over 1,500 worldwide. Significant gains in both public equities and private companies have driven rapid wealth creation for individuals and families, who have started forming “single-family offices” to manage this wealth. As single-family offices’ source of wealth is typically long-dated, permanent capital, direct investing into private companies has become a larger part of their investment strategies. The Stephens Group, LLC (“The Stephens Group”) shares its insight on what’s driving this trend and what advantages these offices may have when investing in private companies.

In 2005, the lowest-ranked member of the Forbes 400, tracking the wealthiest Americans, qualified with a net worth of $900 million. By 2018, it took $2.1 billion to crack the same list. That same year, 2005, there were fewer than 700 billionaires globally, according to Forbes; as of the end of 2018, the number of billionaires worldwide stood at over 2,200.

The wealth creation has in part been driven by significant gains in valuations across both public equities and private companies. The introduction of disruptive business models that can scale faster than ever (or at least be valued in that fashion) has also played a part. Importantly, a good portion of this wealth has become highly liquid in recent years. An abundance of private equity buyers, corporations flush with cash, and more recently an accommodating IPO market, have supported liquidity events and allowed founders, executives, and families to transform significant, concentrated equity value into cash.

Amid this rapid wealth creation, “family offices” are increasingly being formed to manage this newfound liquidity, and investing becomes a centerpiece of their activity. Many individuals are setting up a single-family office (“SFO”), which is typically characterized by a permanent, long-dated capital base with which to invest. While specific strategies may differ, SFOs are often recognizing the distinct advantages this “permanent” capital bestows, particularly as they allocate greater sums to invest directly into private companies.

While direct-investing into private companies has often been considered the domain of traditional private equity, some of the best-known names across the broader alternative-investment universe — upon amassing significant wealth — have gone on to form their own SFOs. It’s a testament to the merits of long-dated investing. Perhaps not surprisingly, given the success of family offices in both protecting and growing wealth, the number of SFOs has tripled over the last two decades, according to UBS.

There are a number of objectives driving the direct-investing trends of SFOs:

• Avoiding some of the economic costs of traditional private equity models is a major factor, as the “2 and 20” fee structure becomes increasingly unpalatable in an environment where private equity returns are already being compressed;
• SFOs are keen to use their permanent-capital status to more fully align their interests with investment strategies that deliver true cash-on-cash value maximization rather than shorter-term internal rates of return metrics. Note that a recent Bain & Co. study calculated that a permanent capital investor who compounded their returns in the same direct investment for over two decades would achieve twice the after-tax return as an investor who bought/sold a series of identical performing investments under a traditional private equity lifecycle (approximately five to six years per investment). Such a differential is created through better optimization of exit timing, more efficient taxation strategies, the elimination of friction costs associated with buying and selling companies, and idle periods between capital deployment;
• Successful high-net-worth investors who built their own businesses often identify with and prefer the opportunity to back founder-led or entrepreneurial-driven situations; and
• Experienced management teams often prefer to execute on strategies that are longer term in nature and that can bring the full potential of the business to reality, as opposed to positioning for sale every three to five years.

So how are SFOs going about bringing their direct-investing strategies to life? A few things to keep in mind:

• Desire does not simply equal outcome. The proper execution of the strategy requires a multi-year commitment and a significant investment in direct-investing infrastructure that can run millions-of-dollars annually to perform at scale;
• Attracting and building teams is tough. The marketplace for talent has never been tighter and establishing high caliber capabilities is difficult;
• Building channels within the marketplace is a complex effort that requires creating mindshare and differentiation that resonates with business owners, investment bankers, lenders and other circles of influence, all against the backdrop of ever more capital sources interested in their own slice of the market; and
• Establishing direct-investing capabilities on par with traditional private equity firms is an exercise in operational excellence that is difficult to ingrain into improved organizational behaviors and decision making; it requires the development of truly differentiated value-creation strategies, strong transactional and governance capabilities, credibility with lenders, and broad resource networks to successfully execute.

Yet, sophisticated players have carved their place into the market and proven the merits of permanent capital. The Stephens Group has been executing its direct-investing model for 50+ years and has invested well over $1 billion in equity capital over the last 10 years alone. We have expanded our staff with new deal team members, operational leaders, and value-creation talent. At the same time, we have driven our deal flow up 44% over the last three years. Other SFOs have organized or are organizing to do the same. In fact, a UBS survey of family offices found that more than 50% of respondents stated they are increasing their allocation to direct investing and building the infrastructure to facilitate these capabilities. We believe the attraction is here to stay (and expect it to gain steam) into the future. The gravitational pull of permanent capital is too great:

• It’s one of the most attractive forms of capital for management teams who truly understand the advantages of long-term decision making;
• It offers the most comprehensive alignment between those who have capital and those who need capital;
• It should produce superior cash-on-cash returns over time for those who take the long view in maximizing value, especially in an era when “hold periods” continue to decrease for traditional private equity (down 17% since 2014 to an average of 4.5 years currently, while a full one-fourth of private equity-backed investments are held for three years or less);
• The best known and most sophisticated investment banks are forming dedicated groups to specifically focus on matching SFOs with the most appropriate opportunities; and
• Even some of the most successful traditional private equity fund managers are trying to carve out their place with “evergreen” or “long-dated” funds to capture the attractiveness.

Private equity as an asset class is being viewed as favorably as at any point in recent history, and SFOs have taken their seat at the table.

ABOUT THE STEPHENS GROUP, LLC

The Stephens Group, LLC is a private investment firm that partners with talented management teams to help build valuable businesses. Our team has a long history of providing sophisticated, strategic expertise and taking a partnership approach to help companies successfully achieve their strategic visions and build long-term value. With over $1 billion invested since 2006, The Stephens Group targets investments in industries across the U.S., including industrial and commercial products and services, specialty distribution, B2B food and consumer products, and technology infrastructure and tech-enabled services, as well as select opportunistic situations.

For more information, visit www.stephensgroup.com