How family offices balance emotion and strategy in private markets investing
Booming appetite for alternative investments is challenging advisors to educate a new group of investors on the strategies for long-term success.
The ongoing democratization of private markets is creating new opportunities for family offices to access illiquid investments. But it is also bringing new challenges for investment advisors, who must balance the appeal of private assets with the emotional discipline that is often needed to make long-term investments a success.
Advisors play a crucial role in ensuring wealthy families avoid behavioral biases and remain steadfast through the ups and downs of private market investing.
According to Michael Zeuner, Managing Partner of multi-family office We Family Offices: “Emotions are a big part of it. We try to assess at the beginning of building a private equity program whether this family has the tolerance to invest in private investments.”
“In other words: can they withstand not seeing valuations? Can they live with a J-curve where money just goes out and returns are negative in the early years and it may take five to seven or eight years to start seeing positive returns?” added Zeuner. “There's a lot more to understanding whether private markets are appropriate for certain families than just the math and the optimization.”
Sticking to the plan
Zeuner was speaking at a recent CFA Institute webinar about the shift of family office allocations into direct private equity and other alternative investments. Speaking at the same event, Tom McCullough, Founder and Chairman of leading Canadian multi-family office Northwood Family Office, stressed the importance of laying out a clear investment policy at the outset to refer to when times get tough.
“An investment policy is something you write when you are sober,” said McCullough. “And then, when you are drunk with fear, greed, busyness or inattention, then you go back to what you wrote when you were sober, to see how it applies.”
In many cases, he said, investors will plan to avoid liquidating private investments to raise capital.
After all, getting cold feet and retreating from investments in private markets can be very costly. “The only way to get out is to sell into the secondary market, and that is a cost of up to 30% discount to the net asset value, depending on the category,” said Zeuner.
Secondary trading of private markets investments has taken off in recent years, but these investments remain relatively illiquid. In some ways, that could be an advantage because it limits investors’ ability to make irrational decisions during turbulent periods.
Lisa M. Corcoran, Head of Private Markets at multi-family office Bessemer Trust, which serves over 3,000 clients, said: “That’s one of the benefits of privates. You can’t make rash, emotional decisions. That’s been a source of that illiquidity premium.” She added that while the emergence of GP-led secondaries and continuation vehicles has given investors access to liquidity, it also presents challenges and creates potential for conflict.
Alternatives appeal
Despite the difficulties of navigating private markets, the number of family offices exposed to them has increased by over 500% over the past decade, according to alternative assets data provider Preqin. More recently, as liquidity-strapped endowments and foundations in the US divest some of their private equity holdings, family offices have been snapping up opportunistic deals in the secondary market.
Corcoran sees the growing appetite as no surprise. “Many of our clients have built companies in the private markets, and that’s the source of a lot of their wealth,” she said. This gives them a natural affinity for private market investments – and, arguably, the temperament to deal with the inherent illiquidity.
Advisors play a crucial role in moderating their enthusiasm, including steering clients away from hot investment trends that might not be suitable for them, such as direct investing.
“The cool kid these days is the direct investor: the sort of rugged individual who says, ‘I’ll go out and find my own stuff,’” said McCullough.
But he pointed out that beyond the rarefied ranks of billionaires, the typical ultra wealthy individual lacks the resources to compile a diversified portfolio of direct investments and may be better served by a fund-of-funds approach.
“Think about a typical centimillionaire,” he explained. “Maybe they’ve got a business that’s worth USD50 million, they’ve got houses and personal effects worth USD20 million and a USD30 million portfolio.” Assuming they allocate about 20% to fixed income and 40% to public equity, that would leave only about USD12 million for alternative assets, which might be split among real estate, infrastructure, private equity and venture. “That’s not very much money,” he stressed.
Direct investor beware
Zeuner noted that in the few successful direct deals by families that he’s familiar with, the family had a deep understanding of the company they invested in. “There’s an insight that the client has about the space that’s really valuable, and they may wind up sitting on the board.”
Still, Zeuner suggested taking a very cautious approach to sizing up direct investments. “Most direct deals that we tend to see, there’s a reason they’re direct deals and a private equity or VC firm isn’t doing them. They’re not as robust and are often not structured using best practices. There are so many complexities to direct investing that it’s really difficult to assess unless you’re an expert.”
For all these reasons, advisors believe that education of new investors will be vital to the ongoing democratization of private markets. “In the meantime, we're going to keep focused on what we've been doing for a really long time and stay disciplined,” said Corcoran.
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