Why Direct Private Investing (DPI)?
More and more family offices are including Direct Private Investing in their overall investment portfolio.
DPI means investing directly in the equity or debt of a private company (the “issuer”). Thus, the investors have complete control over what issuers they support, and the returns from the investment are specifically tied to the performance of those companies.
The alternative is a private fund investment where investors pool their capital. The funds are invested in numerous companies, often following a specific investment theme (i.e., venture capital stage investments in information technology or some other industry segment). The fund’s investment decisions are delegated by the investors to a fund manager. Its return is a blended yield resulting from the performance of all investments made by the fund.
Over 80% of family offices are now adding DPI to their overall investment portfolio allocations. Below are some of the reasons DPI allocations are increasing:
Leveraging family expertise – Most families have accumulated their wealth through previous business success within a specific industry. They would seek to capitalize on this expertise by applying it to investments in other businesses within that industry sector.
Returns based upon fundamentals – Many investors long for the days when business fundamentals could be relied upon to drive equity value in a stock. Hedge funds, algorithm-based trading, meme stocks, and many other influences on public stock now make this increasingly difficult to achieve.
Maintaining control before and during an investment – A fund is a passive investment. It gives discretion to a fund manager. Many families want to retain greater control – both in the selection process and during the period they hold the investment.
Misalignment with fund management incentives – Funds generally have a stated life of 7 to 10 years, with most of the Manager’s compensation tied to “realizations” (the sale of an investment). This structure can lead to a misalignment between the self-interest of the Manager versus each of the fund’s investors.
Cost of investing – Some manager fee structures for private funds are excessive (2% annual / 20% of gains achieved), when compared to expenses relating to DPI.
The flip side…
There are good reasons why the private fund management structure has grown significantly over the past 50 years. It is a passive investment involving investment specialists in this form of investment and/or industry sectors. DPI requires a significant commitment of time to both select investments and monitoring them thereafter.
Carofin strongly encourages those families who choose to include a direct private investing allocation to assemble the resources necessary to identify DPI opportunities, evaluate them and then manage each throughout their life cycles.
Regardless of whether a family office adds private investments to its portfolio through direct investments or a fund structure, such investments continue to carry significant risk; therefore, the portfolio allocations of a family office’s DPI strategy should be well diversified within itself.
The Lifecycle of Each DPI
Each direct private investment is unique – debt or equity, stage of business, management team, industry, etc. However, certain factors are consistent: sourcing the investment, allocating funds, and managing the investment. The following reviews the primary steps inherent to each and identifies the major components of each step.
Three distinct stages accompany each direct private investment:
Origination
Sourcing the investment – Contacting the company needing capital
Evaluating its merits – A process that includes “due diligence” (validating the Issuer’s representations) but that also leads to understanding the “whys” of the business (see
Primary Investment Considerations).
Determining the appropriate form of investment – “Designing” the right security for the DPI (see Understanding Private Securities).
Syndication
Portfolio allocation – Setting limits for how much capital the investor can afford to allocate to a given investment. Importantly, also identifying reserves for follow-on
investment in the high likelihood that these will be needed to further support the DPI … and to protect the original invested capital.
Other investors – Identifying other private investors, either current investors willing to increase their commitments or new investors willing to come alongside, so that the
company is not supported wholly by the original investor.
Closure – Creating the appropriate closing documentation that sufficiently specifies the contractual obligations inherent to the security structure agreed to by all parties.
Investment Support
Monitoring – Establishing the means to stay current with the issuer so that investors can move quickly when necessary to protect their investments.
Distributions – Creating an efficient mechanism to manage any distributions of interest and principal (for debt investments) or dividends and principal (for equity investments).
Knowing what distributions are due and how they are made are also essential to monitoring the investment.
Legal support – DPI are, by their nature, high-risk investments. Legal and other professional resources should be in place before making any investment. These may be needed to
conduct forbearance (resetting the terms of the investment to accommodate the Issuer), foreclosure (pursuing remedies in court), or restructuring (redesigning the investment
terms).
Digging deeper – Carofin’s Support for DPI
In subsequent articles, we identify in greater detail the many aspects of direct private investing: Origination, Syndication, and Support.
Carofin and its affiliates specialize in the origination, syndication, and support of DPI. Since 1995, we have closed over $1.2 billion of private investment involving over 200 debt and equity transactions. We apply the lessons learned over this period to every private investment we sponsor, and we are committed to sharing this knowledge with all investors who include DPI within their investment portfolios.
