By Steve Lebowitz, Brand Velocity Group
Larger family offices are increasing their allocations to direct deals. And for good reason – directs allow for increased visibility into an investment, and often result in lower fees and more attractive valuations. Boutique placement agents have capitalized on this trend the most, with investment banks and wealth management platforms not far behind.
Years ago, direct deals and co-investments on the part of LPs were rare, and often occurred at the behest of a fund sponsor. It was attractive then too, but accessible only to large institutional LPs who were already fund investors with deeper teams to underwrite such transactions.
Our industry has been pushing to “democratize private equity” for decades, with GPs competing to absorb the influx of individual assets into private markets. They’ve largely addressed this opportunity. The biggest names in our industry began marketing outside their core institutional base once it reached saturation. Such firms created feeder vehicles for their flagship funds to be marketed through private wealth channels.
More recently, multi-manager platforms have packaged diversified private equity portfolios into mutual fund-like vehicles, which have been well received. Gaining exposure to private markets is easier than ever, and these options offer the benefit of immediate diversification, which is essential to many investors, especially those with less experience in executing deals themselves.
But systematic access to the really compelling, one-off direct deals – where true home runs are found – remains elusive.
Family offices have grown more sophisticated. No longer vexed by the mechanics of private equity, or inconvenienced by investing outside the public markets, these firms now employ dedicated private equity investment professionals, with expertise in analyzing and underwriting transactions. Similarly, HNW individuals crave that complexity – they often participated, or watched on the sidelines, as friends and their favorite celebrities joined the world of private markets or invested in venture rounds.
In direct deals, investors with industry expertise and bandwidth are afforded significantly more influence over the underlying business, with incentive to drive strong returns. This includes exits; outside the fund structure, there is no predetermined investment period or hold period. This is in stark contrast to traditional funds, which can be opaque.
Direct deals typically involve smaller companies, often in the lower-mid-market. Outsized returns hinge on the ability of investors and sponsors to add value and fuel growth. In addition to more attractive valuations, these deals tend to utilize less leverage – reducing risk – and avoid competitive auctions.
The fee structure is attractive, too. Like traditional private equity, deal teams, often independent sponsors, receive both a management fee (usually a percentage of EBITDA with a cap) and carried interest. However, in direct deals, carried interest is variable; it scales upwards based on performance – up to 20 percent for top performing deals. This differs from how carried interest is paid out in a traditional fund – fixed at 20 percent after the sponsor meets a set hurdle rate, usually 8 percent IRR. Carried interest is the primary form of compensation for any sponsor, and in our opinion, the direct model more tightly aligns the interests of sponsors and investors, encouraging active contribution to the growth of the company.
It’s no wonder that allocations to directs are growing. But there are significant hurdles for private wealth platforms and investment banks to overcome before these become more widely available.
To be clear, directs may never reach the breadth or scale of the aforementioned feeder and 40-act funds. Directs are marketed to qualified purchasers: a person or family office with at least $5 million in investable assets. Even limiting the pool of investors to the ultra-high-net-worth, potential investors would need to act unusually fast. Directs often materialize quickly and sponsors are required to raise money in just a few months. While that can be an advantage to those looking to deploy capital, others may not have capital readily available.
Moreover, sponsors face significant bureaucracy when marketing to large wealth management platforms. Receiving approval to market direct deals on such platforms can take upwards of one year, which doesn’t correspond with direct deal fundraising timeframes. Relationships between parties and strong track records on the part of sponsors can speed this process.
Lastly, wealth managers are not yet accustomed to this. They may not be confident in deploying their clients’ capital to a private deal, and may not be compensated for AUM that leaves their firm. This, in addition to potential concentration risk, may slow the process more among the risk-adverse.
Of course, the benefits outweigh the challenges. Niche placement agents are emerging to fill investor demand for these types of deals and are reaping the rewards. They are building large networks of investors able to raise large sums through smaller checks. Larger placement agents, investment banks, and wealth management platforms can, and should, follow suit.
Steve Lebowitz is founding and managing partner at Brand Velocity Group.