Three top tips for direct investing

Direct investing has become more and more popular over the years, but as seasoned investors in this area, we know that this is an asset class strewn with pitfalls. But when done right, it can be both emotionally and financially rewarding. Here, we explore the three rules for family investors to live by when it comes to buying businesses directly.

There are no right answers here, for some people it is a purely financial exercise and for others it is a retirement plan; a way to share your carefully honed skills with a new generation of management teams. It doesn’t matter what your motivation is, but it is absolutely crucial that you understand what it is, because that will dictate every element of your approach. Be honest and upfront with yourself about your reasons, and what you want to get out of it.

There are myriad motivations for investing directly, many of our clients enjoy the tangibility of it when invested alongside traditional portfolios, there’s also a great deal of buzz around working with young management teams, fledgling businesses and companies with the potential to drive meaningful social or environmental change. But if this is simply going to be a hobby, it can be an expensive one, and not just financially. Take the time cost, for example, of investing in 5 businesses; say they have monthly board meetings, that’s 60 meetings a year, and if you give yourself two days for travel and preparation, that’s 120 days – a third – of the year. That’s the kind of thing that you can outsource, and we help a number of clients in this way, but you’re only going to do that if you’ve thought carefully beforehand about your motivations and expectations for this enterprise.

First and foremost, investing in a private equity fund versus doing it directly are entirely different beasts, and when it comes to asset allocation, they can both play an important role; one doesn’t need to replace the other. Not only do you have vastly different levels of control between direct and fund investing, but the nature of the businesses you provide capital to is different; with direct private equity we’re largely talking about early stage growth capital, whereas funds invest across a broader spectrum of businesses at different points in their lifecycle. So with both greater control, and a more concentrated opportunity set, you are accepting a far greater level of risk as a direct investor.

Even within direct investing, you have a great deal of options. You can go it alone, work with a group of likeminded families, or you can pick and choose which elements of the process that you want to outsource, and which you want to do yourself. All have their pros and cons, and while some may look optically cheaper – in avoiding paying fund management fees – they rarely are. Whatever your route, you are still going to have to pay fees. With a fund, due diligence fees are already baked in, but individual investors have to pay these themselves. This is often a real pain point for families, particularly when you have to pay legal fees to look into a deal that eventually falls through.

Clubbing together can lighten the load for these kinds of issues, but they can be operationally very difficult. We’ve seen plenty of examples of families thinking that they are aligned at the beginning, only to find that as the deal evolves – needing new funding for growth, or in deciding when to sell – that they are in different mindsets entirely. You need to have difficult and honest decisions at the outset in order to mitigate these risks.

It’s easy to see how for someone looking to sell a stake in a business, a family might represent your ideal buyer; a family with long time horizons, deep pockets and none of the rapaciousness of the institutional private equity world. Families can often be seen as partners rather than private equity overlords, offering guidance and a long-term view. So, when properly managed, this creates a dynamic which is advantageous to both parties. Where family deals tend to come unstuck however, is in the detail, and that is a question of due diligence.

Families can also be seen as the ideal buyer for the wrong reasons, in particular, a perceived lack of rigour. Time and time again we see families presented with deals that we know have been around the private equity houses, only to be shifted to direct buyers on this basis.

So, what constitutes good due diligence? One critical starting point that is all too often overlooked is having a good investment committee, and seeking professional independent advice. This can take away the emotional element of decision making, make sure that all stakeholders are truly aligned, and boost the professionalism of the overall investment thesis. It’s particularly critical in the early stages of a deal, because no matter how well a direct buyer might know a particular business or market, you are simply a better investor if you’ve seen 20 deals than if you’ve seen one, and you’re an even better investor if you’ve worked over multiple business cycles than through one regime. Because no matter how exciting the sector or business model looks, it will hit roadblocks along the way. What every seasoned investor knows is that a major part of your early stage due diligence is in assessing the quality of the management team, and in particular, their ability to adapt to change.

There is no doubt that families have some major advantages as direct buyers of businesses, chief of which is flexibility. Having the ability to keep hold of an investment for any length of time, so long as it continues to compound at an attractive rate, sets families apart from their institutional peers. The flipside to this flexibility is a lack of rigour, and the industry can be very quick to take advantage of any perceived weakness on that front.

The sweet spot is in combining the freedom of the individual, with the sophistication of the institutional. Those who do, capitalise on their advantage as the most dynamic investors in the marketplace.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.