Paul J. Carbone is co-founder and vice chairman of Pritzker Private Capital, a family-owned investment business that partners with leading middle-market companies in the manufactured products and services sectors. He discusses why direct investing is a good fit for some families, while for others, it’s not:
Why do families consider direct investing?
Many families consider direct investing but sometimes it’s for the wrong reasons. I hear, for example: ‘My family built up a great operating business before we sold it, so naturally I can create a great investment business.’ Or ‘The fee structure is too high for traditional private equity, and I want to avoid the fees by being a direct investor myself.’ Or ‘The exposure to the private markets is what I’m looking for and I want easy access to those attractive returns.’ None of those are real reasons why any given family should consider direct investing.
The right reason, in my opinion, is that family capital is fundamentally different from traditionally structured capital. When those differences are directed to sellers who care about those differences, family capital can create an inherent advantage over most capital in the marketplace. Those who execute it appropriately can consistently find and win more attractive opportunities and thereby generate consistently higher returns. That’s the right reason – it’s not for fee avoidance and it’s not because you’re a great operator and want to be an investor.
Is direct investing a good fit for all families?
A lot of families talk about direct investing, but most shouldn’t do it. Direct investing is hard — it’s not an easy business to get right.
What are the necessary ingredients for successful direct investing?
One is scale: You need a sufficient amount of capital to sustain and retain your investment, as operating teams work with investee companies over a long value creation cycle. Building great companies and creating significant returns is not a short-term game. Also, you need capital to deploy in multiple investments as you want to mitigate any individual company risk through diversification. In addition, you need adequate capital to justify the meaningful overhead and operating expenses required to be a direct investor: a team, search costs, oversight costs, etc.
But most importantly, I’d say the fundamental determinative of direct investing success is alignment, which starts with the family’s goals and values. That’s the foundation upon which success is built: what does the family want to accomplish and what are the values guiding it to achieve that goal? From there, a strategy can be built that is aligned with your team, tactics, processes, and procedures, and positions you well to execute consistently.
What are alternatives for families who don’t want to become direct investors, or realize they shouldn’t?
The vast majority of families should not focus on direct investing in pursuit of private market returns. However, families who don’t want to — or should not — become direct investors are not wrong in seeking private market returns. After all, private equity has been a massively successful business model over many cycles and many years.
So, what do these families do? They must find great partners who operate with their values and are well-positioned to compete and win in today’s increasingly competitive private markets. They need a systematic, disciplined approach to identify an appropriate portfolio of potential partners and then use the advantages of family capital to maximize the opportunity.
Right now, as a percentage of the overall funding market, traditional private equity doesn’t source a significant amount of capital from families. At the same time, many private equity firms are finding it hard to source capital for their new funds. Families could use their permanent, proprietary, flexible capital to fill fundraising gaps and partner in a real way with traditional private equity.
If families can execute with speed, certainty, and expertise, they could support these great private equity managers by providing co-invest equity capital, private debt capital, capital for continuation vehicles, secondary LP interest, etc., all with reduced or nonexistent fees and expenses. Being a value-added, trusted partner to managers is a winning path to efficiently realize the benefits of the private markets without the complexity of being a direct investor.
Now, some families don’t feel as though they have the capabilities or the interest in picking out a group of managers, in which case they must find an aligned fund of funds solution or advisor who can help them identify great managers. So, there are avenues for families to use their advantaged flexible capital in the marketplace, even if they don’t want to be a direct investor.
Why is family capital advantaged?
There are two fundamental ways in which family capital is distinct from traditional private equity.
One is that family capital is permanent and proprietary: it is a family’s money and is capital without a fixed time horizon. And when you have permanent, proprietary capital, you have maximum flexibility to determine how that capital should be deployed in terms of duration and structure, as well as how companies should be built and with what objectives. When you can customize your capital to the needs of the marketplace, you can create advantage over other providers.
The second advantage is that family capital is inherently imbued with the family’s values and philosophy. So, for instance, here at Pritzker, the family’s values — honesty, integrity, and loyalty — are reflected in all that we do and in every decision that we make. That philosophical attachment to the capital often is attractive to the users, especially when they themselves are families, founders, and management owners. That’s often distinct from more traditional PE, which can be devoid of a distinct value system or philosophy.
Permanence and a distinct ethos are two characteristics that, together, make family capital different. While difference by itself is not an advantage, difference that is valuable to somebody in the marketplace creates advantage.
How involved are direct investors in companies?
One of the ways that private equity accomplishes high sustained returns is by being active with their investments. Of course, there are lots of different approaches, and a continuum in terms of how actively involved firms are with their companies, but a fundamental tenet of private equity is that you’re active with your companies to some degree. That active involvement allows you to work with management teams to change companies’ trajectories.
If you buy a public stock, you’re trusting a management team and directors to use your capital effectively. If you are dissatisfied with the results, your only real option is to sell your shares back into the market. But in private equity, one reason why they typically generate strong returns is because private equity teams provide management with talent, resources, access, skills, and counsel not always readily available to most private companies. Typically, the smaller the company, the more active the investors are. So, if a family wants to go buy a portfolio of smaller companies, they generally will have upside opportunities — but on the flip side, operational issues may be more challenging. What represent speed bumps for larger companies can potentially be terminal for smaller companies. So, you have to be ready to be active with your companies to add value, change trajectory, and deal with difficulties in a proactive way.
It’s a competitive world and competitive marketplace. Market prices are high and reflect values for trend-line performance. If you don’t bring expertise, customer relationships, or other ways of adding value to these smaller companies, you’re going to have a hard time changing that trajectory. A buyer, especially in a competitive world like today, must change the status quo performance of a business to create a return on their capital. So, it is not an easy game, and it’s not for all families. But for those families that have the right capabilities, resources, longevity, team, strategy, and alignment — they can take advantage of that competitively advantaged capital and generate great returns.
What are the challenges families face in direct investing?
Despite having advantaged capital, this is a massively competitive marketplace, and the best of the best investors are resident in those traditional private equity firms that are all looking for great opportunities. So, just because you have advantaged capital, doesn’t mean you will win the race. It simply means you have a good set of cleats on and a good set of lungs.
Second, this is a less than a 1% business. You must look at more than 100 opportunities to make one investment. It’s simply the nature of investing: finding the right company, at the right price commensurate with risks, takes time, effort, and expertise. The investing business is a financial discipline, but it is as much or more a human capital business, requiring a talented team to find opportunities, conduct due diligence, and win the trust and confidence of potential partners. And then once you close, you’re just out of the dugout and onto the playing field, where you now have to play the game.
