Finding the best external equity investor: one size doesn’t fit all

The market is currently flush with cash waiting to be invested, with no signs of a slowdown in sight. In this context, many privately-held family businesses are considering external capital to drive their corporate and family objectives. In their search for the optimal investment partner, family businesses need to make sure everyone’s objectives align – a task easier said than done.

The investment landscape is in a state of flux as more and more family offices and high-net-worth individuals pursue investments in private family firms. Recent studies confirm this shift, showing increasing numbers of European family offices moving from hedge fund investments to active investment strategies in private equity (PE). At the same time, the PE sector has also seen an upsurge in long-dated funds in the 15- to 20-year range, a significant increase over the traditional 10-year timeline.

The result: a diverse market with a range of equity investors and contrasting objectives. Against this scenario, how can family business owners determine the “best fit”? According to our research, family-controlled firms should keep two main factors top of mind: the investor’s time horizon and their motivation to provide liquidity to either the firm or the family.

For family owners with plans to exit in the medium term, traditional PE firms – which generally prefer shorter-term investments – might not always be a good fit. Based on our research, however, they might want to consider evergreen PE firms, which recycle investment returns back into the fund rather than distributing them to limited partners. In consequence, the capital committed is permanent. Longer investment horizons can also help to reap the full benefits of a growth scenario, which typically takes longer compared to scenarios aimed at generating value from efficiency gains.

On the other hand, families primarily interested in raising capital and with no intention to exit might consider long-term PE funds. In recent years, the market has seen an uptick in PE firms with dedicated long-term funds with fund lives in the range of 15 to 20 years. This gives the funds more leeway to realize the full growth potential in their investments or, in the words of one family business owner, allows them to “prioritize smart growth over fast growth.” Moreover, these funds typically target returns of 10 to 12%, well below the 20% returns expected in the traditional 10-year fund model.

“Family-controlled firms should keep two main factors top of mind: the investor’s time horizon and their motivation to provide liquidity to either the firm or the family.”

Finally, mezzanine investors are another option for family-business firms with longer-term horizons and interest in a partial exit or replacement capital, as opposed to additional growth capital. With no extra capital in the firm and lower value-creation potential, these investors often aim to mitigate risk by using a financial structure that emphasizes debt over equity and guarantees a minimum required return.

Other routes include bank-affiliated PE funds or government-funded funds. Bank-affiliated PE investors can provide funding to supplement traditional senior loans of affiliated banks. They are often more willing to consider debt-like models and, accordingly, have lower return expectations than independent PE investors. For its part, government-funded PE might also sponsor these operations as a means to anchor companies in the local economy and spur regional employment.

Lastly, family offices are also worth mention. According to a 2019 study, an estimated 81% of family offices are allocating funds to private equity investments, favoring direct private equity over PE funds to reduce management fees and secure greater operational control. In general, they also espouse longer-term views on investments and a deeper appreciation of the firm’s desire to preserve the family legacy and values.

Diverse time horizons, preferred risk profiles, non-economic goals and the degree of portfolio involvement are among the core issues family-owned businesses should consider when searching for outside investors. By deliberating these factors and aligning needs and expectations, they’ll be able to achieve outcomes that benefit both the business and the family.

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