How family offices partner with private equity funds to find the best deals and save on fees

A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide for the high-net-worth investor and consumer. subscription To receive future issues, directly to your inbox.

Many investment firms belonging to ultra-rich families are keen to buy stakes in private companies directly rather than through private equity funds, which come with lower fees and control.

However, cutting out the middleman can come at a high cost, and requires hiring an in-house investment team to source proprietary deals.

But family offices have found a way to have their cake and eat it too by backing private equity funds while investing directly alongside them.

Under this type of deal, family offices make significant financial commitments in exchange for the right to invest additional capital on their own in individual portfolio companies. They typically pay a discounted management or performance fee on their co-investments, and the private equity fund takes on the burden of sourcing and due diligence.

These co-investment arrangements have increased in popularity over the past decade, family office lawyers and fund managers told Inside Wealth. This trend has been fueled by family offices seeking more direct investments and private equity firms facing challenges raising capital.

“The ability to share the burden, share the costs, and in some cases, rely on private equity funds as a source, [do due] “The diligence, execution and management of those investments is very attractive to families who want direct investment exposure, but don’t necessarily want to build all of that on their balance sheet,” said Scott Beach, who heads Day Pitney’s corporate and business law department.

By teaming up with private equity funds, family offices can take stakes in companies they wouldn’t be able to buy outright, according to Michael Schwam, a partner at Duane Morris and co-chair of the family office practice.

“Private equity funds will almost always outperform family offices, at least in the middle market,” he said. “With the vast majority of families we deal with, most of them realize that they will never be the ones to offer the highest price for a room.”

Private equity sponsors have become more willing to negotiate co-investment rights as a way to get family offices to commit money to the fund, according to Kevin Schmelzer, co-leader of the private equity practice and family office strategic initiative at Morgan Lewis. For example, sponsors may give family offices the right to purchase new shares to maintain their ownership percentage when more shares are issued. Private equity firms may also provide more detailed financial or operating information about portfolio companies than fund investors typically receive.

However, while family offices invest alongside private equity funds, they still represent minority investors. They do not get the same management or operating rights that they would have if they bought the company themselves.

“These family offices, they’re not in the room with the private equity sponsors, negotiating with the seller,” Schmelzer said. “At the end of the day, the family office is still subject to the whims of the private equity fund.”

More importantly, family offices rarely have the right to retain their shares and prevent a private equity firm from exiting. This can be a serious drawback for family offices known for long-term investing.

“This can create some tension on the back side of the relationship,” Beach said. “The private equity firm will want to hand over 100% of the shares to the buyer, so they want the right to continue the family office.”

But in return, family offices are able to deploy capital faster than if they relied solely on finding their own deals or allocating funds, according to Doug McAuley, a partner at Cambridge Investment Advisors.

McCauley expects family offices to allocate more to co-investing as private markets generally become more attractive. Some family clients have as much as 15% to 20% of their investment portfolio in joint investments, he said.

He warned that households need to monitor their liquidity and be selective with fund managers and portfolio companies. When funds invite co-investors to join a deal, it may indicate a lack of conviction from the sponsor or the presence of a risky asset, he said.

“I don’t think the rationale for co-investing is that you’re going to get a better return because it’s a co-investment. You might get a better return because the fees are lower,” McCauley said. “It doesn’t make it a bad deal, but it doesn’t make it a better deal than anything else in their box either.”