Investing directly in private companies is becoming increasingly popular with wealthy families.

Nearly a third of ultrahigh-net-worth investors plan to increase allocations to direct investment this year, according to a recent survey by the Institute for Private Investors -- and the trend has been accelerating since the financial crisis, wealth managers say.

“Many of these are investors who made their wealth through ownership of private operating companies,” says IPI president Mindy Rosenthal. “For many of them, their experience in the capital markets since 2008 has not been good. They are attracted to investing directly in operating companies because this is where they have expertise, connections and where they can exercise control.”


Dissatisfaction with investing in private equity firms has also contributed to the appeal of direct investing, according to John Rompon, managing partner for McNally Capital -- a Chicago-based firm that advises wealthy families on their private equity investments.

Many private equity firms take risks when investing in companies that turn out to be different from what they originally stated, Rompon maintains, a phenomenon he calls “strategy creep.”

As a result, he says, investors can find themselves exposed to risks they already have elsewhere, or correlated risks. “That’s important to wealthy families,” Rompon says, “because risk is almost as important to them as absolute return.”

What’s more, the business model of private equity firm requires them to sell their stake in companies within a certain timeframe -- something that may not be optimal for wealthy families, Rompon argues.

“If they invest directly in a company, they aren’t constrained by someone else’s time horizon,” he says. “The company doesn’t need to go public for them to exit, and if the company is in an industry that has a high degree of success but also a high degree of uncertainty, families  ... can hold on to their investment for an indeterminate period of time.”

Wealthy families with experience in owning an operating company can also leverage their “storehouse of knowledge” to add value to a company they buy into, Rompon notes.

“Families with an ownership background can tap into a wide-ranging network, including employees, vendors, suppliers and prospective clients,” he says. “They can make a well-placed phone call and move the dial.”


So where are wealthy families making direct investments putting their money? Don't look toward Silicon Valley.

“The bigger families we work with are investing in infrastructure,” says Carlos Nieto, managing director for OnNe Consulting, a Miami-based firm that advises family offices and private businesses. “They’re buying into power generation, utilities, water companies and road concessions, as a replacement for fixed-income investments. For longer-term plays, they’re investing in agriculture.”

McNally Capital clients are focusing on capital-intensive companies such as equipment manufacturers that can generate income, Rompon says, as well as companies in “fundamental” industries such as food and beverage, and companies involved in logistics -- such as shipping, trucking and equipment parts.


Yet wealthy investors have to know what they’re getting into before making direct investments, experts caution -- and in many cases, may need to be prepared to roll up their sleeves.

“These are very hands-on, illiquid investments,” Rosenthal says. “Investors can’t be passive. They have to know how to incentivize senior management, manage cash flow and understand the market they’re buying into.”

Responding to demand from its members, IPI will be offering classes on direct investing during its annual forum in New York in October. Other experts offer a few things wealthy families -- and their advisors -- should know before taking the leap into direct investing.

A number of industry experts suggest that clients have a net worth of at least $100 million before considering direct private equity investments. McNally Capital recommends that families should be prepared to allocate $10 million initially across one or more deals and put in more money later, as needed. 

Direct investments in smaller companies can even range as low as $500,000 to $2 million, Neito says. But high net worth investors shouldn’t invest more than 5% to 12% of their portfolio in private companies, he says, and should have a net worth of around $20 million.

Potential investors need to do their due diligence, carefully examine the company’s shareholder agreement and understand “how governance at the company works,” Nieto says. Be sure to “key into a company’s management team,” he adds. “They’re the ones in the trenches running things. Look into their relationships and dynamics and how they work together.”

Direct investors should also be prepared to walk away from a deal, Rompon cautions. “It’s better not to do a deal than do a bad deal,” he says.

Rompon also warns against doing deals with friends. “Avoid investing within an affinity group like a church, club or a vacation home community," he says. "They are good places to make friends, but bad for investments. If other people you know have heard about a deal, it’s a good reason not to do it.”

And members of a wealthy family should be cautious about investing in a company owned by another family member, warns Mark Martiak, senior wealth strategist for Premier Financial Advisors in New York. “You don’t want to be exposed to any gift tax consequences, “Martiak says. “If there is an IRS audit, you have to prove it’s a real investment and not a gift.”

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