Just What You Are Looking For? - Family Office Direct Investing in Search Funds
Family offices are increasingly taking note of “search funds” as a private equity investment alternative within the broader private equity investment class. Over the past five years, family offices have allocated more and more investment dollars to private equity. Within private equity, though, some family offices have been looking to take a more active role in their private equity investments. As a result, some family offices have implemented direct investing strategies where the family invests directly in an operating company. A search fund, however, offers family office investors a unique bridge between investing in a traditional private equity fund and a direct investing strategy.
A search fund is a specialized private equity fund that is formed by an individual or a pair of individuals for the specific purpose of acquiring one target company; the principal(s) of the search fund then step in and operate the target company. Search funds are distinct from traditional private equity funds in that (i) the search fund principals take active operating roles following the acquisition, and (ii) the search fund only acquires one target company and not a portfolio of companies.
In the traditional model, the search fund team initially raises “search capital” of approximately $400,000 to $600,000 from approximately 12 to 16 investors. This search capital provides the search fund team resources to search for an acquisition target, conduct their own due diligence, engage third-party diligence providers as needed, and negotiate terms of and finance the acquisition. The search typically takes 18 to 24 months, and search fund principals each draw a salary of approximately $100,000 to $125,000 per year during the search phase. In exchange for the search capital, search fund investors receive a right of first refusal to invest in the acquisition opportunity that the search fund team finds, and they typically receive a 50 percent step-up on the search capital investment dollars.
The recent trend toward family offices directly investing in search funds is occurring in two primary ways. First, family offices are funding the search—either partially or entirely. This technique brings captive deal-sourcing opportunities into a family office. By funding the entire search, the family office will have the first look at the acquisition target and have the right of first refusal to invest in the deal. This approach would be particularly important for family offices that find deal flow a challenge to their direct investing efforts, or may otherwise lack the investment staff to review potential deals.
The family may also want to have more significant input in setting the investment parameters for the search fund’s target company. If a family office funds the entire search capital, the family will have a say in setting the search parameters— which is important if the family office wants to make an investment in a particular area or industry. For example, the family may have industry-specific knowledge and experience it hopes to utilize in connection with the investment, or they may be looking to make investments in an area of particular interest to one or more of the family members. Search fund principals may also value collaborating with the family and not having to worry about finding and managing multiple investors. While there is a lack of diversification in a search fund when compared to the traditional private equity fund, the family may achieve other goals with having input in setting the search parameters. Also, given the smaller transaction sizes, search fund investments will likely only be a portion of a family’s broader, diversified private equity portfolio.
If family offices decide not to invest at the search phase, a second investment opportunity arises with search funds at the acquisition stage, after a target company has been found. If the search-phase investors do not exercise their right of first refusal and do fully fund the target investment, search funds will need additional outside capital. By investing only at the acquisition stage, the family office does not risk the search fund team failing to find a transaction. Also, the family office can assess each investment on a one-off basis. However, if it does not invest at the search phase, family offices may not even get the chance to invest in the target company if the search phase investors fully fund the proposed acquisition.
As mentioned above, another key difference from a typical private equity fund investment is that, following the investment, the search fund team becomes the management and operates the target company. The collaboration and relationship built between the family office and the search fund team in the search phase can grow even further when the search fund team steps into managing the operating company. The family benefits from having an identified management team to handle the investment. For the search fund team and the investment operating company, the family may bring unique industry expertise and connections to the table.
Because of the flexible nature of the investment model and collaborative relationships built through the investment process, search funds may be just the investment family office investors are seeking.
Direct Investing: Considerations When Serving as a Family-Designated Director
A family office or family investment fund making a direct investment in a company often gets the ability to designate one or more directors to the company’s board of directors. The family usually has the right to designate one or more directors by either owning enough voting control in the company to elect the director directly, or specifically negotiating the right as part of the family’s investment. Important legal and practical considerations must be weighed by a family when choosing to have a family designee appointed to the board of directors. In this article, we identify some of the key fiduciary duties owed to a company and its shareholders by directors, and corresponding legal and practical issues regarding having a family-designated director.
Special considerations apply when designating a director to a publicly traded company, including the application and impact of the stock exchange rules and requirements, insider trading rules, and other disclosure obligations—which are outside the scope of this article.
A director owes fiduciary duties to a corporation and its shareholders. The director’s fiduciary duties are generally divided into two main areas: (i) the duty of care and (ii) the duty of loyalty and good faith.
Duty of Care. The duty of care generally focuses on the ways in which directors make their decisions on behalf of the company. When making company decisions, the duty of care imposes on directors the obligation to fully inform themselves and to carefully consider their decisions. When making a decision, a director should get the relevant information, take time to understand and evaluate the information and decision, consider any relevant expert advice, ask questions and challenge management’s assumptions. In each case, it is important to document the board’s deliberation. During their tenure, directors should review and assess the company’s operations and performance, including periodic updates from management. Directors should also review the company’s financial statements and internal controls. Satisfying the duty of care takes time and effort and each director’s conduct is subject to individual scrutiny to determine if the director has met their fiduciary duties.
A family designee to a board of directors must be prepared and able to spend the necessary time and effort required of a director, including maintaining availability to prepare for and participate in board meetings. In some instances, directors may be allowed to attend meetings remotely, participating by phone or video conference. The family designee must also be able to understand and evaluate the corporate matters and decisions brought before the board of directors. Depending on the nature of the operating business, specific industry or operational expertise may also be important in choosing a director. In fact, direct investing by families often occurs in industries or areas in which the family has particular history or expertise. In these cases, the company looks to the family designee to bring additional industry insight and experience to the board of directors.
Duty of Loyalty and Good Faith. The duty of loyalty requires directors to act in good faith and in the best interest of the company. The best interest of the company must take precedence over any interest of a director not otherwise generally shared by the shareholders. They may see themselves as the “eyes and ears” of the family on the board; however, in their capacity as a director, the family designee owes duties to all shareholders—not just to the family. Complicating matters, if they are an officer or director of the family investor or other family entities, the family designee will also owe fiduciary duties to those entities as well.
When acting in their capacity as a director, the family designee must have the practical ability to exercise their judgment freely. They should not be restricted by a voting agreement, contract or other arrangement with the family to vote in a particular way. Their compensation with the family investor or family office should not be tied to the individual acting or voting a certain way when acting as a director. There should not be any economic bonus or penalty attached to the director voting in a particular manner.
A director cannot give a proxy to another person to vote on their behalf as a director. By contrast, stockholders typically can give voting proxies; a director, though, must exercise their own judgment when voting in such a capacity.
Conflicts of Interest. Once on the board, a family designee must regularly evaluate to determine whether he or she has a conflict of interest in making corporate decisions, which inevitably make a director more susceptible to a breach of the duty of loyalty. Beyond the impact to the individual director, broader governance implications exist for the company and the board if a decision is not made by a majority of independent directors. Under the “business judgment rule” courts generally give deference to business decisions made by the board in a deliberate and informed manner. In a conflict situation, however, courts will not review the decision under the “business judgment rule” but will look to a stricter standard under the “entire fairness test.”
Determining whether there is a conflict of interest is fact-specific. Some conflicts are easily identified; others are not. Close attention should be paid to the personal and economic relationships the director may have—directly or indirectly—with the parties involved in a decision before the board. Having an economic interest in the transaction or getting a financial benefit from the transaction are important factors determining whether a conflict exists. Personal and professional relationships can also create a conflict of interest, which can be particularly complicated for family designees.
Once a potential conflict is identified, the director and the board need to determine how the conflict will impact the director and the balance of the board’s decision making on the issue giving rise to the conflict. The director will need to disclose and discuss the conflict with the board, and the board should tailor its response after careful review and consideration of the facts and circumstances creating the conflict. For example, the board may establish procedures to have the disinterested directors evaluate and approve the proposed company decision; the board may also consider establishing a committee to review potential conflicts of interest. Depending on the scope and severity of the conflict, the board and the director may choose to have the director abstain from voting on the matter or recuse themselves from the board’s deliberation. If the conflict is severe enough and ongoing such that it could impact all of the director’s decisions, the conflicted director may need to resign from the board and the family investor choose another designee.
Indemnification and Insurance. Due to the potential liability in serving as a director, companies typically offer indemnification to their directors. Indemnification protection for directors is generally described in the company’s governing documents. In addition, directors may also enter into separate indemnification agreements with the company. The company may also have a directors and officers (D&O) insurance policy covering claims against the company’s directors, subject to certain exclusions; however, indemnification protection may be limited by law for breaches of the duty of loyalty and good faith. In those cases, the family designee will not be able to rely on the indemnification provisions in the company’s governing document, insurance policy or separate indemnification agreement.
When designating a director, the family investor and the family designee should closely review the indemnification provisions in the company’s governing documents, the company’s D&O insurance policies and consider whether to negotiate a separate indemnification agreement or otherwise enhance the indemnification protections.
Confidentiality. The interplay of various confidentiality obligations the family designee may owe presents another complicated area for family designees serving on a board. Regarding a corporation, its directors generally have a duty not to disclose confidential information of the corporation. As to the family and possibly complicating matters, the family designee may also owe multiple duties to maintain confidentiality to the family investor and other family entities that may be hard to satisfy simultaneously.
As a practical matter, the competing confidentiality obligations can put the family designee in a difficult position. On the company side, the family designee may need to disclose company information to the family investor. On the family side, however, the family designee may need to disclose to the company information about the family investor or other family relationships, in particular when disclosing and describing conflicts of interest to the board.
To help give guidance, a company may adopt disclosure policies or other processes for information sharing between a family designee and the family investor. The family investor and the company can also enter into an agreement allowing the family designee not to disclose any family investor information and to recuse themselves without explanation from any board discussion in which disclosure would otherwise be required.
Designating a director is an essential and common protection for family investors making direct investments. However, the legal and practical implications of serving as a family‑designated director are complicated and require careful review both at the time of appointing the family designee and throughout the family designee’s tenure as a director and the family investor’s direct investment.
Cross-Border Direct Investing
As the mid-market private company transaction market heats up, family office investors will find themselves competing for deals with strategic acquirers and private equity funds—not to mention independent sponsors and other family office investors who have entered the market in recent years. This may compel some of the most sophisticated investors to look abroad for investment opportunities.
Investing abroad is not, however, for the weak of heart. While unusual opportunities may indeed be available, at attractive valuations, conducting the due diligence and implementing and operating those opportunities present unique and, for some, insurmountable challenges.
There are those investors who say that cultural considerations are overrated and that in the increasingly flat, inter-connected world we live in, analyzing a cross-border transaction is no different than a domestic transaction. This may be the case as far as financial models are concerned, but an Excel spreadsheet cannot tell you how your actions will be perceived in a different culture.
Family office investors may have an advantage over strategic acquirers and investment funds in cross-border mid-market deals. Many target companies will themselves be family-controlled businesses, and may take comfort from a transaction with another family-controlled entity, as opposed to an institutional acquirer; private equity funds, in particular, have a bit of a bad name in Europe these days.
To capitalize on this advantage, a family office investor must clarify that it is different from an institutional investor, in particular by connecting not just with the seller, but with senior management, employees and other constituencies, such as local government officials. A willingness to meet in the target’s home jurisdiction and to spend time there (rather than just flying in and out), helps establish credibility. After the transaction is closed, some senior managers may secretly want the new owners to stay far away from the company, but seasoned investors know that a portfolio company investment cannot be managed entirely from afar.
In many countries, a business enterprise is expected to reflect the owner’s values, and ultimately this cannot be accomplished if the owner is hidden from view or poorly represented by a local partner or senior management. This may require some family investors, who cherish their privacy and prefer to remain in the background, to leave their comfort zone, because what would be considered a mid-market deal in the United States is often a very big deal in a non-U.S. jurisdiction. You can expect local newspaper articles, television and radio coverage, and other unwanted attention. Also, in some cultures, a foreign investor can be seen as foreign interloper, or worse—particularly if the investment is in a strategic or culturally significant industry. This provides all the more reason to establish personal credibility and maintain a strong local presence.
Choose a Local Partner You Can Trust
Whether it is someone who is familiar with the company, a local attorney, accountant, business advisor or co-investor, having a local presence that is both respected by the portfolio company and trusted by you is a major asset for a successful investment.
Know Your Management
Even with a local presence, nothing will cause a cross-border investment to succeed or fail so much as the quality of the management team. You must be confident that the management team shares your family office’s values, philosophy and vision, because it will be the management who will be entrusted with implementing your strategy and presenting your public face. Without a trusting relationship, complemented with regular visits and communication, the foreign investor may be seen as a distant, somewhat-malign force. This perception can quickly spread through the company and poison the relationship between you and your management.
Cross-border direct investing can be an exhilarating and profitable experience, but it must be entered into knowledgably, with experienced advisors and partners. As direct investing becomes an increasingly common part of many family office portfolios, cross-border direct investing will no doubt become an active, and competitive, investment area in the years to come.