Last week, Family Capital ran an article entitled “Five Big Ideas of Family Offices”. One of those five ideas was - due diligence doesn’t matter as much as some say.
My view is that it does matter, particularly for private equity-like deals. In fact, good due diligence can save a family office a huge amount of money by mitigating the risk of buying a business that might ultimately fail.
Indeed, the importance of due diligence is greater than ever, because family offices are doing direct deals more than ever. In contrast to private equity funds, family offices have many advantages – for example an entrepreneurial family can offer industry insights, they are not focused on the exit and have a much longer time horizon.
Of course, one big advantage of not using a private equity house is no fees. Every family office knows how much these fees - normally a combination of management fees and carried interest - can be. And many have become reluctant to pay them, because family offices often say the performance of their investments haven’t justified those fees. So, the trend has been for family offices to invest directly themselves. They, as last week’s Family Capital article said: all want to become mini-Berkshire Hathaways.
But, if family offices are saving on these private equity fees, wouldn’t they want to use savings to pay for things like due diligence? Good due diligence, which could include financial, legal, tax, and management, or even environmental due diligence, means that the deal is a good deal. And conversely, bad due diligence is more likely to lead to a bad deal.
Yes, a gut reaction deal, with little, or no due diligence, might just work for a family office in a sector that the family knows intimately because that’s where they made their money. But if family offices want to diversify into other sectors - outside the sector where their gut feeling is good - they better do their due diligence. In fact, the more you get away from your industry, the more you want to do due diligence. Furthermore, if the family investor intends to exert managerial influence on the investment, a sufficiently detailed due diligence will help them to better understand the business dynamics of that particular business.
Also, by saying that you’re not going to spend fees you’re effectively saying that my gut feeling is better than those that do their due diligence - that is, the entire private equity world. That isn’t just foolhardy, but a huge risk. And many private equity deals are just too big to risk failure.
Remember, private equity isn’t venture capital, where you can afford to take bigger risks because typically the amount of investment is far less. Investments in private equity are higher because the business is much larger - with many of these businesses with annual revenues of at least $20 million, and usually much more. The consequences of failure at this level of investment, which usually represent a much larger share of asset allocation, are thus too great to contemplate.
In summary, little or no due diligence for direct deals, particularly at the level of private equity, isn’t an option. Due diligence does matter as much as they say.
Peter Brock, Leader Family Office Services at EY/Ernst & Young in EMEIA and GSA