Family offices have been growing since the end of the Great Recession. Now, family offices face new challenges such as determining diversification strategy and succession planning.

In this episode of The Corner Series, McGuireWoods’ Geoff Cockrell welcomes guest R. Adam Smith, the Managing Director of Salomon Brothers, who advises many family office clients. 

Tune in to hear Adam share his thoughts on family offices engaging in direct investing, the need to hire experienced staff and advisors, and how diversification can provide more financial security.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Corner Series, a McGuireWoods series exploring business and legal issues prevalent in today's private equity industry. Tune in with McGuireWoods partner, Geoff Cockrell, as he and specialists share real world insight to help enhance your knowledge.

Thank you for joining another episode of The Corner Series. I'm your host, Geoff Cockrell, a partner at McGuireWoods. Here at The Corner Series, we bring together thought leaders and deal makers in all sorts of transactions, largely involving healthcare.

Today, I'm thrilled to be joined by Adam Smith, managing director at Salomon Brothers. Adam has got a long and colorful career and history, where he's done a lot of different things. A lot of it focused on family enterprises, both on the advising them generally, and also with respect to sell side advisory work, but also assisting family offices on the buy side.

But, Adam, if you could give a little introduction of yourself, before we jump into some questions.

Great. Thanks for that, I appreciate it. I'm R. Adam Smith. I'm in New York and head up a mergers and acquisitions business at Salomon Brothers. We recently relaunched the firm the last couple of years and now run a middle market practice for clients across a range of businesses.

Originally, I started Salomon Brothers in the good old days, in the early '90s, when things were a bit different. Obviously, there was a significant sales and trading business at Salomon Brothers, and it was quite an active business. Today, we don't run that business but we focus on M&A, both buy and sell side. Of course, there's also securities and capital markets business. There's also an asset management business as well. Then, some international joint ventures with other banking firms.

A bit of my background as well, as we talk more about that. But it's great to be here. Also, in terms of my focus, given the dramatic expansion of family offices and their related businesses the last couple of years, we've paid a great deal of attention to their needs as private companies. Occasionally public companies, but mostly their need to grow and acquire companies, or to sell and monetize some of their holdings.

Maybe tell us a little bit about your work with family enterprises. I know you've built a dramatic network and connect with them on a regular basis. But, maybe give it a little bit of background of what you're doing with family enterprises generally. Then, if you could comment a little bit on some of the challenges that a family enterprise in particular faces.

Sure. Yeah, as you guys know over there, family offices have grown, given the significant expansion of wealth creation and desire to expand holdings beyond the public holdings into private positions. Their move into private positions, I would say, began to dramatically increase after the Great Recession, moving into real estate, moving into direct deals, buying companies, not just co-mingled funds and alternative investment fund product. Of course, the last five years, we've seen almost a doubling of family offices in the world. There's probably 10,000 or so in the US, another 10,000 outside the US. Apparently, five trillion or so of total dry powder or liquid assets, however it's managed. Those are stats by Camden and UBS, and others.

Given the scale, it became apparent to me many years ago as I started with single family offices and some multifamily offices in 2002 even. It became clear, especially the last five or 10 years, that they were going to get larger, and also as they get larger, they're going to be buying and selling more assets. From an M&A perspective, they're increasingly busy. Of course, we could talk about whether that work is done internally or externally, that's another conversation. Then of course, as they go into venture or growth equity, or as they have more private company holdings, they also need to finance or refinance or recap those increasing positions that are not within the co-mingled fund.

I, as well, am seeing a lot of direct investment by family offices. One of the challenges, it would seem to me, as I compare interacting with family offices as direct purchasers, versus say a committed private equity fund, is a little different internal apparatus, whether that's a more fully developed team, resources surrounding platform support. When you're advising family offices that are doing direct investing, how do you think about some of those topics?

According to the research, the average family office in the US owns several distinct companies and they are typically called a family office. But really, the family office is just the euphemism for the legal structure of the organization. It's important that people don't limit their assessment or interaction with a wealthy client or wealthy family, I think just the family office, because the family office can be a subsection or a misnomer of the activities. Sometimes the family enterprise is actually larger than the family office, or the family office is the wealth management arm, or the trustee or administration arm of the family enterprise.

I think it's interesting, maybe we could talk a bit about that. But also in other conversations with people, I think with your clients, to keep this in mind that sometimes the family has not just multiple generations, it has boards, it has a charter, it has multiple holdings. Some holdings are for profit, some holdings are not for profit. Some holdings are acquisitive, some holdings are not. Sometimes they're even public, especially outside the US. 70 to 80 percent of the world's GDP apparently is held by families, even though a large portion of that is public value, especially in the emerging markets. In the BRICS, for example, and in emerging markets, [inaudible 00:06:17] a larger portion of family business wealth is public and much more concentrated in terms of local GDP. It's a fascinating topic, especially outside the US, with that concentration of wealth still staying fairly high.

For family offices doing direct investing, how do you think about their role in sourcing deals? They often don't have the fully developed internal business development teams. One of the approaches that I've seen a number of family offices employ is interacting with independent sponsors, who are of course private equity type people that don't have necessarily a committed fund behind them. They source a deal, and then in addition to needing to source the debt component, they're also largely seeking to source the equity component. The interaction between family offices and independent sponsors has become a much more developed apparatus. How are you seeing those dynamics in your travels?

Direct deals have been going on for decades, or even centuries essentially, where a family office, or a family business or wealthy person putting money into a private asset really could be called a direct investment. It's such a lingo now because the industry is so much more advanced, more institutionalized and more covered. These direct investments have been going on for years, whether they're sourced internally or not, whether they're a growth equity investment or minority investment, or they're controlled transaction investing into a company.

I think direct investing is certainly a very attractive activity, it's certainly very large, it's probably even under estimated because despite all the expansive coverage of the family office industry by lawyers, and by bankers and by databases, including all the Capital IQ, and Affinitiv, and PitchBook, and FINTRX, and Cendex, and so on. Even with all of those databases, there is an opt-in element to it. I'm sure you have clients that don't really want to talk about what they do. It's interesting.

I think the deals are becoming more large. They're becoming more collaborative, in terms of syndications and clubbing. We can talk about that also, a bit. I'm not really sure if they're being sourced more internally or externally. I think as the family enterprise gets larger, they do have more coverage, but they also have more people internally. In terms of sourcing deals, I think generally as I cover the family offices as they grow, as the smaller groups get more mid-sized, they tend to go outside. As they get super large, they tend to have staff of over 50 or even 100, let's say at MSD or a Prtizker type of thing, and then more internally.

One question that often presents itself, especially if I'm, for example, dealing with an independent sponsor that's looking for capital for a deal. One question I've been asked several times is should they think about family offices where the family has made the family wealth in a particular industry, should they think of that family office more heavily within that industry? Or is part of the ambition of the family office is to diversify themselves away from some of that narrow industry sector exposure? As you're talking to family offices, do you see them or are you advising them more to lean into their natural areas of expertise, or lean more into diversification?

Yeah, fascinating question. It's quite complex because of various factors. First of all, the larger that the families get, the family offices get, let's say over a billion and especially over five or 10 billion, the concentration issue becomes significant. If you look at the data and the conversations within the annual family office reports by Camden and UBS, and some of the data from Preqin, and also the comments from Ron Diamond, my friend who's an expert in family offices as well including succession, next gen, human capital compensation and direct yields, it seems like there are concentration issues.

As the core operation position gets larger, it's going to have a huge tax bill. I think as families get advised by law firms like yourselves, and their trusted estates and private bankers over the course of their growth, the smarter ones seem to be diversifying. They're diversifying primarily in [inaudible 00:10:51] investments, previously in hedge funds. I think a lot of the money that family offices took out of their operating companies, and public companies has moved meaningfully into hedge funds 10, 20 years ago, and then into real estate, and then into private equity funds and venture capital funds, and now direct deals and co-investments, and then secondaries. That diversification is growing I think and that's a healthy thing.

However, at the same time, if a family, we can think of Hermes for example, or LVMH, or Ikea, or BMW, Ferragamo, AutoZone. I think it's important to look at these larger families as case studies to look at how they juggle the benefit of concentration, and then also the risks of concentration. We can talk more about that if you'd like.

As you see these family offices building out teams and expertise for direct investing, how do you see them thinking about balancing professionalization, meaning drawing in people that were say in private equity or similar type industries, versus family involvement in that exercise?

Well, what are you think there exactly? You're talking about how they grow as an organization, or more about their wealth, or succession?

Thinking more along the lines of, for direct investing, the decision making people and sourcing people. How often are family offices going outside of the family for that expertise, or bringing along people that are from the family?

Well, certainly the family office recruiting business, if you look at let's say Linda Mack or Korn Ferry, Gary Goldstein, other experts, Heidrick, there is a dramatic increase in the need for talent to run, to build, to expand, to enhance the family office organization because the wealth sometimes can be quite chunky. It can grow dramatically and the organizational infrastructure is not prepared for that, not just in terms of intellectual expertise but also administrative, operational, technological, cultural, governance. There are gaps in the development of human capital for sure.

I have been personally a part of 10 board of directors and 10 advisory boards, and I've bought eight companies with partners directly, with family offices as well. I've been part of seeing this a bit over the last 20 years. Right now, there's a dramatic expansion of the size, but also of the human capital needs and conundrum. I think it's tricky for family offices in the small to mid-range, because they are not typically using source providers as actively, except for perhaps legal and accountants. I see there's a gap in the human capital element of recruiting, using executive recruiters, building boards, and realizing the need to bring in high-priced talent and high-powered talent to run and manage the family office from a leadership perspective. That can also include, of course, the CIO and other elements.

I see deal sourcing teams really picking up once the wealth gets over $1 billion. I'm seeing two or three people interacting with us as bankers, talking about deals they want to see or deals they want to sell, or to recap, or to merge or consolidate. Getting in the two to three person category, once the assets, anyone gets to five billion. Once it gets to 10 or 20 billion, the deal sourcing team can be over five or 10 people. At that point, they are talking to bankers but they're also more capable to manage internally, which is great, and they can also source their own deals. Also, sourcing deals internally, of course, at least it's perceived to be a better value, a more wise decision in order to find deals directly.

That brings the whole question up as to are proprietary deals actually better and are they going to be likely priced better than deals that are not proprietary?

Do you have a view on that question?

I think it's very theoretical. If investment bankers do their job, in terms of broader processes, theoretically the fair market value is higher because there's more eyeballs on it, in terms of price discovery. That being said, the price of an asset is the harmony between buyer and seller, so a proprietary deal, although maybe has less competition, is still going to be based on what the seller thinks or what the buyer thinks. Actually, investment bankers provide a very important service for decades and centuries, because they are really serving an intermediary role to provide a neutral and educated position to give that analysis and to look at what the fair market values are. That data is at times, very important, very useful for the seller, if the seller is in fact either too greedy or under educated, in the sense that their price may actually be too high just out of lack of information or not being realistic. In that case, those deals won't get done or they will get done at a premium, and those pricing can actually be higher than which it otherwise would be in an auction.

Let's swing to the other end of the spectrum. I know you do a lot of advising of family offices that have had a significant wealth event and then they're looking at making investments, but let's roll the clock back earlier. I know you also do a lot of advising of family enterprises that are maybe approaching a sale event and are having thoughts around succession, and things like that. With a family owned business that is looking at exploring both succession and transaction ideas, what are some of the challenges that are peculiar to family business that you encounter?

Well, we could spend a couple hours on that. I have had several audiocasts with global family enterprise experts recently, in the past couple of months. For example, if you read about these succession issues, or cultural issues, or decision making issues, perhaps with Alfredo Di Massis. You can also read Massimo Bau's work, Christina Wing's work, Martin Roll, Guillermo Salazar, Peter Vogel. These are all experts and friends, they've all been guests in my family business audiocast show, which is on LinkedIn, which has been really a wonderful way to just chat casually about the industry, and key elements, and issues and changes within the family enterprise business. That includes family offices as well.

The challenges that are quite clear cut across multiple levels. First, there's culture, there's succession planning G1, G2, G3. There's the challenges in terms of keeping human capital fresh and up-to-date, and also respecting the next generation's goals and interests. Sometimes there are challenges in that transition because the next generation that's younger, and also perhaps less emotionally attached to the business, or the culture, or the mission, or the vision, or the charter, once there is a meaningful gap between the previous generation or the main generation and the new generation, and that younger generation does not want to leave, and they want to actually manage that family office or that family business, they will sometimes encourage a sale.

I see a lot of catalysts in the transactions today coming from, let's say the coming to terms of the different generations. That existing family owners do want to continue the legacy, let's say, of the family business, but they're open to a sale of some of the assets. It could be let's say one of the businesses, or it could be a recap instead of a sale. Or if they just come to terms that there isn't family children to take over the business, they're more pragmatic about it, they respect the next generation and they're open to the sale, then as I tell some of my clients and friends, that even if the family business is going to be sold in total, that does not mean that the legacy of that family is going to be eliminated. It just means that the legacy is shifting from an operating business into cash. Therefore, the question is, what do you do with that cash? There's lots of different things to do with that.

One of the things that's always struck me is that there can clearly be exponential wealth generation aspects of holding onto a single asset. Obviously, some of the wealthiest families and individuals in the world achieve that by holding onto a single asset. It has always struck me though, that that come at a risk of such singular concentration. When you're talking to family enterprises, how do you advise them on how to think about on pathway A, this is the business that's had your family affiliation for a long time, and losing that would be a loss at a number of levels but continuing to absorb that singular concentration, if that one business were to get in trouble, then all of that could be lost. How do you advise people when they're thinking about some of those things?

Okay, so as a banker we are really only involved in one piece of the equation, which is to try to do deals and close transactions at a fair price, and to advise our client to get the best results they can. On the sell side, our job is to maximize their wealth in that role, to sell let's say an asset at the highest price possible so they make more money. Now on the buy side, it's quite the opposite, which is to hold their hands and guide them in the journey to find and purchase an asset at a great price, and to capture value and take that value into growth and consolidation, and create synergy so it can be quite different.

I cover both. Mostly investment banking is sell side but there is a growing demand for buy side investment banking as liquidity expands. There's large cash balances, several trillion dollars of family office money ready to be put to work, as with in private equity. We saw in fact an article today on Bloomberg or somewhere, somebody saying that the backlog, the backup in liquidity events for private equity right now is just absolutely horrible. Which is ironic, because the economy's doing quite well. There is an imbalance in the supply and demand of private equity, and that's also happening in family offices.

I think in terms of concentration, I personally advise family offices to certainly diversify out of one main holding. That can be two or three holdings, there's different ways to do that diversification. Sometimes it can be wise to recap or refi the main operating business, maintaining let's say reasonable leverage. I'm sure you've seen this in healthcare where, once a business gets quite large, it can be more profitable and therefore, their profitability can be levered, and then that leverage can result in cash and that cash can be redeployed into other businesses. I think it's interesting to watch how that cash is deployed however, because in the old days, those distributions would really be distributed to the family members, that still happens, but there's also claims and interest on that cashflow by then G2, G3, G4 to not just receive it in cash, but put it into a trust, put it into other companies, into a kitty fund, into even raising a private equity fund or creating pools for venture capital investments. Or even going into other areas, like real estate or art.

In summary, I think it's super important to be diversified and not have all eggs in one basket, for sure.

Adam, I think we could talk about a number of these topics for hours, but I think we burned through our time. I want to thank you for joining me, this has been a ton of fun and I would love to have you again sometime.

Thank you. Me, too. It was great.

Thank you for joining us on this installment of The Corner Series. To learn more about today's discussion, please email host Geoff Cockrell at gcockrell@mcguirewoods.com. We look forward to hearing from you.

This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information or opinions expressed are solely those of the individuals involved and do not necessarily reflect those at McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.