Family Offices Are Increasingly Turning to Direct Investment. Is Their Due Diligence Keeping Up?

Wealthy families are increasingly turning to family offices as a tool to manage generational wealth; now they are changing the way family offices invest.  Once relying heavily on external managers, a recent Citi Private Bank Family Office Reportfrom Citi Private Bank found that roughly 70% of family offices now participate in direct private deals, either acquiring companies outright or as a partner to, and not a client of, more traditional investment firms.  While the upsides are clear—more control and no more private equity fees eating into profits—this also means that family offices are assuming more of the risk from inadequate due diligence.  

A Changing Market

Accordining to Deloitte, the number of family offices worldwide is expected to increase from just over 6,100 in 2019 to more than 10,000 by 2030.  These offices will likely manage more than $9 trillion by that time, more than double the amount they managed in 2019.  Deloitte expects that family offices will soon manage more money globally than hedge funds.

That growth has led to an expansion in deal activity, with family offices participating in activities traditionally undertaken by private equity firms, hedge funds, and other institutional investors.  These include deals ranging from venture capital rounds to acquisitions of middle-market companies.  Once quiet wealth-management vehicles, family offices are increasingly becoming active participants in private capital markets and in some cases competing with traditional private equity firms for deals.

For family offices, this shifting investment landscape makes sense.  Beyond the obvious savings of fees, many family offices also target industries where the family has operating experience, allowing them to combine investment capital with strategic insight.  These offices are also often lean organizations by design.  While this can be a benefit for efficiency, it may leave gaps in important functions, perhaps none more critical than due diligence.

The Importance of Due Diligence

Experience, insight, and efficiency can help family offices maximize returns on their investments.  However, these expected returns often presume the existence of trustworthy and stable business parters who generate the financial documents the family office relies upon in making investment decisions and who will likely continue to act as business partners once the deal is done.  However, many factors that can turn these deals into disasters do not present themselves on the face of official company documents.  These include litigation exposure, regulatory issues, undisclosed disputes, and reputational concerns involving not only the target investment organization, but the principles behind it. When syndicated deals and club investments are involved, family offices may also rely on the representations of a sponsor or lead investor whose incentives may not always align with those of other investors. 

Several high-profile failures illustrate how missed diligence on investment partners and targets can lead to catastrophic losses.  In the 1990s and 2000s, investors poured tens of billions of dollars into funds connected to Bernie Madoff.  While likely only one of many red flags, due diligence into Madoff’s operation would have revealed that his auditor, Friehling & Horowitz, was effectively a single-practitioner firm that “did not perform anything remotely resembling an audit,” and that regulators had received repeated warnings dating back to at least 1999 that he was likely running a Ponzi scheme.  Indeed, at least one hedge fund investment fund did cite red flags regarding Freihling & Horowitz when warning clients not to invest with Madoff.  When the fraud collapsed, it resulted in losses potentially reaching $65 billion—losses that were enabled, in part, by the failure to investigate these readily discoverable red flags.

More recently, banks provided billions in financing to Bill Hwang’s Archegos Capital Management despite his former hedge fund, Tiger Asia Management, pleading guilty in 2012 to wire fraud and Hwang and his firms paying $44 million to the SEC to settle insider trading charges.  Prosecutors would later describe Hwang as an “unrepentant recidivist.”   When Archegos collapsed in 2021 after misleading banks about its positions, it triggered more than $10 billion in losses for the banks and more than $100 billion in lost shareholder value.  

In these and countless other cases, investors extended massive capital to individuals whose histories warranted closer scrutiny.   While some investors may have been aware of such red flags and chose to invest anyway, these cases illustrate the types of information that can be revealed through due diligence that would make most investors pause before deciding to commit large sums of capital.  Investors who relied upon the belief that other investors must have done appropriate due diligence were likely the most surprised and unprepared when these schemes unraveled.

Invest With Insight

Private markets present inherent information asymmetries.  Unlike public markets, private market transactions operate under a fundamentally different regulatory framework, which results in less standardized disclosure and greater variability in transparency.   While fraud is illegal under any standard, private investments are not bound by the same requirements for audited financials, standardized reporting, or ongoing disclosure obligations that public investments must comply with.  As a result, the scope and quality of information available in private transactions are largely determined by negotiation, access, and the practices of the sponsor or issuer.  As the examples above indicate, the risks that ultimately shape investment outcomes often do not appear in financial models or pitch materials.  As family offices become more active in direct deals, the margin for error narrows.  A single undiscovered issue can materially change the economics, and even the viability, of an investment.

Although, as noted, some large, established institutional investors have built at least part of this function in house, many have long addressed this challenge through independent investigative diligence, supplementing financial and legal review with background investigations and reputational risk analysis on sponsors, executives, and counterparties.  For family offices expanding into direct investments, adopting similar practices may be a natural next step in the evolution of their investment process.  When it comes to due diligence, specialized investigative firms can play an important role.  Jetty Partners, for example, provides independent diligence services designed to help investors identify risks that may not surface through conventional financial analysis alone.

Independent investigative firms can bridge the gap between traditional financial diligence and the often opaque realities of private market counterparties by focusing on the people, relationships, and risks that do not appear in deal materials.  Firms like Jetty Partners conduct targeted background investigations on sponsors, executives, and counterparties, combining public records research, litigation and regulatory analysis, and discreet source inquiries to identify issues such as undisclosed disputes, prior misconduct, conflicts of interest, and reputational concerns.  This work is designed to surface precisely the types of red flags that investors failed to heed in many high-profile failures, including those discussed above.  This intelligence can provide family offices with a more complete understanding of who they are investing in and with.

Direct investing offers compelling advantages: control, alignment, and the potential to capture more value from investments.  While the trend of family offices investing capital in private markets opens the door to new opportunities, understanding the risks behind a deal is what ultimately protects it.