31 Jul 2023

Price discovery- the biggest challenge for family offices.

Peter Guy; Partner Member, Respada
Author: Peter Guy; Partner Member, Respada
7:00 min read

Price discovery sounds like an academic term; however, it represents the cornerstone of the investment process- determining the difference between price versus value. Yet, price discovery represents the most difficult exercise, especially for family offices who, unlike banks or other transaction driven financial institutions, are not normally in the business of pricing assets and deals.

The inability to efficiently and authoritatively price assets not only place the family office and its managers at a disadvantage in negotiations and transactions, but over the long term makes them highly dependent upon their private bankers and outside advisors for pricing and deal sourcing, and development. The price taker (who is captive to the vagaries of the market and advisors) versus a price maker (who influences deal conditions and sets pricing). Driving family office management expertise to a point where it is a price or market maker in certain asset classes or investment situations creates its own information edge. And price discovery represents the difference.

Today, family offices seek a more active role in private equity beyond being investors in funds. Preserving wealth requires taking measured risks to generate returns. They understand the imperative to develop proprietary deal sourcing, and authoritatively manage transactions rather than participate in packaged club deals. Escaping from the orbit of being fed and led by private banks or investment bankers requires active rather than passive strategies.

Private equity practitioners say that success in private equity is determined by your ability to harvest the illiquidity premium and overcome the liquidity risk that is inherent in private assets. This demands banking and investment skills that most family offices may not possess or desire to pay for. Yet, these competencies constitute the core of price discovery. Studies have shown that about 65% of returns in private equity deals are attributed to negotiating a low entry price, followed by exit timing and then adding value to management. Without well-developed price discovery skills, successful investment isn't possible in any asset class.

Whether it's starting from the earliest stages of trying to build a family office that closely resembles an institution or maintaining the family’s legacy into its third or fourth generation or beyond, attaining price discovery skills improves investment sophistication and outcomes for families from different regions and diverse backgrounds.

The investment dilemma for family offices lies in the area of private equity and other unlisted investments where technology alone cannot significantly improve the information edge. Funds and financial institutions charge large premiums and exorbitant terms for managing the entire class of private equity, which is one reason why family offices seek to source and manage their own deals.

Recent trends demand focused investment skills.

Banks and financial service institutions efficiently provide family offices with pricing on most publicly listed assets. Information advantage is a source of sustainable competitive advantage in investment. Whilst information is more widely available for public equities via technology and media, competitors still strive for a "trading edge." Family offices can effectively subcontract their price discovery risk in listed investments to funds and financial institutions.

Price discovery obstacles can be divided between two problems: a flawed market pricing mechanism and information advantages/disadvantages. The former has been flawed for a long period by artificially imposed zero interest rates that have distorted the risk-free rate since 2009. The latter is a specific challenge for family offices to address.

The changing market conditions and family office demands on holding certain asset classes are creating new demands on price discovery skill sets. According to a 2023 family office study by Goldman Sachs, family offices continue to hold outsized allocations to alternative asset classes. Collectively, private equity, private real estate, infrastructure, hedge funds, and private credit account for 44% of holdings. While many expect to maintain their current allocations over the next 12 months, there will be movement, with a considerable number of family offices expecting to increase their holdings in private equity, private credit, and private real estate and infrastructure.

According to the Goldman Sachs study, family offices remain focused on secular growth themes that could potentially endure business cycles and sustain value over the long term: 43% of family offices globally consider their portfolios to be overweight on information technology; 34% of family offices are currently overweight healthcare.

The average asset allocation to private equity increased slightly, from 24% in 2021 to 26%, while the average allocation to public market equities has decreased slightly, from 31% to 28%. This could be explained by continued family office interest in the private markets. Echoing the findings of Goldman’s last survey, family offices on average are allocating 44% total across alternative asset classes compared with 45% in 2021. The report states, “This matches our experience of working with family offices: they tend to maintain a more concentrated exposure to alternative or private investments than other investors.”

With significant valuation resets within the technology sector, many family offices express interest in taking advantage of attractive investment entry points into companies that may be experiencing valuation pressures but have the potential for long-term value accretion. The survey indicates that 43% of family offices consider their portfolios to be overweight in this sector while just 16% feel that they are underweight. 

Despite challenges to valuations in the technology sector, there is a deal focus on innovative companies that aim to improve businesses’ efficiency, productivity, and margins to combat rising input costs. Investors and companies will likely adopt more receptive valuation positions when the market environment normalizes. Top-line growth and business resilience will return to focus and demand strong price discovery skills. The next generation of disruptive technologies, such as artificial intelligence will require new and constructive valuation skills. 

In the real world, deal structure drives valuation.

Price discovery, especially in private assets, becomes more confusing and stressful when complex deal structures are introduced. Determining value in the middle of complicated investment terms requires tested experience in order to confidently reject or close opportunities. Respada’s cases and its partner members demonstrate creative solutions that can overcome obstacles that hinder clear price discovery.

A healthcare company raising a bridge financing round did not possess institutional investors. Its entrepreneurs advocated unrealistic expectations with respect to enterprise value. A Respada partner member advised it to structure a SAFE note (Simple Agreement for Future Equity) where the asset pricing was postponed to a future date and based on negotiated terms.

A publicly listed entity controlled by promoters who held about 55% of voting shares and common equity solved its problem of low daily trading volume after a Respada partner member advised them to utilize an innovative PIPE (Private Investment in Public Equity) structure.

All of these structures require competent price discovery- one of the most important skills and resources for a family office to develop and cultivate. It requires long-term leadership and commitment to learn through experience and industry and asset class focus.

Dr. Lyle Berkowitz, the Founder and Chief Executive Officer of KeyCare and a Partner Member in Respada points out scenarios and strategies that family offices can effectively use in their deal making.

“The easiest scenario for a family-based investor is when a round has already been "priced" by an established institutional investor (such as a VC or PE firm) with experience and a track record. Assuming you trust that organization, you will simply be following an established round.  Other factors to examine in priced rounds are whether you receive any special "preferences" when returns are generated. You should bargain for the same or very similar return preferences as the investors that set the initial price on the round.”

Berkowitz cites a particular deal structuring problem facing family offices. “Companies who are raising money earlier in their life cycle or raising smaller amounts between larger priced rounds may use a "convertible note" structure.  In this case, they are asking you to loan them money and they will pay you back in shares of the company at a discount to the next round.  A typical scenario is for them to offer you a, let’s say, 20% discount on a future fundraising round that will be completed in 12-18 months.  They will also provide an interest rate (for example, 5%) that will also be paid back in equity.”

He elaborates, "So if you invest $1 million to a convertible note today, and the next fundraising round was completed in 12 months at a valuation of $10 million, your $1 million would be used to buy shares at $7.5M valuation - a price 25% less than the current round - which is due to the 20% discount plus one year of 5% interest.  Other important factors in a convertible note include the maturity date and whether it is an uncapped note or if there is a maximum cap on the price of the next round."

The challenge for family offices is to develop the organizational focus pricing without encountering similar costs to a financial institution. To achieve this family offices should leverage their main strength over institutionalized asset managers and investment banks- their ability and discipline to sustain long-term outlooks, commitment, and capabilities. The Respada platform helps achieve this goal by offering a powerful array of investment advice and ideas based on members’ diverse experiences and viewpoints.

Topics: private equity, asset pricing

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