Family offices, and the investment professionals serving them, have long been participants in traditional M&A transactions. Of late, however, middle market and lower-middle market family offices are experiencing an increased migration of private equity professionals from traditional private equity funds. This migration has prompted an increased need for investment professionals (and their advisors) to consider the often-perceived sleepy legal field of trusts and estates when structuring both a family office itself and its transactions.
At their core, trust and estate arrangements address the questions of control over and beneficial interests in family wealth. These foundational principles guide how family offices and their transactions are best designed.
Structuring Considerations
The organizational structure of an established family office and its investment arm(s) are often indistinguishable from a traditional private equity counterpart, with numerous investment vehicles supported by a standalone management company or general partner.
Unlike the traditional market-driven economic terms between a traditional private equity fund and its investors, however, family offices are not subject to the same market-based conventions to inform their equity-based capital allocations. Instead, capital allocations within a family office may be a product of varying investment preferences or perceptions among family members combined with the corresponding level of control those family members exert over various portions of family wealth.
Indeed, just as no two families are alike, a family office structure should be designed to balance the various interests and attitudes of the family member constituents it serves with a focus on the beneficial interests supported by the office’s capital. Among a litany of other factors, family members, as well as their investment professionals and advisors, should take heed of a couple of key structuring considerations:
• The need for capital among family members — both an actual need, to maintain standards of living, and a perceived need for access to capital, to provide comfort in that regard.
• Psychological factors and family dynamics play an important role, and in different manners. Older generations, for example, may or may not be satisfied with a fixed rate of return on capital and may have differing attitudes about a younger generation seeing greater upside benefits from an investment’s growth trajectory.
The legal form in which wealth is owned will be one of the primary driving factors in this analysis. In recent years, many states have provided greater flexibility with — or repealed altogether — laws governing restrictions on assets being perpetually held in trust. That allows wealth to be housed in dynastic trusts on a perpetual basis or for extended terms such as 1,000 or 360 years, in many cases without being subject to estate or generation-skipping transfer (GST) taxes as it passes for the benefit of members of succeeding generations. The structural benefits associated with this type of wealth allow family offices to experience much less concern over committed capital and even to use easy access to capital as a marketing device when courting a potential target.
Other wealth, however, may be the product of legacy planning before the expanded flexibility for trust arrangements or may otherwise be owned directly by family members, exposed to their creditors and subject to transfer taxes during their lifetimes and at their deaths as a result. To the extent otherwise consistent with the family’s interests, this wealth should be exhausted through the family office infrastructure in a manner that shifts value to dynastic wealth free from transfer taxes and benefitting from at least some degree of creditor protection. Additionally, older generations can also offer intangible benefits to younger generations, such as leveraging a family’s reputational goodwill to direct business opportunities to family wealth that has the lowest cost of capital from a transfer tax standpoint.
Transaction Considerations
M&A transaction structures of a family office can, in many cases, be indistinguishable from their traditional private equity counterparts, with tax, legal and accounting considerations driving the majority of the structuring conversation. Unlike the traditional private equity fund, however, family offices have no accountability to outside investors looking for a return on capital over a defined time horizon and have the luxury of being able to invest patiently on behalf of family members and future generations who are less focused on an immediate return.
Family members, as well as their investment professionals and advisors, should therefore consider the following when structuring any M&A transaction on behalf of a family office:
• Investing philosophies and concentration on certain asset classes based on a family’s business legacy and the background of a family office’s investment professionals.
• Strategic objectives determined among family members and any outside advisors tasked with responsibility for governance of the family office, aligning the family’s interests through a disciplined approach to investing and communicated through the office to the family as a whole.
• The degree of tax sensitivity for the family office in the M&A context if an indefinite hold period is contemplated, short-term capital access needs are low, or a basis step-up might otherwise later be achieved, for example through the efficient use of family members’ excess estate tax exemptions at death.
•The degree of leverage desired to be obtained through third-party lender involvement, versus direct sourcing of leverage from capital within a family office.
The level of wealth that gives rise to the need or desire for a family office will likely last for generations on end, and capital for each transaction within an office structure should therefore be allocated to account for how that wealth should benefit the family’s constituents. A combination of debt, preferred equity and common equity, being mindful of the income tax and transfer tax consequences of each, should be deployed to accomplish this objective.
Before structuring a family office or any of its underlying transactions, investment professionals and their advisors should always conduct a thorough front-end analysis of the family’s investment objectives, economic and otherwise.
John Gilson is a Member at Moore & Van Allen. Thomas Cooper is an Associate at Moore & Van Allen.
