The fees saved, the cost of the team and the quality gap put on one scale, giving the programme size at which a family office should go direct.
Direct investing beats fund investing for a family office once the fees it saves on the capital deployed exceed the cost of the team, after any shortfall in deal quality. With an illustrative four-person team costing $3.0m a year and funds taking 4.4 points of a 15.0 per cent gross return, the break-even is $76.9m kept invested in direct deals. If the family's deals earn 2 points less than the funds' deals, the break-even rises to $157.9m.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The case for going direct is usually made on fees: why pay 2 and 20 when the family can hire its own team? The case against is usually made on access and skill. Both arguments can be put on the same scale. The fees saved are a percentage of the capital deployed; the team is a fixed cost in dollars; the quality gap is a percentage too. Dividing one by the other gives the size of programme at which the decision changes.
| Input | Value |
|---|---|
| Head of direct investing, $m a year | 1.20 |
| Two investment directors, $m a year | 1.20 |
| Analyst, $m a year | 0.25 |
| Legal, travel, systems, $m a year | 0.35 |
| Direct team, $m a year | 3.00 |
| Gross return on deals, funds and direct alike | 15.0% |
| Fund management fee, on invested capital | 1.75% |
| Carried interest, over an 8.0% preferred return with full catch-up | 20.0% |
| Direct deal costs not recovered from companies, a year | 0.5% |
| Typical direct ticket, $m | 15.0 |
After a 1.75 per cent fee, the fund's deals return 13.25 per cent. That clears the 8.0 per cent preferred return with room to spare, so with a full catch-up the manager takes 20 per cent of the whole 13.25: 2.65 points. The family nets 10.6 per cent. The fund route costs 4.4 points a year of a 15.0 per cent gross return. How that gap builds up is worked in why net IRR is lower than gross IRR.
Direct net return = direct gross − deal costs − team cost ÷ capital deployed
Break-even capital = team cost ÷ (direct gross − deal costs − fund net return)
In Excel, with team cost in B1, direct gross in B2, deal costs in B3 and fund net in B4:
=B1/(B2-B3-B4)
With the same 15.0 per cent gross return on both routes: 3.0 ÷ (15.0% − 0.5% − 10.6%) = 3.0 ÷ 3.9% = $76.9m. At a $15.0m ticket that is about 5.1 companies held at all times, or roughly 1.0 new deal a year on a five-year hold. Below that, the team costs more than the fees it avoids.
The equal-return assumption is generous to the family. Fund managers see more deals, sit on more boards and can diversify across twenty companies; a family team doing one deal a year sees fewer and is more concentrated. Each point of gross return the family gives up comes straight off the 3.9 point margin. This is the same adverse-selection question asked of co-investments in how much worse co-investment deals can be and still beat the fund, with one difference that changes the answer: a direct programme carries a fixed team cost, so the tolerable shortfall depends on how much capital the team keeps invested.
| Return shortfall, points | Direct gross | Margin over funds | Break-even capital, $m | Companies at $15.0m |
|---|---|---|---|---|
| 0.0 | 15.0% | 3.9% | 76.9 | 5.1 |
| 1.0 | 14.0% | 2.9% | 103.4 | 6.9 |
| 2.0 | 13.0% | 1.9% | 157.9 | 10.5 |
| 3.0 | 12.0% | 0.9% | 333.3 | 22.2 |
| 3.9 | 11.1% | 0.0% | never |
The break-even does not rise in a straight line. A one-point shortfall adds $26.5m to it; a three-point shortfall more than quadruples it. At a 3.9 point shortfall no programme size works, because the family's deals net of deal costs earn no more than the funds net of fees. The question that decides the programme is therefore not "how much do we save in fees" but "how much worse will our deals be", and it is the one investment committees discuss least.
| Capital deployed, $m | No shortfall | 2 point shortfall |
|---|---|---|
| 50.0 | −1.05 | −2.05 |
| 150.0 | 2.85 | −0.15 |
| 300.0 | 8.70 | 2.70 |
At $150.0m deployed the team costs 2.0 per cent of capital, and the programme is worth $2.85m a year if the deals are as good as the funds' and slightly negative if they are 2 points worse. At $300.0m it pays either way. Few families keep $300.0m in direct companies, which is why many end up with a hybrid: funds for breadth, co-investments alongside those funds for lower fees on selected deals, and a small direct team mainly to underwrite them. The economics of that middle route are in what a co-investment programme actually saves.
Comparing the team's cost with the fees on the whole private equity allocation. The team saves fees only on capital it actually keeps invested in companies, not on commitments, not on the fund portfolio it also oversees, and not in the years spent building a pipeline. A $400m private equity allocation with $60m in direct deals is a $60m programme for this calculation, and at $60m this one loses money even with no shortfall.
Divide the team cost by the margin: direct gross return, less deal costs, less the fund route's net return. Here it is $76.9m with equal deal quality and $157.9m with a 2 point shortfall. Then ask how many companies that implies and whether the family can source and govern them. Whether the office as a whole pays for itself is a separate threshold, worked in at what level of wealth a family office starts to pay; the cost of the office itself is modelled in the free workbook for this case.
It depends on seniority and location, and any figure should come from the family's own quotes. The worked case uses an illustrative $3.0m a year for a head of direct investing, two directors, an analyst and running costs. What matters is the ratio: at $150.0m deployed that team costs 2.0 per cent of capital every year.
Enough that the fees saved exceed the team cost after any shortfall in deal quality. In the worked case that is $76.9m kept invested if family deals match fund deals, $103.4m with a 1 point shortfall and $157.9m with 2 points. With a 3.9 point shortfall no size works.
Often, for a family below the direct break-even. Co-investments alongside a fund usually carry reduced or no fees, use the manager's sourcing, and need a smaller team to underwrite. In the worked case a full direct team loses $1.05m a year at $50.0m deployed even with no quality shortfall, which is where co-investment tends to win.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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