Archive for: Whitepapers

Private Debt Secondaries: Beyond GP/ LP Transactions into the World of Liquidity Management

By Marc J. Sharpe, M.A., M.Phil., MBA, John Bohill, Kenneth McLaughlin, and Orla Walsh

As one of the fastest-growing areas of the private markets, the attractiveness of private debt as an asset class is broadly recognized. Its’ defined duration, low volatility, and limited drawdown risk relative to other alternatives is often desirable, particularly when considered with empirically stable returns.¹ As such, a natural evolution of a maturing primary market is developing volume in secondaries transactions.

Private debt secondaries (PDS) have prospered in recent years, providing liquidity to investors in a putatively illiquid asset class. Investment managers have responded—raising dedicated secondary funds and partnering with strategic players. In recent years, we have experienced the secondary market bloom from a nascent opaque market, focused initially on bilateral transactions and purchases of LP interests by private equity secondaries funds at steep discounts. Following Covid, the market transformed, and the associated dislocation has brought opportunities.

In 2022, substantial challenges in the liquid markets exacerbated the so-called denominator effect, leading institutional investors to be overweight several illiquid asset classes. Counterintuitively, the relatively strong performance of private debt meant that accepting a haircut on those valuations would require a comparatively modest markdown (particularly against devalued fixed income and equity holdings), and thus transactional volume arrived, reaching $17 billion in 2022 (more than 30x larger than 2012 levels), per Coller Capital.² Savvy family offices and other institutions became buyers of performing direct lending LP interests at prices reflective of private equity returns.

Relative “Haircuts” When Markets Head South

Secondaries volumes in 2022 were down across all asset classes, except for private debt, where volumes increased by 30.3%.³ Investors utilized the secondary market for reasons varying from strategic redirection to rebalancing due to portfolio limitations and portfolio optimization. Investors sold private debt exposure because valuations remained stable relative to the public market (both debt and equity) and other private market asset classes.

Figure 1 illustrates this point: The 2022 price decline in buyouts was more pronounced than in private debt. Notably, there is large price variance from the average prices listed below and the type of private debt strategy is influential to pricing; in 2022, senior lending funds priced in the low 90s, mezzanine strategies in the 80s and distressed/special sits in the high 70s. Compared with private equity discounts, which range from 15–25% during dislocations, private debt can offer an attractive alternative.

Discounts Matter, But Not as Much as One Would Think….

Price bands are important but insufficient to determine returns on their own. Consider that direct loans have an average economic life of 3 years (4 years in the current environment)⁴. Against a less liquid private equity portfolio, the distribution profile should be more condensed and predictable.

• Thus, price may vary greatly depending on the stage in the fund term and corresponding drawn and undrawn commitments, its current yield and any expected refinancings in the portfolio.
• In addition, historical loss rates must be considered and flexed for manager particulars such as concentration and industry exposure.
• Finally, transaction dynamics come into play, including approved buyer lists, speed of execution and any “stapled” primary investment requests attached to a current manager fund. There may be an amount of book building by the broker due to varying demand for specific funds and available ticket sizes.

This profusion of factors affects bid-ask spreads, but ultimately pricing is only one variable. In short, discounts matter but not as much as you might think!

PDS Market Formation

With a plethora of opportunities and an advantageous supply-demand imbalance, dedicated PDS investors stepped into the market in 2022, armed with lower cost of capital, the ability to apply portfolio leverage (at the investing entity), transaction leverage (through deferred payments), and alternative views on loss rates and cashflow modeling. For these investors, capital at work is as important as IRR and TVPI. Therefore, their desired outcome differs from your stereotypical private equity secondary buyers. So do their target returns: Over 50% of buyers seek a net IRR/TVPI below 12.5%/1.5x.⁵ This market intervention is a positive secular change for existing private debt investors in need of liquidity.

The term private debt covers an array of vastly different sub-strategies, some of which are covered in Figure 2. The market is in fact more disparate, with many more sub-strategies. Having broad coverage and asset class expertise is required to cover the universe.

Vetting broadly diversified direct lending portfolios requires in-depth market data and views on repayment speeds and expected loss rates. Conversely, concentrated distressed portfolios require familiarity with each company and line-item equity-style underwriting. The ability to accurately forecast returns across multiple strategies allows secondary buyers to provide broader and encompassing liquidity solutions. Market coverage is paramount.

Financial Innovation and Bespoke Liquidity Management Techniques

The PDS market may be in its infancy but innovative financing solutions from the private equity market are already being implemented.

• NAV-Financing is a broad term for financing underpinned by a diversified portfolio, which can contain private equity companies, real estate assets or even private debt funds. The portfolio’s NAV is used as collateral for the loan, generating liquidity for the GP or LP while retaining the future upside from the original portfolio exposure. Realizations in the underlying portfolio are used to fund the repayments of the NAV facility. This product is established in the private equity and real estate markets, but only recently adopted in the private debt secondary market as an alternative to secondary sales.
• Collateralized Fund Obligations (CFOs) have similar goals to secondaries, i.e., to enhance liquidity for GPs and LPs. CFOs are securities that create leveraged exposure to a portfolio of fund investments through the issuance of an equity tranche and one or more debt tranches. Think: CLOs with funds replacing the underlying loans.

For sellers, structured solutions may be preferable to a secondary sale in order to generate liquidity. Investors can maintain exposure to private debt while generating interim liquidity to rebalance their portfolios. Secondary investors are attracted to this investment style, as it meets the desired returns with a relatively attractive risk profile. With private equity secondaries, buyers and sellers often have differing views on the future valuations and potential upside of the assets. Since upside is relatively limited for private debt, differences of opinion tend to be narrower and more focused on repayment speeds and loss rates. When both parties’ views on future valuations are aligned, the variance in pricing is much lower and a structured solution which accommodates both parties’ requirements is often optimal.

PDS—The Flywheel Effect

In 2022, private debt represented only 4% of the total secondary market.⁶ As the asset class matures, we expect this share to expand. We suggest the continued growth and effectiveness of the private debt secondaries market will open private debt to a new investor cohort that previously had concerns about liquidity, term, or liability mismatches.

Conclusion

The private debt market is forecast to continue its growth due to its attractive yields throughout credit cycles, low volatility, limited drawdowns, and relatively high risk-adjusted returns. By that same token, volume in its secondary market is expected to increase. Family offices and institutional investors are supporting this growth in both the primary and secondary markets. We have observed LPs making tactical sales of relatively stable private debt portfolios, without exiting the private debt market entirely. We also observe several other important value drivers, in addition to discount emerging. Furthermore, activity has moved beyond traditional secondaries and into the more bespoke world of liquidity management through financial innovation.

By providing innovative liquidity solutions, Family offices and institutional investors are improving asset class accessibility to a new investor base. Now investors can confidently enter the private debt market and avail themselves of its illiquidity premium with the comfort that there will be liquidity if they seek to rebalance. Furthermore, due to the illiquidity of private debt and its corresponding valuations, investors can often transact at relatively attractive prices. As the PDS market matures, structured solutions will develop. Traditional secondary sales, while prevalent in the current market, may only cater to a certain investor group; investors in need of interim liquidity may prefer alternative financing solutions.

About the Authors

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at SMU Cox School of Business: Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families.

About StepStone

StepStone Group Inc. is a global private markets investment firm focused on providing customized investment solutions and advisory, data and administrative services to its clients. StepStone partners with its clients, including sovereign wealth funds, insurance companies, prominent endowments, foundations, family offices and private wealth clients, to develop and build private markets portfolios designed to meet their specific objectives across the private equity, infrastructure, private debt and real estate asset classes.

StepStone Disclosures

This document is for information purposes only and has been compiled with publicly available information. StepStone makes no guarantees of the accuracy of the information provided. This information is for the use of StepStone’s clients and contacts only. This report is only provided for informational purposes. This report may include information that is based, in part or in full, on assumptions, models and/or other analysis (not all of which may be described herein). StepStone makes no representation or warranty as to the reasonableness of such assumptions, models or analysis or the conclusions drawn. Any opinions expressed herein are current opinions as of the date hereof and are subject to change at any time. StepStone is not intending to provide investment, tax or other advice to you or any other party, and no information in this document is to be relied upon for the purpose of making or communicating investments or other decisions. Neither the information nor any opinion expressed in this report constitutes a solicitation, an offer, or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service.

Past performance is not a guarantee of future results. Actual results may vary.

On September 20, 2021, StepStone Group Inc. acquired Greenspring Associates, Inc. (“Greenspring”). Upon the completion of this acquisition, the management agreement of each Greenspring vehicle was assigned to StepStone Group LP. Each of StepStone Group LP, StepStone Group Real Assets LP, StepStone Group Real Estate LP and StepStone Group Private Wealth LLC is an investment adviser registered with the Securities and Exchange Commission (“SEC”). StepStone Group Europe LLP is authorized and regulated by the Financial Conduct Authority, firm reference number 551580. StepStone Group Europe Alternative Investments Limited (“SGEAIL”) is an SEC Registered Investment Advisor and an Alternative Investment Fund Manager authorized by the Central Bank of Ireland and Swiss Capital Alternative Investments AG (“SCAI”) is an SEC Exempt Reporting Adviser and is licensed in Switzerland as an Asset Manager for Collective Investment Schemes by the Swiss Financial Markets Authority FINMA. Such registrations do not imply a certain level of skill or training and no inference to the contrary should be made.

In relation to Switzerland only, this document may qualify as “advertising” in terms of Art. 68 of the Swiss Financial Services Act (FinSA). To the extent that financial instruments mentioned herein are offered to investors by SCAI, the prospectus/offering document and key information document (if applicable) of such financial instrument(s) can be obtained free of charge from SCAI or from the GP or investment manager of the relevant collective investment scheme(s). Further information about SCAI is available in the SCAI Information Booklet which is available from SCAI free of charge. Manager references herein are for illustrative purposes only and do not constitute investment recommendations.

Source:  StepStone Group LP. The information contained herein is © 2023 by StepStone Group LP.

Disclosures

TFOA is a peer network of Single Family Offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Texas Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

By Natalie Walker, Daniel Krikorian, and Michael Venne, and edited by Marc J. Sharpe, M.A., M.Phil., MBA

As inflation rages, and central banks raise policy rates, concerns about the health of the economy have been front of mind for investors. Although the US has so far managed to avoid a recession, many consumers and investors are now hunkering down.

When the economy shrinks, consumers typically respond by paying down debt, saving more, and spending less on nonessential goods. Institutions, on the other hand, try to adjust the “tilts” of their portfolios. They increase their allocations to defensive assets like real assets and private debt, and seek ‘safety’ with larger, more familiar private equity fund managers. Necessarily, this comes at the expense of small, emerging, and diverse managers, which some regard as riskier than their larger, “more proven” counterparts (Figure 1).

The institutions that reduce their allocations to private equity’s small market managers during turbulent markets treat this tranche of the buyout market as a luxury good, something that is consumed when the economy is booming.

Instead, we believe investors should consider it a staple that can bolster and diversify their portfolios regardless of the macroeconomic backdrop.

As global investors contemplate their 2023 budgets and allocation targets, they should resist the temptation to pull back on small-market buyouts. Contrary to what LP actions would imply, now is the time to lean in on the low(er) end.

Why Now May Be the Time to Lean In

The segment of the market we refer to as small-market buyouts (“SBO”) consists of private equity GPs that raise funds smaller than US$1 billion while investing in companies with a total enterprise value (TEV) of US$250 million or less. Although there are several benefits to investing in SBO, we have chosen to highlight the ones that are most salient to current market conditions.

Vast Opportunity Set yet Underallocated

The SBO market is the largest and most dispersed tranche of the buyout market. In the US, which has the largest and most mature SBO market, it is significantly larger than the middle and large markets combined based on number of companies (Figure 2). In fact, the small market is home to nearly 90% of private companies in the US yet represents only a fifth of the capital raised.

Family Offices’ propensity to cut back on SBO during downturns means there will be even less capital chasing the segment.

As seen in Figure 3, SBO dry powder has increased modestly compared with other strategies, growing at a CAGR of 3% between 2016 and 2021. While the trend lines for each have been up and to the right across the entire buyout market for many years, SBO has been most insulated from this frothiness.

Greater Focus

Most SBO funds target businesses with less than US$25 million of EBITDA, (Figure 4). Businesses of this size are less likely to be represented by sophisticated intermediaries (if they are represented at all), enabling SBO managers to source investments in a less competitive environment. By sourcing directly, SBO firms generate value from price inefficiencies, improved asset selection, and greater awareness of the true operational value-add potential of a business.

Less Leverage

As seen in Figure 5, which illustrates leverage multiples for various tranches of the buyout market, small-market companies have used considerably less leverage than their larger counterparts. Because they have less debt to pay down, small-market companies have more free cash flow to reinvest in their businesses.

Multiple Expansion

Historically, purchase price multiples have been much lower for small-market companies (Figure 6). And while the low-interest- rate environment that has characterized the past 15-plus years has allowed valuations to increase for all assets, entry multiples for small-market companies have risen more modestly.

Low entry multiples and a greater capacity for operational improvements create ideal conditions for multiple expansion. Harkening back to Figure 3, ample dry powder, particularly upmarket, suggests the pool of potential buyers is well funded.

“Home Run” Potential

Large sponsor interest in high-quality assets that can serve as a platform for consolidation of high-growth or fragmented sectors can lead to home run deals. Of the 387 realized North American buyout deals tracked for his whitepaper that have generated a 10x outcome or better, 77% were in SBO funds (Figure 7).

While multiple expansion can certainly boost an outcome from good to great, it’s not required to generate strong returns given the other value creation levers available in the small market.

In response to questions around the sustainability of multiple expansion as a source of return, one should ponder the impact on both existing and new deals. While the range of potential multiple expansion may compress on existing deals, valuations for new deals have also compressed, providing the same opportunity for multiple expansion in the future. Simply put, multiple expansion is a feature of the valuation environment and competition (read: dry powder) at different segments of the buyout market, which we believe positions SBO well for the foreseeable future.

Sensitivity to Public Market Volatility

Adding private markets to a traditional portfolio provides exposure to assets that may be underrepresented in listed markets. Over the past 30 years, the size and composition of listed markets have changed markedly. As seen in Figure 8, the number of public companies has fallen by half. At the same time, the average market cap has grown markedly, suggesting the number of public micro- and small-cap companies has fallen as well. Investors building well-rounded portfolios are therefore looking increasingly to the private markets to gain small-cap exposure. Moreover, because small-market companies are underrepresented in stock markets, they are less sensitive to swings in the stock market than larger companies.

To get a sense of just how sensitive, we compared the peak-to- trough performance of mega, large, middle and SBO funds with the public markets’ during three crash and recovery cycles: the dot-com bubble, the Global Financial Crisis (GFC) and Covid-19. We refer to this analysis as upside/downside capture.¹

Figure 9 illustrates the market capture during the GFC. As you can see, SBO valuations rose 13.7%, capturing 91% of the gains in the public markets, on average. By contrast, mid, large, and mega fund valuations rose by 15.2%, in line with the public benchmarks. However, upside is only half of the picture. To get a sense of how the two tranches performed during the entire cycle, we also examined the downside. From their peak at the end of September 2007, SBO valuations fell by 12.6%, roughly 75% less than either public benchmark. Mid, large and mega fund valuations, by contrast, fell by more than one- third, capturing closer to 70% of public market downside. These results were consistent across all three cycles. On average, we found that SBO captured 30% of market downside and 94% of upside. This seems to run contrary to the popular assumption that SBO is riskier than other buyout strategies. How can this be?

Several factors may explain why small-market funds are less sensitive to fluctuations in equity markets.

1. Because the preponderance of small-market companies are privately held, there are fewer comps in the public markets.
2. SBO funds are generally more conservative in marking up businesses despite mark-to-market accounting. Mega and large buyout funds are more visible (some GPs even public themselves) and possibly held to more stringent accounting standards.
3. Large buyout managers tend to come back to market sooner, often raising capital for alternative strategies or products or both. Therefore, interim returns matter. This speaks more to upside capture.
4. SBO funds depend more on carry than management fees, which are calculated from a smaller basis. Small-market managers generally care more about exits than interim marks.

SBO Can Offer Great Access to Diverse Buyout Managers

We define a diverse fund as one that passes the “33% test.”² Of the 1,400-plus North American buyout managers tracked by SPI,³ 128 have raised a fund that passes this test. SBO managers account for 100 of them. As seen in Figure 10, diverse managers not only skew smaller but younger as well. Nearly three-quarters of diverse-managed private equity funds are new or emerging, and 90% are smaller than US$1 billion.⁴

A substantial body of work examining the effect diversity has on decision-making, organizational health and investment performance has emerged. For example, A 2021 study by the National Association of Investment Companies found that diverse private equity funds beat the Burgiss median across several key performance indicators: net IRR, MOIC and DPI.⁵

We have observed similar outcomes in our diverse manager track record (Figure 11).

• For primary buyout and growth equity funds, diverse managers’ net TVM of 1.6x outperforms the benchmark median of 1.49x over the same vintages.⁶
• This outperformance has been concentrated in the lower end of the market, where funds raising less than US$2 billion have generated a net TVM of 1.8x.

Notwithstanding these impressive returns, Family Offices have historically underweighted SBO where 90% of diverse talent exists. That said, the number and share of diverse funds has been increasing (Figure 12).

Though promising, it all feels a bit too frail. Unless Family Offices back enough of them, and diverse GPs consistently deliver competitive returns, few will survive, let alone graduate. Until that happens, SBO is buyout investors’ best / only realistic choice.

Challenges & Solutions

For all its benefits, SBO can present Family Offices with some challenges. It has more managers than any other segment of the buyout market. That many of these GPs are new or emerging means there are a lot of unproven teams and track records to decipher. Moreover, the difference between first- and fourth-quartile managers is widest for SBO.

The importance of manager selection is a common refrain in private markets. Within buyouts, this axiom rings truest for SBO funds, which have exhibited the highest and lowest return potential relative to other tranches (Figure 13).

Not only are the inter-quartile spreads widest for SBO, but they also have the widest average “intra-quartile” spreads.

When comparing SBO managers, quartile may be too coarse a measure; Family Offices and their advisors might consider thinking in terms of deciles.

Unless a family office has significant resources in-house, attempting to cover the small market can feel like a tall order, and they might feel tempted to default to brand-name managers. But is it worth it to try?

Incremental Effort

To help family offices determine whether they should attempt to dedicate resources toward SBOs, we compared the hypothetical spread of performance one might expect from assembling portfolios of either brand-name or SBO funds.

We examined buyout funds raised between 1985 and 2021. We defined brand-name funds as those whose fund sizes were in the top tercile (67th percentile) for a given vintage; SBO funds as those whose fund sizes were in the bottom tercile (33rd percentile). We created 100 portfolios made up of 10 funds by randomly selecting five of each fund type. To approximate hypothetical median performance—and avoid overweighting a good vintage or a poor fund—we also equally weighted vintages as well as commitments in each. We measured hypothetical performance across three dimensions: IRR, Direct Alpha, and Kaplan Schoar PME. The hypothetical results are summarized in Figure 14.⁷

To help answer our question, we calculated the standard deviation (σ) of each measure. Harkening back to SBO’s return dispersion, it should come as no surprise that SBO had a higher σ. But this wide distribution isn’t necessarily bad: We found that a 1σ increase in SBO’s IRR is roughly equivalent to a 1.3σ increase in brand names.⁸ In other words, the marginal return on effort is higher for SBO.

Think of this as an optimization exercise. In a world of limited time and money, we must choose how to spend either. Suppose a family office CIO must choose between randomly selecting one type of fund and spending resources vetting another. Clearly, they should randomly pick from the pool of brand- name managers where the marginal returns of climbing to the next decile are lower, and the risks of picking poorly are less pronounced. In assembling an SBO portfolio, a CIO needn’t even aim for the top quartile; if they can get to the 40th percentile, their time and energy will have been well spent.

Conclusion

As Family Offices ponder the composition of their portfolios for 2023, they may feel tempted to flock to familiar managers at the upper end of the market. Based on the data, we would say: Fight the urge! We believe now is the time to lean in to SBO. Less competition, attractive entry valuations, lower leverage, dry powder upmarket, multiple arbitrage, and a low correlation with stock market volatility are several reasons why. Regardless of market cycles, SBO can play a central role in an family office’s portfolio, complementing other private equity strategies by providing alternative return drivers and diversification benefits. Moreover, cutting back on SBO disproportionately affects capital going to diverse and emerging managers. However family offices choose to proceed, we believe investing in SBO to be well worth the effort. And there’s no better time than now.

Appendix A | Peak-to-Trough Performance

Appendix B | Hypothetical Results

About the Author

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe is active in the community and has served on the Board of the Holocaust Museum Houston, the HBS Houston Angels, and on the Investment Committee for two Texas based foundations. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members, and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

TFOA is a peer network of Single Family Offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Texas Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

This document is for information purposes only and has been compiled with publicly available information. StepStone makes no guarantees of the accuracy of the information provided. This information is for the use of StepStone’s clients and contacts only. This report is only provided for informational purposes. This report may include information that is based, in part or in full, on assumptions, models and/or other analysis (not all of which may be described herein). StepStone makes no representation or warranty as to the reasonableness of such assumptions, models or analysis or the conclusions drawn. Any opinions expressed herein are current opinions as of the date hereof and are subject to change at any time. StepStone is not intending to provide investment, tax or other advice to you or any other party, and no information in this document is to be relied upon for the purpose of making or communicating investments or other decisions. Neither the information nor any opinion expressed in this report constitutes a solicitation, an offer, or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service.

Past performance is not a guarantee of future results. Actual results may vary.

On September 20, 2021, StepStone Group Inc. acquired Greenspring Associates, Inc. (“Greenspring”). Upon the completion of this acquisition, the management agreement of each Greenspring vehicle was assigned to StepStone Group LP. Each of StepStone Group LP, StepStone Group Real Assets LP, StepStone Group Real Estate LP and StepStone Group Private Wealth LLC is an investment adviser registered with the Securities and Exchange Commission (“SEC”). StepStone Group Europe LLP is authorized and regulated by the Financial Conduct Authority, firm reference number 551580. StepStone Group Europe Alternative Investments Limited (“SGEAIL”) is an SEC Registered Investment Advisor and an Alternative Investment Fund Manager authorized by the Central Bank of Ireland and Swiss Capital Alternative Investments AG (“SCAI”) is an SEC Exempt Reporting Adviser and is licensed in Switzerland as an Asset Manager for Collective Investment Schemes by the Swiss Financial Markets Authority FINMA. Such registrations do not imply a certain level of skill or training and no inference to the contrary should be made.

In relation to Switzerland only, this document may qualify as “advertising” in terms of Art. 68 of the Swiss Financial Services Act (FinSA). To the extent that financial instruments mentioned herein are offered to investors by SCAI, the prospectus/offering document and key information document (if applicable) of such financial instrument(s) can be obtained free of charge from SCAI or from the GP or investment manager of the relevant collective investment scheme(s). Further information about SCAI is available in the SCAI Information Booklet which is available from SCAI free of charge. Manager references herein are for illustrative purposes only and do not constitute investment recommendations.

Authored by Nick Fisher and edited by Marc J. Sharpe, M.A., M.Phil., MBA

Context

This white paper outlines the strategic importance of private capital investment in the US and Western defense and national security sectors and invites family office investors to consider the significant impact and potential returns of such investments.

“The last man lives in a world without conflict or danger, without passion or excitement, without love or hate. He lives in a world without history.”

– Francis Fukuyama, The End of History and the Last Man

Executive Summary

In today’s rapidly evolving geopolitical landscape, the United States and her Western Allies face an imperative need to enhance the collective Defense Industrial Base (DIB). While government funding plays a crucial role, it alone cannot sustain the significant expenditures required to maintain a robust and innovative defense and national security sector, notably at this juncture of history with increasing geopolitical challenges and emerging budgetary constraints. To that end, a significant generational opportunity exists for family office private capital to bridge this gap, providing a strategic advantage to the US and Allies in strengthening the ‘Arsenal of Democracy’.

Global National Defense Spending ($ Billion)

Current challenges in defense and national security funding include:

• Capital Market Constraints: Environmental, Social, and Governance (ESG) guidelines have limited access to critical funds. Furthermore, the consolidation of capital markets and a lack of defense sector-specific knowledge has restricted investment in related sectors.
• Economic Volatility: Recent economic disruptions, such as the collapse of Silicon Valley’s primary lender, and rising interest rates, have led to a retrenchment in the venture capital ecosystem, negatively impacting funding availability.
• Chinese Military Civil Fusion (MCF): China has successfully integrated civilian innovations into military applications at a rapid pace, leveraging fewer barriers between civilian and defense sectors. This strategy has given China a competitive edge in developing advanced military capabilities.

Despite these challenges, private capital markets in the US, with $4.5 trillion in private funds (McKinsey Global Private Markets Review 2023), hold immense potential to enhance defense and national security capabilities. Strategic deployment of these resources can address capability shortfalls, fund technological advancements, and support transformation efforts across the sector. Family offices have a key role to play here by funding projects with flexible, patient, and sophisticated capital.

Key investment areas where family office capital can have the greatest impact include:

• Technological Innovation: Funding cutting-edge technologies that can be quickly integrated into defense applications and fielded with the warfighter.
• Dual-Use Technologies: Investing in commercial technologies with military applications, such as drones and satellites.
• Early-Stage and Lower Middle Market Enterprises: Supporting critically underfunded sectors that drive commercialization of innovation and enable fielding of new capabilities. This is particularly relevant to hardware manufacturing businesses ranging from sensors and weapons systems to energy storage and advanced materials.

The intersection of current geopolitical, capital markets, government, and investor conditions present a clear opportunity for family office capital to play a transformative role in defense and national security. By providing the necessary funding, private investors can support critical innovations, enhance the US’s strategic capabilities, and achieve attractive returns.

The Current State

The United States and Western allies, in particular the UK and Australia (AUKUS trilateral agreement), are engaged in a strategic competition on a global scale that threatens Western hegemony. The post-WW2 and Cold War peace dividends that delivered relative stability throughout the second half of the 20^th century and much of the first quarter of the 21^st century have been exhausted. The West has now re-entered a period of geopolitical instability where peer or near peer competitors struggle for dominance over their desired spheres of influence. The emerging global landscape, driven in large part by changing economic and demographic conditions, underscores the end of ‘Pax Americana’ unipolarity established in the wake of World War II and the shift to multipolarity global power dynamics.

Note: G7 includes United States, United Kingdom, Canada, France, Germany, Italy, Japan

Note: Old BRICS includes Brazil, Russia, India, China, and South Africa

Note: Remaining BRICS includes Russia, China, Iran, India, Brazil, South Africa, Argentina, Saudi Arabia, Egypt, Ethiopia, and United Arab Emirates Source: The World Bank. (2023, February 8). GDP, PPP (current international $)

While, for a variety of geopolitical, sociological, societal, and economic reasons, this is unlikely to result in a direct kinetic conflict between the main protagonists, it is of critical importance to our collective national security that we are prepared to deter and, if necessary, defend against the threats posed.

Note: Adversary includes China, Russia, and Iran.

Note: See above prior graphics for constituent definitions of AUKUS, Remaining BRICS, and BRICS+.

Source: Stockholm International Peace Research Institute (SIPRI). “Trends in World Military Expenditure, 2022.” SIPRI, 2022

Leaving aside issues of root secular causes, the Russian invasion of Ukraine, alongside the Iranian instigated and backed proxy war in Gaza that threatens to spread into Lebanon, all concurrent to the growing tensions in the South China Sea, clearly highlight the multi-theatre challenges faced by the West. The strategic purpose of these actions reaches far beyond the apparent tactical objectives. While Vladimir Putin may portray himself as a modern-day Katherine the Great, emulating the second partition of Poland (1793) and reincorporating something akin to the 9^th Century Kyivan Rus territory into the Russian Federation. In reality, his “Special Military Operation” represented to him a seemingly low risk opportunity to test the resolve of the West by applying pressure to NATO and the EU.

Similarly, the Iranian backed proxy war in the Middle East, notably bringing together previously adversarial Shia (Hezbollah) and Sunni (Hamas) factions in a common cause of attacking Israel, has less to do with securing a homeland for the Palestinian people and more to do with stress testing the resolve of the Western leaning Gulf Cooperation Council (GCC), discrediting Israel in the eyes of Western allies, and derailing the strategically important Abraham Accords.

Beyond these kinetic conflicts, and arguably of greater significance, is the Chinese led low intensity probing and challenging of Western influence that can be seen across the globe. These activities range from deniable actions, such as deployment of adversarial capital into Western innovation ecosystems, cyber-attacks and influence operations, to more overtly state sponsored acts of economic warfare and saber rattling (e.g., Spratly Islands, Papua New Guinea, Solomon Islands, etc.) in their attempts to subjugate their near abroad.

Key to countering these threats is the clear national strategic imperative to develop a robust and broad DIB across the Western allies but, in particular, domestically in the US. The current DIB has proven to be insufficient to meet the equipment, technology, and munitions needs required for a potentially protracted conflict across multiple theaters. Western government funding simply cannot sustain ever increasing expenditure needs and therefore suitable private capital resources are needed to amplify government spending, increase manufacturing capacity and foster innovation.

Military Civil Fusion (MCF)

In China, and to a lesser extent Russia and Iran, the government is scaling proven ideas into deployable systems at lower cost and with a velocity that is orders of magnitude faster than the US and other Western allies (which are bound by the conventions of traditional defense procurement). China, in particular, is actively utilizing Military Civil Fusion (MCF) programs and strategies to develop the most technologically advanced military in the world. A key part of MCF is the elimination of barriers between civilian R&D, commercial activities, capital markets, the military, and the defense industrial sectors.

China is implementing this strategy, not only through its own R&D efforts, but also by acquiring and diverting the world’s cutting-edge technologies, including through nefarious means, to achieve commercial and military dominance. To further enable this strategy, China has deployed ever increasing quantities of state funds to rapidly establish and develop its industrial base more broadly. In doing so, China has aggressively secured raw materials from primary industries across the Global South and allies of convenience, such as Russia, Iran, and North Korea, creating a vast sphere of influence, controlled largely by the creation of financial dependency on the Chinese State. Chinese, or Chinese proxy, control of a large proportion of the world’s natural resources, combined with a disproportionate concentration of processing capabilities in China, has created a significant advantage for Chinese manufacturers with the added benefit of creating market control and supply chain dependencies that adversely impact many Western industries, including our critical defense sector.

MCF is key to China’s developing a “world class military” by mid-21^st century while also deploying commercial technologies globally that provide unrivaled information and actionable intelligence on competitors and adversaries critical to advancing its regional and global ambitions¹. China is systematically reorganizing Chinese industry to ensure that new innovations simultaneously advance economic and military development, leveraging its growing GDP to expand its defense industrial sector.

Conversely, over the past thirty years US and broader AUKUS policies led to boom-bust cycles of defense spending and drastic consolidation of the largest defense contractors, which has impaired the legacy of Western military innovation.

The Counterbalance, a Critical Need for Private Investment

Key industry insiders are aware of the need for private capital to address US and AUKUS objectives and have become increasingly frustrated with the lack of progress and the persistent funding gap. “VCs are critical to this,” Joseph Felter, director of the Gordian Knot Center for National Security Innovation at Stanford University urged recently, before suggesting commercial investment in US defense was “incomparable” to that of China. Thomas Tull, founder, and chairman of the US Innovative Technology Fund, has said, “We can stand around and complain, but every day we do nothing, we are losing ground on our adversaries.” David Spirk, senior counselor at Palantir and former USSOCOM Chief Data Officer added, “If we can’t slow them down, we can accelerate ourselves.” At the AUKUS level this sentiment was echoed and emphasized by former Australian Prime Minister and incumbent Ambassador to the United States, Dr. Kevin Rudd, who in October 2023 publicly called for the Australian superannuation funds to begin investing a portion of their $2.5 trillion to support the expansion of the defense space across the AUKUS alliance, stating to a joint US Australian defense centric audience in Washington, D.C., that “the time for seminaring (sic.) is over, the time for action is now!”

“A dollar can do more damage than a bullet.”

– Major General Gary Harrell, Former Delta Force Commander

Recent initiatives, such as the formation of the Office of Strategic Capital within the Pentagon to ensure that the US maintains its technological superiority and secures its DIB against current and future threats, have helped define the capital need; however sufficient sources of capital continue to lag.

Notwithstanding the urgent and growing demand for capital, with expected asymmetric returns, private capital, in addition to credit capital, are simply not proceeding apace in providing adequate funding to the landscape. In part, this is due to idiosyncrasies in government contracting structures; confounded by expanding and restrictive investing promulgations prohibiting most institutional investors (which practically includes all investment funds, private equity, and venture capital sources) from investing in many defense asset classes. These circumstances, when taken together with the shifting global conflict matrix, the evolution of warfighting to increasingly be reliant on technology, the profound increase in the deployment of dual-use commercial technologies, and lessons learned in recent conflicts, have created a unique market window for family offices to step in and take a leading position.

While limited sources of investment and liquidity are available to large, well-established players in the target markets, early-stage and lower middle market enterprises represent a critical, severely capital starved element of the defense and national security ecosystem. Combined, these factors catalyze an opportune investing environment with an established prime contractor landscape providing viable exit opportunities. Considering the historical and prevailing geopolitical, market, government, and investor conditions, there exists a clear and present opportunity to provide deeply needed private capital with reasonably predictable attractive investor returns. Knowledgeable investors working closely with government (US / AUKUS) and understanding the needs and the landscape, can deliver flexible private capital to mitigate the identified challenges and generate attractive investor returns.

Government Response and Opportunity Landscape

The US, along with its AUKUS partners, is implementing significant changes to its defense acquisition processes to address critical needs and maintain technological superiority. These efforts aim to modernize, diversify, and build resilience into the DIB while attracting new commercial partners to the Department of Defense (DoD).

Key initiatives include:

• Small Business Focus: The DoD is required to award at least 23% of its contracts to small businesses, with prime contract awards to small businesses now exceeding $80 billion annually. Other agencies involved in these efforts include the Department of Energy, Department of Homeland Security, and various other agencies/branches.
• Innovation Programs: The DoD has established various innovation hubs and programs, such as the Rapid Defense Experimentation Reserve, Defense Innovation Unit, AFWERX, SOFWERX, NavalX, Army Futures Command, and the Chief Digital and Artificial Intelligence Office.
• SBIR/STTR Programs: These programs stimulate technological innovation by directing contracts to small businesses for R&D, promoting commercialization of technology beyond core defense markets. They offer a beneficial structure allowing companies to retain commercial ownership of developed technologies.
• New Funding Initiatives: Recently introduced programs include:
  • Office of Strategic Capital (OSC): Provides financial assistance to critical defense technology companies for scaling up operations.
  • Defense Innovation Unit (DIU): Identifies and supports the development of commercial technologies with defense applications.
• Established Programs:
  • Defense Advanced Research Projects Agency (DARPA): Focuses on innovative technologies for national security.
  • In-Q-Tel: The Intelligence Community’s venture capital arm, investing in innovative technologies.
  • DoD Manufacturing Technology Program (DMTP): Supports US defense companies in adopting new manufacturing technologies.

Source: National Defense Industrial Association (NDIA), Department of Defense (DoD), Small Business Administration (SBA).

These initiatives create various direct and comingled investment opportunities that offer attractive prospective returns for family office investors within the defense and dual-use sectors. Focus areas include:

• Seed / Venture: Over the past decade a robust ecosystem of defense and national security technology centric venture firms have emerged, many led by Veterans, seeking to deliver innovative capability into the hands of the warfighter on an expedited basis. These range significantly in scale and focus from the deeply technical (e.g., Razors Edge), to the highly sector specific (e.g., Veteran Ventures), and the more generic but with an interest in the sector (e.g., Crosslink).
• Venture Debt: A multitude of non-sector specific venture debt providers operate in this sector (e.g., SVB) alongside a variety of factoring businesses, however a gap exists in the market for the provision of government contract underwritten credit solutions aimed at providing non / less dilutive capital options to high growth, venture backed technology companies scaling to deliver against government needs.
• Late Venture / Early Growth Equity: A small number of DoD centric late-stage venture / early-stage growth funds operate in the market (e.g., Shield Capital) and are largely focused on emerging technologies graduating from specific DoD funded initiatives such as DIU. Opportunities also exist to invest alongside the government through equity and convertible debt placements into companies benefiting from scale up SBIR Phase III awards designed to bring capital intensive technologies into service. Beyond this there is a value-added follow-on investment need to bring capital paired with sector specific acquisition expertise in support of companies that have made initial inroads into the DoD but are yet to scale, this is the domain of a number of niche funds.
• Credit: At the larger end of the market credit funds alongside traditional banks are active but in the lower middle market there is a significant opportunity for contract-backed financing, with an estimated $20B private credit market capital gap supporting recipients of $335B in US government prime contract awards to small businesses. A number of new funds are seeking to fill this void.

Despite these efforts, there remains an insufficient amount of private capital addressing strategic national security initiatives. The defense ecosystem represents a significant opportunity for family offices to fund high-growth investments in companies that have secured early government contracts and are looking to scale.

About the Authors

Nick Fisher is a Principal with Anzu Partners and a Fellow with the Australian Strategic Policy Institute. Over the past 25 years Nick has gained significant experience across the defense, national security and government contracting sectors of the US, UK, Australia and other allied nations. During this period, he has seen service as a Commissioned Officer in the Royal Navy, has acted as an advisor to government departments on the matter of private capital participation in the national security related innovation ecosystem and has undertaken corporate roles globally ranging from government sector business development to venture capital and lower middle market investment banking focused on the aerospace, defense and the government sector. Contact: ndf@anzupartners.com

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at SMU Cox School of Business. Contact: marc@tfoa.me

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

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Disclosures

Authored by Jay Goldberg and edited by Marc J. Sharpe, M.A., M.Phil., MBA

Family offices serve as an intergenerational hub for family legacy, comprehensive and effective wealth management, as well as estate and business transition. Life insurance can play an important role in the strategic planning for successful families, although feelings towards such insurance, in many cases, is best described as a love/hate relationship. Almost two thirds of high-net-worth individuals and families have expressed a distrust of the insurance industry, while, in direct contrast, three quarters of them acknowledge that life insurance plays a role in their strategic planning¹. This whitepaper will explore the value of life insurance as part of a robust estate and/or business plan and its role within the big picture perspective of family office legacy planning.

Despite the insistence of some overzealous agents, life insurance is not the panacea for all financial ills. It does, however, provide a solution for specific risks facing successful families; and when utilized and structured correctly, can help instill a sense of tranquility during turbulent times. Both simple and complex solutions can be tailored for the family office, but it is important to elevate the discussion beyond simply product towards risk exposures, risk management, and only then, optimal product solutions.

The purpose of this paper is to highlight some of the planning issues facing family offices where life insurance may be a viable solution; as well as sophisticated techniques utilized by family offices to structure coverage. As noted, the discussion of product selection is secondary to identifying the problem and developing strategies required to resolve specific issues.

Liquidity Needs

Liquidity at key moments for the family, the business, and the family office is essential, and if life policies are correctly owned and executed, they become immensely valuable in mitigating the dangers around illiquidity.

• Survivorship — Whether the family office is embedded in a business or operating as a stand-alone entity, the majority of assets are often invested in illiquid holdings. It would seem counter-intuitive that these wealthy families would need insurance coverage for survivorship, yet, in many cases, the patriarch’s or matriarch’s passing can cause a significant disruption as family members grieve and their family office begins the arduous probate process. Many families find that maintaining a policy on key family members can bring a sense of calm to an otherwise tumultuous period. The dollar amount of coverage can be nominal when compared to their overall wealth, but the liquidity provided can allow family members and the family office to take a deep breath and make optimal decisions. To avoid inclusion inside of one’s estate, the policy should be trust-owned, and a spousal trust, children’s trust, or other legacy trust are all viable options for ownership.
• Estate Taxes — The most prevalent usage of life insurance by high-net-worth families and their family offices is to provide liquidity for their heirs to pay projected estate taxes. It is only one of several legacy planning issues but the one with the most immediate financial implications. A 40% tax on assets inside of one’s estate can cause a significant liquidity crisis, particularly since the tax is due within nine months of the date of death and due in cash. Illiquid assets can create a challenge when the need for liquidation is relatively immediate and trust-owned life insurance becomes a valuable risk management tool in these instances. One of the many responsibilities of a family office is to coordinate a comprehensive effort to effectively shift as many assets as possible outside of the family’s estate. This is done to minimize the effects of estate taxes as well as for asset protection purposes. The reality, however, is that it is difficult to eliminate all estate tax liability, but implementing an effective estate plan can reduce and better define the projected amount of tax due. Life insurance can then be utilized to provide the needed liquidity to avoid a forced sale of assets.

Estate Planning

Outside of the need for estate liquidity, there are other legacy planning issues where life insurance can be a viable solution. For example, family offices often find themselves struggling to find answers to succession and inheritance planning that allow heirs to live self-determined lives while maintaining family harmony. There are several other areas, in addition to estate tax liquidity, where well-structured life insurance can be utilized to solve planning issues facing successful families.

• Estate equalization — one of the more difficult decisions that successful families and family offices face is how to effectively deal with the “fair” distribution of their estate. The difficulty lies in the fact that, in some cases, there needs to be a differentiation between “fair and equal.” This determination, however, is easier said than done and life insurance can play an integral role in solving a number of these needs.
  • Second marriages — estate planning for blended families can be a delicate and complicated process, particularly if one spouse entered the marriage with significantly more wealth and sustained earnings. Whether both spouses had children prior to this marriage or not, determining an agreed upon estate plan can be a challenge. Life insurance is an answer to this dilemma, allowing potentially separate property assets to remain within one family line while insuring an inheritance for the other.
  • Business holdings — a challenge facing business owners is planning for children in or out of a family business. Children working in the business may not agree with a plan that includes sharing both revenue and value equally with their siblings. Once again, life insurance, structured to help equalize the estate, is an attractive solution. If all children already own stakes in the business, a buy-sell plan between family members is critical planning for a family office. In this case, regardless of terms of valuation metrics, insurance can provide the necessary liquidity to execute this plan.
  • Farms/Ranches — a challenge for family offices is planning for the family farm or ranch. In many cases, this asset represents a significant holding, but like the family business, not all heirs necessarily participate equally. As with the other estate equalization needs, insurance can be the solution to help maintain family harmony. In addition, if the family wants to maintain the farm/ranch as a legacy asset, the family office might consider funding a Family Trust with enough life insurance to both purchase and fund the future maintenance of the ranch. By implementing this strategy, they can create a multi-generational legacy asset, outside the reach of estate taxes, which has the ability to sustain itself for years of family use.

Charitable Planning

Family offices are charged with the effective use of charitable planning to meet the needs and goals of the families they serve. In most cases, the donation of existing assets is the most fulfilling method since it meets the family’s altruistic goals while providing a current tax benefit for them. There are several uses for life insurance, however, that can be helpful within a family’s estate plan.

• Direct Gift — many families and their family offices find that using life insurance to meet a testamentary pledge may be an efficient way to fund their desired gift. This is especially true for families with substantial illiquid investment holdings. The family office may find that the payment of premiums today is more cost-effective than the liquidation of assets upon death.
• The Zero Tax Estate — the charitably inclined family may decide that the most attractive means to reduce estate taxes is to leave their assets which remain inside their estate to charity. Many times, this involves a family foundation or donor advised fund. After all, there are only three potential beneficiaries for accumulated wealth; their family, charitable institutions, or Uncle Sam; and few choose to benefit the latter. Life insurance can play a significant role for the family office by replacing the donated wealth with tax-free benefits for the heirs. For some families, this allows the flexibility to give all their estate to charity and ensure that their heirs receive an equivalent benefit via insurance. It can be utilized by family offices to reduce the complexity of what can become quite complicated estate planning and enable families with the ability to make large charitable gifts during their lifetime.

Business Planning

Planning for the succession of business assets, whether that be an operating business or more passive investment entities such as LLCs and FLPs, can be more challenging than traditional estate planning. For non-related business partners, strategies are typically more straightforward, though still with a degree of complexity but absent the softer issues of family dynamics. When the succession plan includes children in and out of the family business, family offices are tasked with the more complicated responsibility of managing the goals and aspirations of all heirs. Once the original wealth creators have passed, it may become apparent that not all heirs have the same level of interest in the family business or necessarily care to be co-invested with their siblings. As Mark Twain said: “You never really know someone until you share an inheritance with them” and the succession of business assets can be a major catalyst for family disharmony. Life insurance, structured in conjunction with well-drafted legal agreements, is an effective solution to help fund a comprehensive succession plan and maintain family harmony.

• Buy-Sell — creating effective buy-sell plans is a requisite not only for an operating business but for the more passive entities formed to hold and protect investments for family members. Family offices not only have to ensure that continuity strategies are in place for these entities, but for the family office itself. Not only must comprehensive plans be developed, but they must be flexible enough to conform to the complex tax issues related to these asset sales. In addition, they must be reviewed periodically to ensure they meet the needs of all owners and contain default language acceptable to all parties, should the periodic document review be overlooked. Life insurance is the most viable option when it comes to funding these plans, but it still requires several decisions ranging from policy type, ownership structure, and tax -effective funding to ensure they comply with the overall tax strategy. Company ownership of the policy can cause an increase to the overall valuation of the business (based upon a recent IRS ruling² necessitating a degree of creativity in how these policies are owned.
  • Term vs. Perm — many buy-sell plans are funded with term life insurance, yet that may not be the best option in most cases. Term insurance has a significant advantage when it comes to being cost effective, but the reality is that over 90% of term policies never pay their death benefit. Typically, if the owners live beyond 65-70 years old, the term policy has expired. They then find themselves without a funding mechanism when it is most needed.
  • Permanent Life — though a more costly option than term, family offices should consider utilizing permanent life insurance in business succession planning when economically viable. In addition to having the funds available for the life of the insured parties, there are other uses that may advantage family members and business partners alike.

    • Bonus out the policy — One of the attractive features of permanent life insurance is the fact that it will be in-force when most needed. If a business partner, family member, or key person decides to retire for whatever reason, the policy is an attractive benefit that can be bonused to them for a variety of uses. This is a valuable instrument that can be utilized as a company benefit for retaining key personnel.

    • Cash value — depending on product chosen, funding structure, and guarantees, many permanent insurance policies build cash value in addition to offering a death benefit. Policies can be designed to offer maximum cash value at the optimal window (projected time of retirement or business transition), which allows for substantial flexibility in the use of the policy.

    • Retirement income — a popular strategy is to utilize the cash value of a life insurance policy for retirement income. This is achieved through tax-free loans from the policy and can help the retiring party with supplemental cash flow (tax-free).

    • Disability/Long-term care — depending upon riders associated with the policy, a permanent life insurance policy can help solve for needs regarding both disability and long-term-care.

    • Estate planning — whether individually or business owned, the policy can be gifted or sold to a trust to provide liquidity for surviving family members for both estate and/or potential income taxes.

    • Business asset — for businesses that have capital requirements to meet loan covenants, adding a high cash value rider to a permanent life insurance policy helps maintain the policy’s cash value, making it a valuable asset for the business’s balance sheet.

    • Pension Plans — family offices looking to shelter income for high-earning family members may consider the more “modern” versions of pension plans, such as hybrid cash balance plans. Depending on a participant’s age, pre-tax contributions can range to almost $400k a year and there is no age limit for starting a plan. Coupling this substantial contribution with a portion dedicated to funding permanent life insurance within the plan, can truly supercharge the overall benefit. With proper structuring, the policy can be removed (via sale) once premiums are paid, providing substantial flexibility for its uses. Pension plans can be a tax advantaged method to fund life insurance with pre-tax dollars.

Tax-free Investment/Income

For many years, the consensus has been to defer income tax as long as possible through qualified plans and other specialized tax-advantaged investment strategies. The reality being faced by family offices and wealthy individuals today, is that tax rates may be higher in the years ahead, making deferral not quite as attractive. Despite how it may feel, today we are truly in the golden age of taxation with the lowest tax rates seen in the U.S. since the 1930’s. This is across the full spectrum of tax including income tax, estate tax (along with the highest exemption in history), corporate tax, and capital gains tax. With deficits growing and government spending continuing to increase, it is hard to imagine that tax rates will remain indefinitely at such historically low levels. This is a valid reason for family offices to consider life insurance from an investment perspective as well as a source of income since both the death benefit and policy distributions (using loans) are generally tax-free.

• Internal rates of returns for an insurance policy’s death benefit, based upon the insured’s actuarial age, typically range from 5%-7%, depending upon policy construction and chosen product. Inventive methods of policy funding may increase these rates of return even higher. The taxable equivalent return for traditional investments may have to exceed 9%-10% to match the return generated by a permanent life insurance policy. In addition, some family offices are looking at interest rate sensitive products such as Whole Life or Universal Life, as a hedge to their equity exposure without directly investing in fixed income instruments. Life insurance, which can provide a secure, tax-free rate of return, is increasingly viewed as an investment class, as opposed to simply a risk management tool, by wealthy families and their family offices.
• Tax-free distributions from a life insurance policy can be an important part of a family’s financial plan. This source of tax-free income, based upon policies with favorable loan provisions, will become even more valuable should we encounter a higher income tax rate environment. Structuring a policy for cash accumulation and eventual income distributions is an art form in itself and product selection is an important component. Historically, Whole Life policies have not been the best option for this strategy due to higher loan costs and lack of flexibility, while Universal Life policies tend to be better suited to meeting income/distribution goals. For family offices looking to generate tax-free income, a well-structured insurance policy may provide both a near-term death benefit and future income for the families they serve.

Policy Funding

For the typical family with a need for life insurance coverage, funding their policies is typically simpler, becoming more a function of desired benefit, product selection, underwriting status, and desired length of premium payments. For family offices, however, much larger policies are typically required to execute estate and business planning strategies and funding mechanisms become significantly more complicated. In addition to the costs of premiums and illustrated payment structure, there are tax consequences, both income and estate, as well as contribution limitations that must be carefully considered.

• Premium structure — once the desired amount of coverage is identified, the next “solve for” is to determine the most efficient method of funding the policy. As noted, for most conventional coverage, there are rarely significant tax consequences, even if the policy is to be trust-owned. By including children, and grandchildren as beneficiaries, along with a current annual exclusion of $18,000 per person ($36,000 per couple), most families can avoid gift tax and fund relatively substantial premium payments. However, this is not always the case for many and certainly a challenge for family offices looking to procure significant amounts of benefit for the families they serve.
  • Traditional premium structure — for most policies, premiums are typically structured in what is termed a “shorter pay” manner (typically 10, 15, or 20 years) or payments for life. As a rule of thumb, the shorter the payment period, the higher the IRR at the insured’s actuarial age. Cash flow restrictions, in many cases, dictate the desired choice of years for policy funding.
  • Skip design — some family offices may find that there are advantages to front loading a policy to take advantage of a current excess of cash available. In this case, future premiums can many times be “skipped” for a number of years, ranging from as few as 3-4 years up to 25+ years of no premium payments. Though an attractive strategy to many with improved IRRs through the insured’s actuarial age, the downside is substantial premium costs later in life. Living beyond that point in time greatly reduces the return profile of this strategy.
  • Income and pension design — for families looking to generate maximum income from their insurance policy or fund life insurance within a pension plan, most utilize a shorter premium payment period of between 5-7 years. For incomes strategies, this allows for substantial premium contributions to the policy to quickly accumulate tax-deferred. For use of permanent insurance within a pension plan, the shorter premium period facilitates the repositioning (via sale or distribution) of the policy from the plan once all premiums are paid.
  • Private split dollar — this planning technique is attractive to family offices and their clients by allowing payment of annual premiums on trust owned policies without incurring gift tax consequences by making large gifts that would exceed the client’s lifetime exemption. The loans made to trust have income tax implications and are usually treated as either a collateral assignment (economic benefit calculated upon the cost of term insurance) or a loan regime (typically an interest rate tied to the long-term AFR rate). In addition to traditional split dollar, there are private switch dollar plans (switching between the economic benefit and loan regime upon a triggering event) and intergenerational split dollar plans (grandparents funding policies on children’s lives for the benefit of grandchildren). Split dollar planning is an important tool for family offices looking to acquire life insurance but not utilizes additional estate tax exemption or generate gift taxes. They should be aware, however, that private split dollar plans require diligent administration and compliance to ensure their efficacy. This includes proper legal agreements that outline the responsibilities of all involved parties on issues including premium payment responsibilities, death benefit allocation, and the sharing of policy cash value.
  • Premium finance — for the past decade plus, interest rates have been historically low making the financing of insurance policies through third party loans attractive to family offices and the families they represent. Provided that an arbitrage exists between loan rates and the policy’s rate of return, this is a strategy that has the potential to substantially increase IRRs based on the age-old strategy of utilizing leverage. Though there are plenty of well structured, financed policies with accompanying credit facilities, the use of premium finance, sold many times as “free life insurance,” has also had its share of pitfalls. The reality is that if a plan is well-structured, with realistic assumptions for both interest rates and market returns, as well as a viable exit strategy to retire the loan, premium finance of life insurance is a good strategy for family offices to consider. The current rate environment, with interest rates more “normalized” than over the past decade, presents an opportunity to illustrate realistic assumptions with the opportunity for upside should rates decrease in the future. As with all life insurance tied to either fixed income or market returns, the moving parts, both returns and costs, are based upon assumptions. The use of financing brings another variable to that equation. Current trends utilized by family offices include the restructuring (rescue) of previously issued policies as well as the blending of Whole Life into product selection to add return stability.

Private Placement Life Insurance (PPLI)

High net worth families are attracted to the potential benefits of private placement life insurance, and this strategy has grown rapidly over the past decade due to substantial interest from both family offices and investment advisors alike. PPLI is a niche life insurance product that offers high-net-worth investors an opportunity to combine the benefits of life insurance with tailored investment opportunities in a tax advantaged manner. Though it still functions as a life insurance policy, it allows the policyholder to allocate a portion of the premium payments to a wide range of investment options, including hedge funds, private equity, real estate, and other alternative investments. Being a life insurance policy, the cash value grows tax-deferred, allowing the accumulation of wealth without incurring annual income taxes on their investment gains. This is valuable for investments in tax inefficient strategies such as hedge funds and other alternatives which generate substantial short-term capital gains. Other benefits include the tax-free death benefit passing to beneficiaries, making it a valuable tool to help mitigate potential estate tax liabilities, as well as the asset protection provided for insurance related products. While this strategy can provide certain tax advantages, it is a complex financial tool and not without potential drawbacks. Some of the “cons” of PPLI are the costs associated with the strategy, which includes management fees, insurance charges and administrative expenses. In addition, family offices need to be aware of the liquidity constraints related to this strategy and potential legislative risks. Along these lines, it is important to note that the Senate released a report in February 2024 specifically targeting private placement life insurance. Though no regulatory changes were enacted, the strategy is on the government’s radar and proposals to curb the use of this strategy may be forthcoming. Family offices should rely on competent legal and tax advice (not necessarily from an insurance agent or investment advisor) before engaging in this strategy.

In conclusion, there are four core risk pillars for the family office – strategic risks, commercial risks, financial risks, and personal risks. Life insurance should be seen as a risk management solution for these families, which are often immensely complex in their business and investment holdings, as well as their family dynamics. Family offices are increasingly focused on helping families achieve overall financial wellness by analyzing clients’ lifestyle and financial goals – both personal and professional – and then using tools such as insurance to develop a holistic financial strategy that puts them on a path to achieving those objectives. As noted earlier, it is key for family offices to not simply talk product, but to understand the role of life insurance in the strategies utilized to meet their clients’ objectives. Life insurance is not a panacea for all financial ills but, as I hope we have illustrated, can be an integral component of a comprehensive plan, transferring wealth in a tax-efficient, protected manner and as a funding mechanism for estate and business planning strategies.

About the Authors

Jay Goldberg is Founder and CEO of Integris Legacy Solutions, a life insurance consulting practice focused on bringing transparency to the design and structuring of life insurance as well as the often-overlooked need for ongoing policy review. Prior to forming Integris, Jay was a Founding Partner of Mosaic Advisors, a consulting group providing comprehensive tax, financial, and business planning advice to UHNW business owners and their families. His experience of reviewing policies for firm clients lead to the conclusion that there was too much opaqueness in the life insurance industry and that few clients truly understood the workings of the insurance products they owned. Jay formed Integris with a commitment to in-depth design and review of life insurance policies along with an emphasis on educating and empowering clients so that they can make informed decisions regarding their insurance needs. Contact: jay@integrislegacy.com

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at SMU Cox School of Business. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.