What The COVID-19 Crisis Will Mean For Family Office Investment Disputes
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As businesses around the world steady themselves for an unprecedented economic downturn, many commentators have weighed in the implications for SMEs and fund managers. Articles and interviews have included concern around working capital shortages for entrepreneurs, VCs and investors rescinding term sheets, and governments’ fiscal responses to ease trade credit and payments issues. What’s been missing from the conversation, however, is what this means for family offices investing and operating globally.
Of concern are the effects of the downturn on family offices and institutional investors and how disputes and working capital problems will affect investors. Inevitably, the family office community will need to be more prepared than ever to handle investment-related disputes as they arise in the coming months.
Family offices: the original entrepreneurs
Pioneered by successful entrepreneurs, single family offices (SFO) are the privately-held investment companies built when a successful company founder sees a major liquidity event. This ever-growing group of successful founders has emerged as a massive institutional investor class globally, and it continues to fund the next wave of entrepreneurs and startups in the region– “founders funding founders”.
The current COVID-19 pandemic is placing a cap on the longest bull market in post-war history. For the past ten or more years, we have seen some of the most prolific wealth creation by entrepreneurs. Alongside wealth creation has been the increasing professionalization and globalization of the family office as an institutional investor.
As of 2019, the global market for single family offices included approximately 10,000 organizations (Bloomberg) with an estimated 2,335 billionaires among them, according to Knight Frank. UBS states that, as they expand globally, over a third of SFOs operate two or more international offices, asset allocation strategies seek a global geographic diversification; and, core founder or family-held businesses may also continue to expand internationally.
Alongside this growth in global wealth creation has emerged a common problem for family offices that, as they invest and build businesses in new international markets, some proportion of deals arise in disputes and hard-to-enforce cross-border lawsuits. According to 2019 estimates from our research at Emissary Holdings, the global SFO market was exposed to as much as US$32.4 billion in alternative investments under distress by an external counterparty or stakeholder dispute.
For family offices, investment disputes take various forms including, for example, valuation disputes with fund managers, breach of contract disputes with buyers of companies, or proxy contests against other investors in the same companies. However, family offices differ from other kinds of investors such as private equity firms or hedge funds in that they typically run leaner teams whose expertise is not in managing contentious matters. Importantly, they will have reputational incentives not to litigate blindly, but to seek negotiated settlement when a dispute arises.
As a consequence, SFOs globally are sitting on tens of billions of dollars of value in exposure to investment disputes, but opting to take write-offs than to litigate publicly. And while the litigation funding market has grown globally to over $10 billion in assets under management, the litigation funding model is priced toward claimants who require a balance sheet to fund resolution of a dispute, which family offices by definition will not. What is needed for family offices is a trusted advisor who can not only provide bandwidth and expertise to supplement the investment and legal team, but also help to explore and structure the resolution options. These could involve litigation, arbitration, mediation or negotiation. Most importantly, and a key part of the work we do at Emissary Holdings with our partners, is bring a structured, controlled process of resolution to investment disputes.
What the COVID-19 crisis will mean for family office investment disputes
The nature of this crisis is inherently economic as opposed to financial, not to mention the severe human toll. The world has experienced a demand shock; the pandemic has created a forced stall of consumption and production of a substantial portion of goods and services globally. Media reports that the Institute of International Finance predicts a 1.5% drop to global GDP.
The challenge for companies is that as demand for most goods and services drops dramatically, they are unable to reduce their fixed and variable costs in line with this drop. As we can read in the news, for most businesses, COVID-19 equates to a working capital crunch, which is then passed on to suppliers and customers in trade credit shocks and to workers in the form of forced leave and redundancies. As more news emerges of job losses, we are likely bracing for further impact in financial markets. This is why governments are responding with astoundingly large amounts of fiscal and monetary support.
An effect of this chaos is that family offices will start to see unusual behavior from certain fund managers and portfolio company managers, who may now struggle with cash issues. Distressed fund and company managers may target family offices first (among all investors) for renegotiation of terms and/or withholding of distributions or information. Family office principals and investment teams must therefore be ready for breaches of agreements and be prepared to manage these cases efficiently.
For any family office who encounters an investment-related dispute in the coming months, we recommend five principles for avoidance and resolution:
1. Patient investors can play the long game.
Family offices are intergenerational investors by definition and can therefore trade near-term cash for longer-term returns. If you can maintain trust and confidence in your counterparties, the current economic shock can hold many such investment opportunities based on renegotiating for longer-term economics.
2. Map out all your resolution options in expected-value terms.
Every dispute can be resolved by one of litigation, arbitration, mediation, negotiated settlement or the sale of exposure. Which of those you choose to prioritize should be based on your optimal financial and reputational outcomes.
3. Develop a “war plan” for legal action in the event of a sustained dispute.
You will want to know your legal strategy and merits, budget and time this will consume, and what you are likely to recover in terms of expected value. You should be able to assign a net present value (NPV) figure to your legal action.
4. Develop a “peace plan” as your preferred option.
Your deal parameters should be based on a compromise that achieves a higher NPV than your legal action plan. Identify all the reasons that the counterparty should want to take this option over the legal path and be prepared to make your case directly.
5. Know that the greatest lever in the time-value of dispute resolution is time.
Every dispute has an NPV associated with it. You don’t want to be caught in a long, expensive process of legal recovery of assets, particularly where enforceable assets may be elusive.
These times are daunting. For an established family office or a successful entrepreneur investing globally, preparation is key to navigating these unchartered waters. Every dispute has a potential resolution if you are able to take the time to uncover and use these levers to your advantage. Like in politics, cross border negotiations require diplomacy and now is the time to find your Emissary.