The Role of the Family Office & Managing Risk
Four key risks
Apart from the risks inherent in their businesses, entrepreneurs and CEOs face four broad categories of risk:
- Concentration risk
- Management risk
- Balance sheet risk
- Succession risk
Concentration of investment can be great way to grow wealth, but diversification is the more prudent path to preserving wealth. The trick is knowing how and when to convert that single, concentrated asset into a more diversified pool of assets, to mitigate the risk of their own business because they know it so well. Regardless of the type of business, having all your eggs in one basket leaves you exposed substantial loss if something were to go wrong.
It is important for entrepreneurs and senior executives to have a diversification plan in place, as it is not easy to move quickly when difficulties arise. Transitions can be dangerous inflection points.
Private businesses are generally illiquid and significant public share holders usually have regulatory constraints on their ability to buy and sell shares of their company. The ‘mother of all transitions ‘comes when the business is sold or the deferred compensation vests (usually on retirement).
These events need to be well planned for, both from timing and tax representatives, to mitigate the potential impact of unforeseen negative events and help ensure the highest possible value of the asset.
When a business owner sells a business or a CEO retires and their wealth shifts from concentrated, relatively illiquid operating company to more diversified set financial assets, they are often unprepared for the different skills and resources required to manage this form of wealth. It would be unimaginable for a CEO or business owner to run an effective operating business totally on his or her own. Most CEO’s have a team of executives with diverse skill sets; Sale , Marketing, Manufacturing, Accounting with whom they regularly sit around the boardroom table to strategise and to manage the company.
Sometimes that logic does not play a role in the management of substantial wealth. Wealth holders may have no specific strategy for their financial assets. The new set of required senior ‘executives’ – tax, legal, investment, planning, philanthropic – rarely sit around the table together to manage the financial wealth in an integrated, strategic manner. Often there is no active ‘CEO’ OR ‘COO’ of the financial wealth. Aqua will assist in this place.
Three factors can exacerbate this management risk. First behavioural psychology tells us that entrepreneurs and corporate CEOs have an independent streak that helped create success. At the same time, however, they are subject to feel overly confident that they can manage anything (‘if I could manage my business successfully, why shouldn’t I be able to manage my financial wealth?) but financial wealth can be a different animal to an operating business. It requires a different set of skills. It also requires at least the same level of attention that the business did. It can be learned, but it takes diligence, effort and time to do well and to stay current with new developments. Aqua can assist here.
Financial metrics tells investors that managing financial wealth is easy and you should, in fact expect to be able to regularly outperform indexes or be able to select the best investment managers on a consistent basis. Unfortunately, the reality is quite different, as any investors who have been through a few cycles will know.
The third and perhaps most important issue is the way the financial services industry is structured. Most firms are organised and offer services around one areas of expertise or their interests, whether it is investment insurance or tax.
On the other hand, the needs of the wealth holder are usually integrated and interconnected in fact the mist financial issues cant be neatly folded into particular discipline or another. It leaves the wealth holder responsible for connecting all the dots to ensure that an objective, unbiased assessment is made and that all potential consequences are taken into account. The lack of integrated approach to the management of financial wealth can result in a collection of investment islands with no connections to one another or to the goals for the family or their wealth. It can also lead to costly dropped balls and missed opportunities. Again a properly managed Family office will defray those risks.
Balance Sheet Risk
Most entrepreneurs and corporate executives are very comfortable around a corporate balance sheet. They know that there must be enough current assets to meet current liabilities, they recognize the need to balance liquidity, cash distributions and reinvestment of capital into the business. All will understand how an excess of liabilities can weigh on the health of an enterprise and limit its future options.
The same risks and constraints apply to a family balance sheet as to a corporate balance sheet. Short-term assets with minimal variability (such as cash) must be available to fund current liabilities (such as this month’s private school bill). Longer-term assets (such as equity or real estate) will be required to meet long-term liabilities (such as bequests).
Too great a focus on investment returns (vs. the entire family balance sheet) can put financial wealth at significant risk. The quest for the highest possible return without appropriate regard for specific objectives, risk of loss, or the appropriate matching of assets and liabilities, can push the wealth holder further out on the risk curve than they realize or than they need to be. It can also lead (aided and abetted by the investment industry) to a loose collection of investments that serve no specific purpose on the balance sheet. In fact, most of the investments in wealth holders’ portfolios have been sold to them by one of the purveyors rather than bought by them to meet a specific need or to play a particular role on their family balance sheet.
It’s no surprise that the word ‘success’ features prominently in the word succession. It is vitally important that the business is prepared to continue its success once the current leader moves on, particularly when the wealth of a family is underpinned by just one asset. A well-planned succession has a significant impact on the continuing cash flow of the founder, if he or she plans to retain a stake in the business, or on the price the buyer is willing to pay for the business. Well-thought out succession is also relevant to senior corporate leaders who often continue to own shares in the company, and that form a meaningful component of their wealth.
While preparing a business for effective succession is a critical component of a family wealth plan, there two other types of succession must also be considered.
The first is family succession – essentially preparing next generations to know how to live with the wealth they will inherit. The impact of that wealth can be overwhelming and even ruinous to next generations who have not been educated in the stewardship, responsibilities and management of wealth, and the access and privileges it can buy. Communication between parents and children can be challenging at best, and a sensitive topic like money can make it even more difficult, unless it is handled well.
Respected wealth psychologists Dr. James Grubman and Dr. Dennis Jaffe have an interesting take on the relationships between the first-generation wealth creators and the next generation. In their excellent paper entitled ‘Immigrants and Natives to Wealth’*, they liken becoming wealthy to a move from one country and culture to a new and very different country.
The ‘immigrants’ to wealth have left their proverbial ‘home country’ (a more modest socio-economic status) and through a business or corporate success have moved into the new ‘land of wealth.’ It makes sense that they doe not always feel completely comfortable in the new land and still carry with them many of the values of the old culture. Contrast this with their children, who are typically ‘natives’ in this new land of wealth, having been born and grown up in it with little or no knowledge of the old country or its values.
You can imagine (or may have experienced) this culture clash, either from the perspective of an immigrant or a native.
The second additional succession component is the succession of the wealth itself. Families that want their wealth to last through their own lives and to be available for future generations have a special task to sustain and grow that wealth so that it can continue to fund the needs of the family for the future. This can be a tall order, since investment returns tend to grow in a linear fashion and family size grows exponentially. A common problem several generations out (without the proper planning) is that the wealth will prove to be insufficient for meeting the needs of the increasing number of family members.
The family office as a risk mitigator
The family office was developed to mitigate the above-mentioned risks and help build sustainability into family wealth.
There are three main roles the family office plays in this risk mitigation. Diversification of the core concentrated asset is often a prudent way to protect the risk of loss should the unthinkable happen. This diversification must be undertaken in a thoughtful manner, and be well managed at each turn. At the same time, it must be flexible and leave family options as open as possible.
A family office’s job is, almost by definition, integration. The issues wealthy families face don’t fit neatly into one particular practice area. The family office, with its deep knowledge of the family and its goals, as well as its staff’s experience in a wide variety of professions of origin, plays an important role in providing the family with objective comparison, perspective and integrated advice and recommendations.
Discipline is the third factor a family office can bring to bear on managing wealth. Just as doctors typically engage other physicians to treat them and their family members, family offices can play an important role with wealth-owning families. The family office can bring independence and objectivity, a less emotional perspective and a fair and fact-based decision making process that can significantly improve the workings of a family and the management of its wealth.
Many entrepreneurs and senior executives have not thought much about the risks discussed above. It is important to take the time to step back to identify the family’s objectives, and then to determine what steps are needed to meet the goals. That may be the most important legacy an entrepreneur or senior executive can leave his family.
A key aspect of a family office is its private nature. The family office looks after the affairs of a single family. Depending on the needs of the family, and cost requirements, Aqua will offer anything from a dedicated, hand picked team to setting up a completely independent legal entity, run from a separate office.
Being able to cope with change is not only an advantage, but essential. A family office is designed to be able to evolve and flow with the family. It is designed to fit around the existing investments of the family and to be flexible enough to accommodate the inevitable changes and developments. A family office can work with the family business and assist in coordinating all of the investments and interests that make up a family's wealth.