The Investment Process | Generational - Multi Family Office

The Investment Process

Background

How do family offices invest their principals’ money? There are no fixed investment regulations that apply. Family offices tend to follow their own individual investment policies, because, unlike banks and other financial service providers, they are generally subject to the more relaxed regulations applicable to companies, trusts and foundations. However, the degree of freedom enjoyed by family offices is reduced in proportion to the level of services provided by third parties and the number of families served by the family office.

Family offices can often diversify their assets very broadly, much more than institutional investors can, thanks to the amount of assets under management. Family offices are also generally better able to think and invest on a more long-term basis, and they primarily pursue wealth preservation in order to pass on assets to the next generations. Many prefer direct investments, and where organisations have an entrepreneurial principal, they are more likely to get directly involved in the investment process.

Many family offices take an open approach to their investment policy and try to avoid conventional investment paths. This can be seen in the way that many invest in alternative investments, such as yachts, horses, art, forests and farmland, or car, wine or watch collections. This enables them to spread risks while reflecting the personal preferences and passions of family members.

The growth of family offices is a relatively new trend, and because of the diverse origins of many family fortunes and the different backgrounds, it is difficult to pinpoint a uniform family office investment process. Very broadly, the process should first set out an investment “road ahead”, listing goals and risk tolerance, and resolving issues relating to business shareholdings and family member stakes. The next phase is to establish the portfolio structure (i.e., how much in equities, real estate, etc.) to deliver the risk | return trade-off the family requires. Implementation and governance then follow — finding the appropriate investments to make up the portfolio, and overseeing their performance.

Role of the family

The crafting of an investment process is heavily dependent on legacy issues. In what economic sector has the family made its money, to what extent is the family still actively involved in the business? Each of these factors has a tendency to produce a strong behavioural bias on how a family’s wealth is invested and on the subsequent need to produce a diversified portfolio for the long term.

Another issue that is also important is the composition of the family. For example, a family office that is set up by a first-generation entrepreneur would probably be very different in its aims to one that is established by a large fourth generation family. As a result, the behavioural, financial and legal issues involved in structuring the investment process of a family office are complex and fascinating.

Most family businesses, even those at the third generation and older, do not yet have a family office. Cost and complexity are two contributing factors here, though it is also clear that the rate of growth of family offices is accelerating, and that the need for a transparent, independent and structured investment process is a key reason for this.

Setting investment goals

For most investment funds, whether they are sovereign wealth funds, endowments or family offices, the first step is to establish clear investment objectives and risk profiles. These different investment structures can have varying goals and objectives, and there is also variety in how these objectives are constructed. For example, some institutional investors work with inflation-related return objectives, others might not.

An important distinction can also be made at this stage between liquid assets, such as tradable securities, and illiquid assets, such as direct investments, private equity and real estate — the latter being difficult to value and often requiring some support in terms of funding. From a conceptual point of view, many family office members tend to view illiquid assets in a different way, when it comes to returns and investment horizon, to liquid asset portfolios.

Examining prior investment styles and questionnaires can help to identify the family’s tolerance to risk. In addition, scenario testing that illustrates and draws out important sensitivities to risk and portfolio drawdowns can be useful. The discussion of the investment process is led by the multi family office (MFO) and will include a more collective discussion involving family members, and cover any desires they have to establish charities or philanthropic initiatives alongside the family office.

Once an asset allocation recommendation has been reviewed, understood and accepted, the family should formalize their investment plan in an investment policy statement. Such a statement is a road map that is the focus for all parties involved in the client relationship, including investment advisers, investment managers and trustees. It also provides a course of action to be followed in times of market dislocation when emotional reactions may result in imprudent courses of action.

Once the specific investment goals and the risk profile of the family office have been established, the next step is to structure an overall portfolio and then bring to bear the necessary investment tools to drive the investment process. In some cases, historical asset return data is used to give a sense of what future returns might look like, but, as stock market history has shown, the past is not always a guide to the future.

Tax considerations

Selecting the most efficient combination of assets for the family requires an adjustment to portfolio optimization that takes into consideration the ultimate after-tax return that they would expect to receive. For each asset class, the expected return should be deconstructed to reflect the income yield from interest and dividends versus return from capital appreciation. Based on the level of turnover typical for each asset class, it is possible to estimate the percentage of asset appreciation that comes from realised versus unrealised capital gains, and also the extent to which realised capital gains would be treated as short-term as against long-term tax liabilities. Providing asset allocation analysis on an after-tax basis presents a realistic view of the return the family can expect from its portfolio investments, as well as an optimal mix of investments tailored to a family’s specific tax situation.

Stress testing and modelling

Once an initial portfolio shape is in place, several further exercises can be useful, such as stress testing the return profile of the portfolio to demonstrate to family members how the portfolio might behave during periods of volatility. In performing this type of analysis, it is sensible to examine all the family’s wealth, not just their investment portfolio.

Modelling the core business holding of a family as a form of private equity or direct equity holding, and then analysing and optimizing other components of a family’s wealth with respect to this, is a difficult but necessary task.

In the context of family businesses, one common outcome of this part of the process is to show that the initial investment portfolio of the family office could be better diversified, since it often has a large holding in the underlying family business or, in some cases, legacy investments that tend to be over-concentrated in certain asset classes (e.g., private equity).

The importance of cash flow

Family offices are different from other organisations, in that there is often a greater and more irregular call on the investment portfolio. Family members request funds for business-related or private equity stakes, philanthropic and impact investments, or ongoing expenses. In this respect, being able to model the impact of cash flows on an overall investment portfolio is important, and experience suggests that the focus on yield and cash flow tends to be higher for family offices than for other client types. Accordingly, families should consider their overall liquidity needs carefully during the portfolio construction process.

Implementation and governance

The implementation and governance quality is crucial. From an investment point of view, how a portfolio is implemented must be consistent with its objectives and portfolio structure. Having a formal investment policy statement in place is an important step in maintaining an appropriate governance structure. In addition to reviewing the family’s goals and objectives, it is vital to review asset allocation. This can be done by re-running asset allocation diagnostics on portfolios at least once a year, in order to make sure that they perform as initially prescribed. Governance and transparency are also very important, and regular meetings and calls between principals, the family office designated management and external advisers will help to clarify broad macro views, turning points in strategy, and issues relating to implementation.

In summary, while the family office space is growing and evolving quickly, several building blocks can be identified as forming the key components of a family office investment process. These are:

  •  Consideration of how legacy issues determine the starting point
  •  Objective setting and creation of an investment policy statement
  •  Mapping risk tolerances
  • Building a portfolio structure across all liquid and illiquid assets
  • Implementation using strategic and tactical investment tools to ensure that investment solutions fit the goals and objectives and meet cash flow needs
  •  Governance
  • Rebalancing
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