Making a family fortune is very different from managing it. The traits which build entrepreneurial wealth first time round, including personal drive, self-confidence and very narrow focus (not to mention luck) may not be so useful in guiding a more strategic wealth management programme.
So, what should a newly established family office do about deciding who will manage their assets? For a long time, the default choice was to turn to someone you know and trust already, and for many, this tended to be a senior operational manager who had shown success in running the operational business that generated the wealth in the first place. Trust is naturally very important, but it is not a substitute for expertise and, over time, this sort of personal connection has given way to a more rigorous selection process. Performance increases have generally followed.
Private banking and wealth management has become a massive business and a vital income stream for large financial institutions all over the world, but in recent decades, where scale has allowed, the trend has been towards organisations more specifically dedicated to family investors, often established by families themselves: the family office was born, and in time, spawned the multi-family office, enabling assets to be pooled, giving investors access to management talent, and to asset pools they could not reach alone.
Owners appreciated the more bespoke degree of strategic planning and asset allocation this approach allowed. It creates a flexible and diverse portfolio. And the structure provides a way to pick best in class managers, rather than take in-house product pumped by captive sales managers. This independence of decision making, allied to very active performance monitoring and low switching costs, has again enhanced returns to investors.
Curiously, in recent years, some families have begun to reverse this trend in parts of their portfolio, specifically as regards direct equity investments. A number of families or family offices have pulled back from private equity fund investments, citing either the impact of fees on performance, or the lack of influence over which assets are acquired via blind pool structures. Additionally, many have felt a more positive reason – the desire to bring their own knowledge and network to bear, to get involved directly. Sometimes, this has a very positive effect. In markets where there is a material surplus of me-too capital and not enough deal flow to go round, a new player who can speak from first-hand experience about the challenges of owning and running a successful operating business can bring an affinity and empathy with sellers that gives the firm a real edge in deal sourcing, especially when discussing the challenges of generational transition. And let’s not forget the simple attraction of success – sellers may be drawn to work closely with proven winners; that experience has a value and may enhance the chance of repeat success.
And yet, securing the deal at an emotional level is only one piece of the puzzle; it has to make sense at a commercial level as well. This is where we have seen the emergence of a hybrid model that combines the heritage and backstory of first-hand entrepreneurial ownership with the technical expertise of proven investment professionals. Specifically, as financial sector headhunters, we have run multiple search mandates in recent years for investing families looking to bring on board senior private equity investors.
There are complications on both sides. For the owners, this is usually an expensive fixed cost option, especially if they are to offer compensation to align with long term capital gains, in the nature of a typical private equity carried interest schemes; aligning this to existing employee structures is complicated and often controversial. Scale also plays a part here – below a certain level of investable assets, this sort of fixed cost is simply unviable, and a fund route makes more sense. One must remember, this is a risky asset class and while it may be exciting, proper stewardship of family wealth demands this should only represent a relatively small part of the overall asset allocation.
For the individual looking to be hired in such a role, the two big factors, beyond compensation, are transparent decision making and a long-term commitment to the asset class. For the position to be fulfilling, the owners need to let the talent do its job and follow a proper process. Putting such a structure in place means ceding some decision making authority. There is a place for instinct and even personal bias but when prices are so high, this has to be balanced by considering all the options, using due diligence, structuring and scenario analysis to weigh up downside risk as well as upside. In stark terms, it may be your money, but that doesn’t mean you get to decide what to do with it.
Owners also need to take a very long-term view of these investments. They are by nature illiquid and usually can’t be excited easily. To avoid excess risk concentration you also need to invest across vintage years, so you need to anticipate several years of net negative cash flows before seeing any return on investment. Can you stomach that at an emotional level, let alone regarding liquidity? A serious external hire is going to need the comfort that you can stay the course.
But, done correctly, in this model the family office deploys its own ‘brand’ and reputation, allied to first world analytical skills. The advantages of both DNA strains can be seen: industrial insights, winning relationships and long-term capital, plus process rigour, and best practice in risk management and diversification.