Family office growth and governance

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Family offices are powerful, a financial force to contend with. Even many in the financial world have yet to understand the family office’s sheer influence, especially when retail investing, private equity and venture capitalism have the limelight. The family office has deliberately preferred to remain relatively incognito when it comes to announcing investment and wealth management strategies.

The family office serves as wealth and trust management of high net worth families. Families can be defined as multi-generation family businesses, as well as high net worth individuals who may have come into inheritance or independent net worth. The family office can comprise an individual, department or separate firm whose sole objective is wealth management and legacy planning for the family. The single family offices (SFO) serves the investment needs of one family while the multifamily office (MFO) is structured much like an asset management firm, providing customized wealth management and planning to a larger number of families and high net worth individuals. This explanation may sound simple; rest assured, the family office structure is one of the most complex in the entire investing sphere.

Family offices are on the rise, and institutional investors are feeling the effects. U.S. Bank’s Ascent Private Capital Management has coined the term “insti-viduals” to describe the marked increase in family office dealflow usually presented to traditional institutionals such as pension funds. And why should the finance industry be surprised? We have had constant challenges with U.S. public pension funds and alternative investors such as hedge funds metting out disappointing returns. While traditional institutionals and hedge funds are very regulated, family offices do not have to register with regulators once investment advice is kept within ten generations of ancestry.

According to Campden Research’s most recent family office report, family offices hold more than US$4 trillion of assets, and the global average for assets under management (AUM) comprises US$921 million. Family offices are fast approaching the alternative investment cumulative AUM of US$5.7 trillion, albeit with much less sensastionalism. Indeed, The Wall Street Journal reports that since 2011 three dozen hedge funds have converted into family offices. The symbiosis between family offices and private equity is also strong and growing, where family offices are taking higher stakes in private equity deals.

Such astounding growth demands a inherent need for continuity. We are confident that the family office is stepping in to fill investment gaps left by failing institutionals and alternative investors. Upon exclusive study of the Family Office Exchange’s FOX Guide to the Family Office, The Family Office Club’s Family Office Report and Trusts & Estates’ expert panel discussion of The Famiy Advancement Sustainability Trust (FAST), we suggest beneficial processes for family offices. In this regard, measures of internal policy ensure family office longevity and legacy.

The Family Office Exchange (FOX) stipulates critical management issues faced by family offices:

  • Goals for the Family and Roles for the Family Office: Ultimately, family investment, philanthropic and legacy objectives dictate the family office’s focus. Issues are further subdivided by:
    • Ownership and Governance;
    • Scope of Services and Delivery Process;
    • Cost of Offices and Allocation of Fees;
    • Operating Structure and Management Talent;
    • Network of Internal and External Advisors;
    • Communications and Client Reporting;
    • Back Office Systems and Procedures.

FOX Family Office Benchmarking™ provided surveyed data from its family office membership concerning family office risk perception. Most families are initially worried about financial and operational challenges. Business risks such as talent acquisition, operating structure, and investment advisory comprise a hefty 37% of the families’ risk perception. Economic and financial risks comprise 26% of risk concern. However, when it came to actual family challenges such as legacy continuity, the family risk perception measured a mere 7%. Via Trusts & Estates’ Family Advancement Sustainability Trust (FAST) analysis, the risk reality shows quite the opposite.

On examining the quantitative and qualitative data of family business challenges affecting the family office, roughly 60% of disruptions and failure stemmed from family communications and generational problems, while only 3% of issues arose from financial and investment advisory challenges. Talent and advisory acquisition in the financial industry does not pose a threat to the family office in our current workforce environment. The Institutional Investor reports a marked increase in hedge fund managers either leaving lagging funds to manage family offices, or converting hedge funds into family offices for streamlined clientele. Private banking divisions at Citigroup, Morgan Stanley and J.P. Morgan have dedicated top senior bankers to be primarily responsible for multifamily office dictates. Family offices have a wealth of investment and estate talent to choose from. Given the flexible regulatory nature of a family office, top talent once constrained in the institutional arena may find room to expand expertise for the family office. In short, it is truly the “Ownership and Governance” issue that needs prioritized attention.

FAMILY OFFICE GOVERNANCE

As with any enterprise, family office governance policies need to be formulated long before execution of any financial and operational implementation. Family offices are in need of much more qualitative guidelines for business and wealth continuity. The Family Office Club based out of Key Biscayne, Florida gives specific insight into structuring family office ownership and governance guidelines via The Family Office Report. Remember, unlike standardized business or investment firms, each family office would have highly tailored objectives, so customization of certain objectives and criteria would be necessary. However, this framework helps with organizational structure across the board. Key components are as follows:

  1. Mission, Vision, & Goals:

    The mission is the starting point for what The Family Office Club coins “The Family Compass.” Family businesses may already have commercial mission and vision statements. However, the family office is responsible for management of the actual family’s qualitative mission, vision and goals. These are high level objectives for wealth creation, succession, philanthropy and legacy.

  2. Ethics & Values Policy:

    The ethics and values policy defines what is acceptable to the family’s core values when it comes to external talent, vendor transactions, business acquisitions, paths of philanthropy, and internal code of conduct. The ethics and values policy covers all issues of compliance such as money laundering, insider trading and bribery concerns. This policy should be reviewed consistently in strategy sessions with both family and external professionals within the family office.

  3. Investment Mandate:

    As expected, this mandate delineates family office investment governance. The investment mandate sets the investment criteria and asset class composition of investments for the family office. All taxation, income growth, wealth creation strategies, liquidity concerns and payout requirements must be detailed in this mandate. According to the Family Office Club, the Chief Investment Officer is responsible for the creation of this mandate, along with input from the CEO and vested family members. The mandate can be revised on a monthly basis. Quantitative social capital investments and philanthropic endowment strategies should be included in this mandate, if applicable. This mandate also aids the family office in shareholder activist campaigns when the need arises.

  4. Key Performance Indicators:

    Key Performance Indicators (KPIs) are highly detailed and action specific dictates per each member of the family office. Measurable outcomes are expected for involved family members and external hires. We would suggest broad KPIs be set for all external vendors, businesses and asset managers who deal with the family office. The Family Office Club suggests creation of at least three KPIs per member, as well as three “smart numbers” comprised of various KPIs for the entire family office.

  5. Systems & Processes:

    Systems & Processes here covers the details needed for organizational continuity within the family office. Where the ethics and values policy or strategic plan may deal with broad succession planning, systems and processes deal with the documenting of detailed processes carried out per member, so that in the case of natural causes or termination, talent or legacy replacement can occur without severe disruption to actual procedures. According to the Family Office Club, each member may add to a mini-process book, which then should be reviewed by selected family office executives.

In addition to the governance policies stated above, the family office will greatly benefit from the creation of a Family Advancement Sustainability Trust (FAST). The FAST is a brainchild of Marvin E. Blum, JD, Thomas C. Rogerson, Gary V. Post, JD of the Blum Firm. The FAST has the structure of a directed trust, but encompasses more than the typical mandate for disbursement of funds to heirs or philanthropic beneficiaries. In the authors’ own words, the FAST is “A pool of funds to invest in the family members—in the family relations, development, and advancement—rather than just distribute to the family members.” The FAST comprises four committees: the Trust Protector Committee, the Investment Committee, the Distribution Committee and the overall Administrative Trustee. Both family members and outside professionals within the family office comprise these bodies. The FAST is primarily for continued family education, family cohesiveness and legacy in both qualitative and quantitative concerns.

The family office has existed across geographies and dynasties, quietly providing funding and making investments long before our global banking system came into play. Modern day family offices are now formalized, and are stepping in to fill investment gaps that are fast being created by lagging institutional and alternative investors. Thus, it is of utmost importance that existing and newly created family offices implement solid governance practices to ensure financial, operational and legacy continuity.

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The Looming Public Pension Fund Crisis

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The United States’ public pension funds are in a terrible predicament. As of August 2017, Bloomberg reported that 43 out of 50 States have had a disturbing increase in their funding ratio gaps, with only District of Columbia being overfunded out of all 50 states. The PEW Charitable Trusts reports that overall, the public pension fund system is underfunded by more than US trillion, with a record number of Baby Boomers going into retirement. These events spur not only financial, but social crises. If retirees have learnt no wealth creation and preservation techniques other than a dependence on pensions, the U.S. may face a widening of socioeconomic strata en masse.

Initially we blame local and state governments for failing to meet tax dollar fund contributions, and rightly so. Wayne Winegarden, Sr. Fellow at the Pacific Research Institute, states that from 2001 to 2015 total state contributions only met 88% of total nationwide contribution requirements. Full contribution is not expected in the short term, due to increased pension liabilities. States such as Oregon, Minnesota and Colorado have funding ratios gaps of more than 10%; Minnesota’s funding ratio worsened by a whopping 26.6% for FY 2016. That is terrifying from an economic standpoint, filled with nationwide implications reminiscent of Detroit’s 2013 bankruptcy filing. As Winegarden clearly points out, there are three fiscal policies that can mitigate worsening funding gaps:

  1. Cut promised pensions;
  2. Levy future tax increases;
  3. Reduce future government spending.

In addition to these fiscal mitigating policies, public pension funds need to adjust fund return expectations. From the late 1990s to 2000 both private and public pension funds had similar return projections approximating 8%. However, while private pension funds have adjusted fund expectations to consider the tech crash and Great Recession repercussions, public pension funds by and large have not. Indeed, private pension funds now have an adjusted return of approximately 5%, while public pension funds still have expected returns of 8%. Yet, the funding ratio gap widens for 86% the United States’ public pension system.

Second to consider is the change in asset allocation within public pension funds over the past decade. Public pension funds have made a marked shift to alternative investments for portfolio diversification, which have heightened risk and reward implications. The Pew Charitable Trusts (PEW) April 2017 report, State Public Pension Funds Increase Use of Complex Investments, give a thorough overview of issues and challenges regarding the state pension fund system. According to the PEW report, public pension funds have undertaken a stronger portion of alternative investments within fund portfolios that require customized expertise, different from stock and bond management. From a governance perspective, the PEW report states that overall most public pension fund boards may have been lacking in expertise to be part of investment decisions of such complex caliber.

The PEW Charitable Trusts report does not purport that alternative asset allocation is the reason behind our failing public pension system. The PEW report relates that there was no solid correlation between the use of alternative investments and fund performance. However, the PEW report found that pension funds with “long-standing alternative investment programs” outperformed similar funds that made trigger decisions to add alternative investments to the portfolio, where the original strategy consisted of mainly conservative investment vehicles. For instance, the Washington Department of Retirement Systems (WDRS) has one of the strongest track records in fund performance, and has had an alternative investment strategy since 1981, with 36% alternative asset allocation. Conversely, the South Carolina Retirement System (SCRS) quickly changed its fund portfolio to 31% of high yield alternative investments based on a 2007 state stipulation, with 10 year returns decreasing from 8% to 5%, even with a higher risk/reward objective. In addition, public pension fund valuation reporting for both fixed-income, public equity, and alternative investment portfolios has led to confusion in fund performance evaluations.

Third and the most insidious issue is the gargantuan rise in investment fees which public pension funds have faced. The PEW Charitable Trusts clearly delineates that public pension fund allocation to alternative investment vehicles has increased fund investment fees to aggregate US$10 billion as of 2014. Reported fees as a percentage of total assets have increased by 30% to date. And, these figures pertain to reported fees. Unreported performance fees carve a hefty portion of gross fund returns and can remain undisclosed depending on state fee disclosure requirements. According to the PEW report, unreported fees may amount to US$4 billion per annum. Public pension funds need to invest in higher yielding assets, since on the fiscal side contributions are sorely lacking. However, if total investment fees outweigh net returns, we have a further exacerbated public pension liability position.

The PEW Charitable Trusts give specific recommendations to begin the process of effective internal governance within the public pension fund system. Highlights of these recommendations are as follows:

  1. Public pension investments now have higher risk in portfolios comprising bond, stocks and alternative investments. Investment policy statements must be made fully accessible online for all stakeholders. All statements must fully disclose investment strategies.
    1. Include performance results by asset class, to highlight the performance and cost of all utilized investment strategies.
  2. Performance reporting is extremely inconsistent within state public pension funds. Some states report gross of fees, while others report net of fees. All public pension funds should report both net and gross of fees regardless of positive or negative returns.
  3. Public pension funds do not report comprehensive undisclosed fees such as carried interest. Include line itemization of fees paid to individual investment managers in comprehensive fee reporting.
  4. Most public pension funds report returns in a 5 to 10 year window. It is recommended to increase fund performance reporting to a 20 year horizon to get a fuller understanding of long-term strategies.

A combination of strong fiscal and governance policies at the state and local level are immediately needed to restructure the public pension fund system, and curb the worsening funding ratios over 43 of all 50 states. Public pension funds need to fully admit the glaring issue of underfunding, and possibly look to successful funds such the Oklahoma Teachers Retirement System or the Washington Department of Retirement Systems for replication of certain investment strategies. State and local overspending on aesthetics and mismanagement needs to be curbed and channeled into the basics, such as pension fund contributions. We cannot depend solely on the U.S. federal government to prevent such a financial catastrophe as possible public pensions default. It is up to the state and local governments to take a long, hard look at current mismanagement and ineffective governance, and bring pension contributions back to positive. We cannot have a replay of Detroit’s 2013 pension fiasco pan out over 43 states.

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