Originating in the Renaissance era but relevant to this day, family offices have been integral to extending the life cycle of a family’s wealth and immortalizing its legacy.
With a surge in the billionaire population globally, the role of family offices is becoming increasingly evident.
How do family offices navigate the complex decision-making involved in preserving such a massive wealth? Here are six key decision-making frameworks that they use –
Clear Objectives
At the center of the investment philosophy sits the all-seeing, all-governing Investment Policy Statement (IPS). The IPS guides the investment decision process for the family and by establishing suitable boundaries, prevents significant deviations, limits ad-hoc investment decisions and sets the guidelines for asset allocation and performance evaluation.
A family can have multiple IPS for different pools of capital. For example, there may be one IPS for the larger family investment portfolio managed by the family principals, and different IPS for individual family members based on their risk appetite, return expectations, and liquidity requirements.
Driven By Purpose
Most evolved family offices define the purpose of their investments as it helps to highlight the family’s multi-generational story. Family offices can drive significant societal change through their choice of investments.
The family office of the Nintendo Family in Japan, Yamauchi No. 10, ‘We are determined to create a society that encourages people to nurture their unique creativity’. Several purpose-driven family offices have aligned their investment philosophy with their family values.
Some avoid sin industries while others may want to make up for the fossil fuel emissions of their previous generations through impact investments in renewable energy. What is clear is that you can’t build a legacy without having a purpose.
Risk Pool Management
Risk pool management introduces the concept of creating investment portfolios across three risk buckets: Personal, Market, and Aspirational Risk Pools. Personal risk ensures that the family’s basic standard of living is not jeopardized.
Market risk strategies aim to maintain the family’s lifestyle and preserve purchasing power, while Aspirational risk considers investments that have the potential to exponentially enhance a family’s wealth.
In most cases, Family Offices allocate capital to fixed-income instruments to manage the personal risk pool. They use a combination of equities, fixed income, ReITs, InvITs, and diversified instruments to manage the Market Risk Pool.
The Aspirational Pool comprises largely illiquid investments primarily in private markets, through direct investments in companies and/or Private Equity and Venture Capital funds.
Asset Allocation
Asset allocation is the holy grail for all complex decision-making done by family offices. It brings discipline and consistency. A strategy to invest across uncorrelated investments helps to balance risk and returns, whilst managing volatility, potentially enhancing returns, and protecting the portfolio from market downturns.
This plan is at two levels – a strategic asset allocation, which is reviewed annually, and a tactical underweight / overweight asset allocation to capture market dislocations, risks, and opportunities.
Each asset class / sub-asset class tends to perform differently every year, hence the need to diversify across asset classes. For example, Gold gave -0.2% returns in FY21, but was the best-performing asset class in FY23, giving an overall 13% return. Asset allocation acts as a shield to an investor’s impulse.
Fund Manager Selection
Once the asset allocation has been finalised, Family Offices must then engage with multiple fund managers for the investment. Portfolio outcomes tend to improve through fund allocations as compared to direct investments, despite the higher cost of investment (i.e., fund management fees) associated with allocating to fund managers.
To evaluate managers, family offices use both quantitative and qualitative metrics. While there is much more publicly available information for listed investments, for unlisted investments, the stability of the team, a proven exit track record, access to deal flow and an exit strategy become key.
The family office eco-system of single and multiple family offices often interacts with each other to exchange ideas on fund manager selection ensuring a meritocratic approach.
Cost Of Investment
The total cost of wealth management is the sum of investment costs such as advisory fees, brokerage and transaction costs, fund management fees, and performance fees; and non-investment costs such as tax and estate planning, accounting, etc.
The two key factors that can significantly increase costs in wealth management are wealth structuring strategies and alternative investment strategies, which often involve significant management fees paid to Private Equity and Venture Capital funds.
An understanding of the complexity of the required services and economies of scale at play is crucial when assessing wealth management costs, and the careful management of costs can significantly enhance net returns.
In Conclusion
When viewed in isolation, each of these frameworks provides an insightful approach to a specific facet of decision-making within a family office. However, their true strength emerges from their integrated functioning.
Together, they create a dynamic, robust decision-making framework for family offices. This integrated approach equips family offices with the strategic acumen required to navigate black swan events as well as regular market volatility.
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