Creating Best Practices for Your Family Office

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The "family office" is back in vogue. The dramatic increase in wealth creation during the last thirty years has given rise to a new generation of Rockefellers, Mellons, and Phipps. Today, families with sufficient wealth – typically at least $500 million – now adopt a classic wealth management strategy: they create and control their own family office (FO).

First and second generation wealth creators use their family office to establish a legacy and a structure that will allow future generations to more easily manage, understand, use, and preserve that wealth. The two most cited goals are to avoid the pitfalls of "shirtsleeves to shirtsleeves in three generations" and to teach a set of family values and culture that will bring cohesion and sustenance to family members facing variations in life over generations of time.

The most important question, therefore, is how to build and manage a family office that has the best chance to succeed and fulfill the goals of the founding family members. We offer our best suggestions below and encourage you to begin the dialogue both with your family members and your professional advisors.

Investment Management

Managing wealth (and wealth preservation and growth) is the most important role for the typical family office. Evaluating, selecting, and replacing investment managers is more or less complex depending on the number and type of managers used.

Since few, if any, families allocate all of their assets to one investment firm, the FO must have access to the skill sets required to select and evaluate, at least quarterly, a large number of diverse third-party managers. Many families also become involved in direct investing strategies (i.e., investing directly in private and public companies), which requires additional and very different skills and often is poorly managed by family offices.

Family offices should maintain detailed investment guidelines relating to allocation percentages, diversification, liquidity, etc. and should have some understanding of the variety of investment manager due diligence and evaluation tools, such as alpha, Sharpe ratio, etc., in order to accurately assess investment risk, portfolio risk, and operating risk. It is no longer acceptable to rely only on the advice of third-party managers and funds of funds.

Most importantly, therefore, families must be willing to recognize the importance of hiring talented investment professionals, with the appropriate skills, and at market rates of compensation, in order achieve their investment and risk management objectives. This is an area in which many FOs make avoidable mistakes by employing loyal but inexperienced professionals.

Relevant Questions:

  • Who invests? One firm, multiple firms, a selection of third-party managers, FO managers (or some combination thereof)?
  • Who selects and evaluates managers? With what criteria, e.g., returns net of fees and after taxes, correlations to market, correlations to other investments, strategy drift, implied risk, market conditions?  How often? With what external advisors?
  • Will there be direct investing or co-investing? Who decides and manages?
  • Who manages the “big picture” issues, such as portfolio risk, diversification, liquidity, performance, tax efficiency, and fixed and discretionary distributions?

Managing the Owned or Closely-held Family Business

Many families generate wealth through the creation of a successful business that some family members continue to own and operate, i.e., the family business (FB). Hence, in addition to liquid wealth, these families have a large illiquid asset that is both very valuable and very important to the family on a personal and emotional basis.

The FB also is very important as a source of increasing family wealth and the ownership and management of the FB, therefore, will have an impact on how wealth is created and distributed within a family, especially as the family grows from generation to generation.  This is evident regardless of whether family members or independent professionals are managing the FB.

As an investment management matter, the FO must account for the existence of the FB, as both an asset class and as a risk factor, in its asset diversification, allocation, and liquidity strategies, as well as understand any ownership change across future generations. In so doing, the FO can insure that it is managing a large illiquid investment, in addition to all other investments, for the benefit of both existing family members and the designated beneficiaries.

The FO also can be very helpful in serving as a source of information and as an honest broker in offering answers to the questions that typically arise about the FB. This is especially true in the context of multiple generations and family members uninvolved in the family business.

Relevant Questions:

  • Who owns and controls the FB and how will ownership and control change over time? What is the financial impact on family members? What role does each family member have in the family business? What role will future generations have and how will those roles be decided and by whom?
  • What resources are available to family members who create new family businesses or their own personal business endeavors? What financial and economic disparity exits for family members who either do or do not participate in the family business?
  • What role does the FO have in managing expectations about the FB, such as the roles of family members, the distribution of control and wealth, the impact on future generations, and its strategic plans and future disposition?

Accounting and Reporting

Every FO seeks to provide coordinated and consolidated accounting, tax reporting, and investment reporting of the family’s assets. This is the holy grail of FO management and, even with the current emphasis on transparency and real-time data access, most FOs find that it takes a significant amount of labor to achieve. 

Reports that evaluate the investment performance of managers are quite different than the reports required for tax compliance or the reports required for managing the family’s needs. Clear and concise reporting also is important as a communications tool for family members. Best FO practice requires that family members, accounting, and investment professionals all are engaged in designing and evaluating reports.

With ever-improving software and some amount of customization and coordination with third-party managers, most FOs are able to provide both regular investment reporting (monthly, quarterly, annually), as well as same day answers to any investment-related question.

Some FOs decide to use a third-party custodian to hold and consolidate the reporting of all investment managers in order to reduce the number of employees. It is not unusual, however, for an FO to have an accounting and reporting staff consisting of five or six persons (e.g., a chief financial officer, a senior manager, and two or three bookkeepers).

Relevant Questions:

  • What information does the FO need to fulfill its investment management objectives, its federal and state reporting requirements, its business operations, and its internal communications?
  • Who will review the information above? How often? With what objectives? What controls exist to eliminate fraud and theft by professionals or staff in the FO?
  • What is the reporting role of third-party service providers, such as custodians, accounting firms, and investment consultants?

Coordinated Estate, Tax and Insurance Planning

With the complexity of the tax code, the high cost of estate and gift taxation, and the unpredictable and frequent changes in the interpretations and enforcement of the rules, there is no more important role for the FO than to stay constantly vigilant and aware.  Consistent application of core rules of investment management, such as diversification and liquidity, typically will protect families from catastrophic loss. This is not true in the area of taxes and estate planning.

Most FOs rely on skillful legal and actuarial professionals to advise in these matters and many FOs use multiple advisors to evaluate issues and create consensus on the more complex issues and structures. In addition, estate, tax, and insurance planning necessarily involve an increase in the number and type of entities, each of which requires separate accounting, reporting, and investment management, as well as the appointment of non-beneficiary fiduciaries.

Therefore, an FO must establish a program to manage these issues on an ongoing basis in order to evaluate the risks and the opportunities of legislative, regulatory, and judicial changes in the federal and state tax codes. Managing these issues correctly is essential for ensuring that wealth is extended to multiple generations and becomes part of a future legacy of wealth. It is a far more creative and complex burden than most families recognize.

Relevant Questions:

  • Who coordinates the professional advisors and manages the periodic evaluation of existing entities and arrangements Who can make changes?
  • Who solicits new ideas and methods (and ensures these matters are included in investment management decisions)?
  • Who is there to speak on behalf of future generations?

Philanthropy

Almost all families become involved in philanthropic activities both because of the charitable and educational interests they may have, individually and collectively, and because tax planning techniques present both a need and opportunity to address this issue directly as a method of reducing taxes.

Philanthropy is another management item for the FO and, here again, families can manage this activity either with third-party providers or FO staff or a combination of the two. Philanthropic entities, either a non profit corporation or a trust, face federal and state tax reporting and significant compliance issues, as well as specific contract-related issues depending on the terms and conditions placed on any charitable gift.

In many cases, families use philanthropy as an avenue for encouraging inter-generational communication, values clarification, and skills training. Philanthropy can play an important role in establishing a family culture that allows younger family members to learn important business concepts and work together in establishing objectives, analyzing data, and presenting and defending personal points of view.

It is widely understood that first generation family members have an emotional and psychological connection to their wealth because it is the product of their labors. Subsequent generations, however, often do not have a personal context for their inherited wealth and, therefore, have more difficulty establishing their own sense of responsibility for its proper use and preservation. Philanthropy often helps to close that gap.

Relevant Questions:

  • What are the goals of the philanthropy for the family, both individually and collectively? How are different views and interests accommodated? What impact does the family hope that philanthropy will have on the family members?
  • What are the goals of the philanthropy for the recipients? What impact does the family hope to have on the issues and institutions it addresses through its giving? How will it be measured?
  • Who will oversee the management and reporting of this philanthropic entity? Who will develop the criteria for and evaluation and oversight of the giving? Who will be the “public face” for the family’s philanthropy?

Intergenerational and Family Issues

From time to time, most wealthy families (like all families) will experience life events that will cause some amount of conflict and that will impact the management of their wealth. Matters involving divorce, re-marriage, extended families, and disagreements with minor age and adult children can create emotional, and often legal – and publicized – burdens on everyone involved.

As a family grows in number, and new individuals and generations become more interested in being involved in the management and use of the family wealth, there will be more opinions and desires to be considered. Internal family communications become much more important and challenging.

The role of the FO, first and foremost, is to avoid the destruction or dissipation of the asset base through poor investment management and to continue, as directed by the owners and fiduciaries, to accurately report and communicate the status and details of the family’s wealth.

In addition, the best FO managers will provide suggestions for creatively solving problems and resolving disputes within the family and will suggest how to incorporate consultants and advisors with experience in understanding the specific conflict at issue. Very often, the FO manager’s network and relationships with other FO managers and trusted advisors will be very helpful in indentifying the appropriate information and resources.

Relevant Questions:

  • What planning can be completed in advance to avoid or minimize known potential conflicts? Who within (or outside) the family has control of which assets presently (and in the future) and the authority to modify existing arrangements?
  • Who solicits new ideas and methods and ensures these matters are included in family planning discussions relating to trustees, beneficiaries, and distributions? Who thinks about unforeseen contingencies?
  • Who is there to speak on behalf of future generations?

Family Office Administrative Tasks

Most FOs are involved in the management and execution of numerous administrative tasks associated with wealthy families, including evaluating, hiring, and firing household and non-professional staff and vendors; managing personal banking relationships; paying bills; arranging travel; coordinating parties and other events; managing primary and vacation homes; managing aircraft and yacht operations; purchasing liability, automobile, and other insurances; assisting in the purchase of significant assets, such as automobiles, artwork, and jewelry; and such other matters as they arise in a family’s personal lives.

In the case of families with owned and operated aircraft or a large number of domestic and foreign houses, the number and cost of FO support staff may be quite high; as will be the burden of the oversight, accounting, and reporting for such operations. Obviously, as the number of family members increases, some of these FO services may or may not be available to, or even desired by, each family member.

In this area, there are no specific rules or guidelines and family preferences determine the kind and number of services provided by the FO. In every case, however, families must be sure to recruit to the FO the appropriate quality and number of professionals and staff.

Relevant Questions:

  • What administrative tasks will the FO perform? Who will manage these functions? What arrangements exist to ensure 24/7/365 coverage?
  • What rules exist regarding the use of FO professionals and staff by family members? What are the channels of communication to avoid conflict or abuse of FO staff?
  • Who manages the third-party providers and vendors? What controls exist to eliminate fraud and theft by FO staff and vendors?

Health, Safety and Security

There is no more important issue facing families than their health, safety, and security and yet, these are the most difficult issues for a family and a FO to analyze and manage. Many families often avoid addressing these issues entirely.

For the FO, the issues range from protecting the family from the most predictable events, which requires the usual and customary practices and tools, to protecting the family from highly unpredictable and uncommon, but catastrophic, events, which requires more elaborate and costly preparations.

Many FOs are involved in such matters as providing background checks and psychological evaluations of household and personal staff, vetting contractors and vendors with access to family property, maintaining medical records (often with online access), monitoring personal information in the public domain, installing and maintaining home and office security systems (both for property and communications), and generally being aware of potential risks to personal safety.

Some families desire more comprehensive security measures, which requires the FO to assess such services as safe rooms, protected vehicles, kidnap and ransom insurance, trained and armed security, foreign country extraction, and contingency planning for catastrophic events, such as pre-arranged helicopters, boats, and planes, and pre-positioned chemical and radiation protection. In such matters, the FO can work with a number of specialized companies that assess security risks and provide a wide range of solutions.

Relevant Questions:

  • Who is responsible for thinking about and suggesting solutions for issues relating to personal risk?  Who will manage risk assessment on an ongoing basis?
  • What risks does the family want to manage, at what cost, and how does the family wish to communicate about these risks to family members?
  • What resources will the family require when an emergency arises and who will provide them?

Conclusion: Next Steps

The business steps for creating a single family office are much the same as for any other business.

Step I:  After discussing your preferences and options with the appropriate lawyers, accountants, and consultants, and after consulting with your family, create a preliminary business plan for the FO, which should describe:

  1. Goals: What are the objectives and responsibilities of the family office? What do you want the FO to do for the family? In what order and in what timeframe?
  2. Structure and Ownership: How will it be structured legally? Who (or what entity) will own and control it? Note that new rules by the U.S. Securities and Exchange Commission define the scope of the family office, which persons are included in the definition of "family member," and who must own and/or control the family office.
  3. People and Skills: What skills are required to fulfill the objectives and responsibilities of the family office? Write the job specifications for the key professionals. Create an organization chart.
  4. Management and Communications: What information do you want from the FO? How, when, and to whom will information be communicated? What is the reporting structure?
  5. Costs: How much will the FO cost to operate? How much will various service providers cost? Create three or five-year draft financial projections. What is the source of funding?
  6. Service Providers: Which lawyers, accountants, investment advisors, family office, security, and other consultants will be used to assist the family office? Create a preferred service provider list.
  7. Operating Metrics: What are the appropriate metrics for measuring the performance and success of the family office? 

Step II:  Start the process of meeting with potential candidates for the job of “head” of the family office.

  1. Create a Job Description: The job description should describe a seasoned professional with legal or financial background who understands various asset classes and has a broad understanding of the numerous financial, legal, tax, and personal factors that impact a wealthy family.
  2. Together, Recruit a Team: A good family office CEO/COO will seek to recruit other skilled professionals who will have the specific expertise to manage investment selection and oversight and the accounting and tax functions. These three professionals likely will be the core team that builds your FO, works with you to provide solutions to your issues, and creates a culture of quality and loyal service to your family.

Step III:  Remember the two key criteria of successful businesses: first, they must be adaptable and flexible in order to meet their objectives in an environment of constant change and, second, they are only as good as the people who lead and manage them. The threshold question, therefore is, are you prepared to recruit, incentivize, and delegate to a team of loyal and talented professionals?

Topics:  Closely Held Businesses, Family Offices, Investment Management

Published In: Business Organization Updates, General Business Updates, Finance & Banking Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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