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Some Thoughts on Single Family Office Risk Management

By Marc J. Sharpe, M.A., M.Phil., MBA

Introduction

While most SFOs are founded to provide investment and concierge services for the family, perhaps the most important role of the SFO is to monitor and manage risk. With all investments and related activities managed by a single team, the SFO is in a better position than any individual family member, advisor, or external service provider to measure risk systematically and ensure SFO assets are protected. While a comprehensive risk-analysis discussion is beyond the scope of this whitepaper, a well-run SFO should be, at least, focused on the following risks a family may face:

Reporting Risk

SFOs tend to manage many, complex private entities within a broad portfolio of private and public investments, all of which report their individual performance at different times and in different formats. As a result, generating timely, accurate and comprehensive investment performance reports is one of the most difficult challenges for most SFOs. When a family considers creating an SFO, it should plan to allocate a significant portion of the annual budget to consolidated investment performance reporting related expenses. At the very least, a consolidated P&L and balance sheet should be generated and available to the team responsible for managing and oversight of the family office. SFOs that under invest in developing their reporting capability often find themselves trying to make decisions with inaccurate, outdated information.

Accounting and Tax Reporting

Most SFOs manage tax reporting and estimated payments for family members, who will have local, state, and federal tax filing obligations and may need to file in multiple jurisdictions. With complex holding structures, incorporating multiple pass­ through entities and grantor trusts, the task of com­ plying with tax reporting obligations can become very difficult. The risk is significant: failure to file accurate tax reports and make timely payments can subject the client to audit, interest, and penalties. In addition to working with in-house and outside tax counsel, to ensure timely filing and payments, the SFO will need to stay ahead of tax law changes and new filing requirements.

Estate Planning

Most SFOs play an important role in helping families put in place effective tax planning, and ensuring the plan is properly implemented. As with accounting and tax reporting, the prevalence of complex investment and wealth holding structures can lead to highly complex estate planning structures. The SFO will generally be responsible for coordinating with counsel on the development of estate- and gift-planning strategies and updating the plan as circumstances and assets change. SFO clients often include one or more multigenerational trusts created by prior generation family members, and the SFO is typically responsible for handling much of the administrative work for existing and new trusts, including maintaining accurate books and records, producing detailed accounts, and handling tax reporting and compliance. If the trustee of the trusts is a Private Trust Company (PTC), the SFO will typically manage administrative and investment functions for the PTC.

Investment Risk

In addition to direct investments in equities, fixed income and other securities, SFOs typically invest a substantial portion of the family’s wealth in mutual funds, hedge funds and private equity funds, in an effort to diversify the portfolio and boost alpha-related returns. Fund investments deserve careful due diligence before capital is committed and regular oversight reviews for as long as the investment is in place. Investing in funds can bring a variety of risks that need to be monitored by the SFO and its advisory team:

Asset Protection and Reputation Management

A major creditor claim – whether from a divorcing spouse, an injury occurring on family property, or con­ sequences of a car accident – can be a significant threat to a wealthy family. How a given asset is titled, held, and insured can be critical to managing such threats successfully. The SFO generally will be responsible for managing asset protection strategies and for implementing multiple strategies (such as limited liability holding structures, insurance, indemnification agreements) where circumstances warrant a layered approach. SFOs for celebrities and prominent families should develop detailed risk-management plans that lay out procedures for family and staff to follow in the event of an incident or emergency.

Such plans are particularly important for families that travel abroad frequently or maintain a high public profile. With the rising use social networking sites by family members, many SFOs are also developing reputation-management protocols to reduce the risk of identity theft, kidnapping, extortion, or harassment of family members.

Background Checking & Monitoring

One of the biggest risks to a wealthy family is a theft or other crime perpetrated by a member of the family’s inner circle of staff, advisors, and service providers. Most SFOs undertake detailed background checks of potential hires, and many do extensive vetting of advisors and service providers as well. Appropriate monitoring of the SFOs staff and external advisors should be an ongoing activity, not simply a one-time event at the time of hire.

About the Author

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at Rice University and SMU Cox School of Business. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

Some Thoughts on Single Family Office Infrastructure

By Marc J. Sharpe, M.A., M.Phil., MBA

Introduction

The structure of your SFO will depend on the jurisdiction(s) in which it will operate and the types of investments the family owns or intends to own…

Many SFOs in the USA are structured as limited partnerships or limited liability companies and are organized similarly to hedge fund management companies (i.e. the SFO entity does not own any of the assets it manages; rather, it is a service entity that provides services to the SFO’s clients on a contract basis). It is highly recommended you engage with experienced securities counsel who have worked with other family offices regarding the potential impact of SEC rules on their structure and operations.

Dodd Frank and SEC RIA Registration

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, an organized effort was undertaken by single family offices nationwide that successfully convinced Congress to exempt SFO’s meeting certain criteria from the definition of investment adviser under the Investment Advisers Act of 1940 (previously, such family offices were deemed to be investment advisers and relied on the ‘less than 15 clients’ rule to avoid registration under the Act, a rule that was eliminated under Dodd-Frank). The Securities and Exchange Commission (SEC) promulgated the final ‘family office rules’ on June 22, 2011. An SFO that does not fit within the definition of a ‘family office’ or qualify for an exemption as a bank trust company must register with the SEC. While some family offices have opted affirmatively to register with the SEC, others are greatly burdened by the increased administrative burden and loss of privacy that registration imposes.

Any individual or entity providing ‘investment advice’ must register as a Registered Investment Advisor (RIA) unless an exemption is available. Registration can be costly and entails detailed disclosures that families typically are reluctant to make. An RIA must maintain and preserve specified books and records and make them available to Commission examiners for inspection.

An RIA must also implement substantive compliance programs, prepare, and file reports with the SEC, and provide detailed written disclosures to their clients (known as ADVs). Every RIA is subject to SEC audit. Failure to register may subject an advisor to criminal and civil sanctions and penalties. SFOs may avoid registration by:

Private Trust Company

With a Private Trust Company (‘PTC’), a family­created entity, rather than a third party, serves as trustee of the family’s trusts. Private Trust Companies are sometimes recommended by advisors as a mechanism to avoid RIA registration, but PTCs may also offer substantial additional benefits for the SFO:

SFOs seeking to establish a PTC primarily to avoid RIA registration are advised to consult knowledgeable securities counsel with experience advising family offices.

Structuring Investments

The various investments managed by an SFO are typically held in individual limited liability entities, to reduce the risk that losses and liabilities from one investment will affect another. For example, if the SFO holds commercial real estate, each parcel of real property is best held in a separate entity. If a passer-by slips on the sidewalk in front of one building, incurs a severe head injury and sues for medical expenses and lifetime maintenance, any liability in excess of the SFO’s casualty coverage will be limited to the assets of the entity that owns that building, thereby protecting assets held in other entities.

SFOs are increasingly utilizing sophisticated holding structures such as tracking partnerships. A tracking partnership permits family office clients to hold different partnership assets in different percentages, with performance results tracking accordingly. By way of example, assume the tracking partnership has four separate classes of interests: Class B (bond portfolio), Class S (indexed stock portfolio), Class A (alternatives portfolio) and Class R (REIT portfolio).

• Partner 1, an individual seeking a broadly diversified portfolio, might hold a 10% interest in Class B, a 10% interest in Class S, a 20% interest in Class A and a 15% interest in Class R.
• Partner 2, a trust intended to fund education expenses for Partner 1’s 10 grandchildren, might hold 40% of Class B and only 5% of each of the other classes.
• Partners 3, 4, and 5 would hold the balance of the interests in each Class, each in accordance with their individual investment goals.

A tracking partnership gives partners the investment flexibility they would have if they formed several partnerships but permits them to trade between classes from time to time without recognizing gain or loss for tax purposes. Such partnerships offer considerable flexibility, custom tailoring of client portfolios, and a consistent governance model for SFO clients. However, they also bring with them complex tax, accounting, and reporting issues, and so need to be designed with the help of knowledgeable legal and accounting counsel and managed with care.

Carried Interests

A carried interest is a share of profits from a partnership or LLC that is paid to a participant who did not provide any capital to the venture. A carried interest may provide a tax-efficient mechanism to fund family office expenses and may be used to structure incentive compensation opportunities for SFO staff. Particularly considering Dodd Frank and the SEC’s family office exemption, staff participation in SFO investments should be reviewed to ensure that they do not unintentionally trigger RIA registration requirements. SFOs are strongly advised to seek guidance from tax and accounting advisors before putting in place any carried interest structure or incentive compensation plan for SFO staff.

Insurance

A critical task for any SFO will be monitoring and managing risk for the family. Property and casualty, liability, health, and life insurance typically will be overseen and coordinated by SFO staff through relationships with an insurance firm that has experience working with SFOs and a comprehensive offering of insurance products. Certain assets, such as private jets and other aircraft, require unique holding structures, insurance coverage and regulatory compliance.

As the SFO grows and its clients and investments change over time, it is a good idea for the family and CEO to undertake a structural audit from time to time, to make sure that the SFO structure is optimal for its purpose. The audit may uncover opportunities for eliminating or reorganizing holding entities within the structure, thereby reducing reporting, accounting, and compliance expenses for the SFO.

Business-Owning Families

Many business-owning families create a family office within the business administrative group. The company’s accounting team handles personal tax filings and financial record-keeping, while administrative staff keep track of insurance, record-keeping, and bill-paying. The benefits of an embedded SFO are obvious: the family can leverage an existing resource, so the family office appears to be extremely cost-effective.

However, there are serious drawbacks to setting up your SFO in this way. First and foremost, the focus of a family office (i.e. wealth preservation) will be very different from the focus of the operating business (i.e. wealth creation). A dual staff will often struggle to manage the varied responsibilities and objectives, and skills that are critical in the business may not necessarily translate into the family office realm. For example, partnership accounting and reporting for trusts and complex investment structures is very different to corporate accounting, and staff may lack the time, training, and technology to handle both jobs well. The legal structure and governance of an SFO will also be quite different than those of the business, and mistakes may occur when business practices are automatically carried over to the family office. Lastly, priorities may be unclear, such that if an emergency occurs in both the business and family office, at the same time, there may be significant conflict or a lack of sufficient resources to tackle both. Risks of gaps in reporting and compliance increase exponentially when the same staff are responsible for both the business and the family office.

Families with operating businesses are recommended to seriously explore developing a separate family office to handle their personal investments and manage their non-business assets. Having a separate office provides for greater privacy and confidentiality and allows for hiring staff with the specific skillsets required by the family office. A dedicated family office staff, not subject to the hiring practices of the corporation, will facilitate the development of an SFO-specific organization chart, with separate responsibilities, compensation, and work practices. This will also allow for a longer-range focus for the family’s personal strategic planning, as distinct from that of the operating business.

Building the family office apart from the business also increases opportunities for involvement of family members who don’t participate in the business. By expanding family involvement, the SFO can become a force for strengthening family cohesion. Some families are using their SFOs to create entrepreneurial venture funds, investing in promising new businesses and technologies, and thereby increasing the odds of growing rather than simply preserving the family’s capital.

About the Author

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at Rice University and SMU Cox School of Business. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

By Marc J. Sharpe, M.A., M.Phil., MBA

Introduction

Creating an SFO to fit your family’s specific needs and circumstances requires considerable thought and preparation. Families considering forming an SFO should put together a motivated group of family leaders and trusted advisors to lead the planning effort, with input from outside specialists, as necessary. The following, while not totally comprehensive, serves as a helpful checklist to get started:

Mission Statement

Families planning an SFO should take time at the outset to consider the purpose of the SFO and its role within the family. A critical early task in setting up an SFO is defining the mission of the family office. Developing a concise, focused mission statement to guide the work of the SFO will help to avoid ‘mission creep’ in future years. The founders should avoid drafting a mission statement that is vague and short on specifics. A consultant can help a family mold its vision and values into a practical and useful tool to guide the work of the SFO for generations to come.

Needs and Objectives

There are three critical questions to be addressed early in the planning and development phase of creating your family office:

1. Who are the clients?

Defining which individuals and entities will be served by the SFO is a critical activity. A comprehensive list should include all individuals and entities to be served, including family branches, investment entities, businesses, trusts, trust companies and foundations. The design of the SFO will need to consider each client’s unique needs and requirements.

2. What assets will be managed?

Once the clients have been identified, a list of all the assets the SFO will be responsible for managing is needed. This will include marketable securities, hedge funds, MLPs, direct investments, oil & gas leases, operating businesses, residential real estate, commercial real estate, farms/ranches, collections, aircraft, yachts, horses, sports teams, etc. The SFO will need to hire or outsource the specific expertise needed to oversee and manage the assets.

3. What services are needed?

Families with extensive investments, or with liquid capital to be invested, will need investment management services, including an investment policy statement and asset allocation plan, manager due diligence, and investment reporting. All SFO clients will need comprehensive and accurate performance reporting, accounting, and tax-return preparation. Coordination of risk management – such as insurance, security, and reputation management – will also be needed. Development and coordination of estate and tax planning, possibly including management of a private family trust company, is another obvious need for multi­generational families, but can be equally critical for a first generation entrepreneur who wishes to perpetuate the family’s long term legacy. Other possible services include property management and staffing, bill payment and concierge services.

The adage of “shirt sleeves to shirt sleeves in three generations” is well known. It has been documented throughout the world, across numerous countries and cultures. It is one of the driving reasons why many families of wealth recognize the need for proper family governance and family wealth-planning strategies during the lifetime of the family wealth creator. However, even after implementing a family governance system during the design phase of an SFO, families must constantly refine and re-evaluate their values, vision, and mission as their SFO adapts to the changing needs of the family and the global environment.

Business Plan & Budget

Once the clients, assets and needs have been identified, a business plan can be developed that outlines the services to be provided, a short and long-term timeline, employee and outsourced talent required, service partners required (for example, custodians, tax counsel, security services) and technology needs.

A key objective in developing a business plan should be determining the budget. SFOs are not inexpensive to operate. However, when compared with the expense of managing the family’s assets via an outsourced or third-party solution, taking into consideration all costs, fees and expenses, the expense of an SFO will likely be lower. Certainly, because the SFO will be custom-tailored to the family’s needs, the return on that expenditure will be much higher.

Typically, SFO budgets are defined as a percentage of assets under management. SFO operating costs vary widely, with smaller SFOs, or those managing complex assets, costing more to operate than larger SFOs, or those managing a simpler portfolio, because there are fewer economies of scale to exploit. The budget of an SFO managing an extensive portfolio of alternative investments and commodities for three generations of family members, all of whom also share a passion for modern art and house their collections in multiple homes around the world, will necessarily be larger, both as an absolute number and as a percentage of assets under management, than the budget of an SFO managing a portfolio of publicly-traded securities for a single family unit. The budget will drive the creation of benchmarks to set expectations for SFO performance.

An SFO serving the needs of a multi-generational family must consider how the costs will be allocated and charged to individual clients of the SFO. Future conflict between family office clients or between the family and the office can be avoided if the method of allocating expenses, determining the expected contributions by each client, and collecting fees is made explicit from the outset.

Leadership and Staffing

The plan should identify the expertise required to meet the specific needs of the SFO’s clients, given the specific assets to be managed and the available budget. The plan should also specify whether such expertise will be provided internally or outsourced. Once staffing needs are determined, the issues of location, office space needs, technology, security, administrative support etc. can be addressed.

Finding the right talent is generally the most challenging aspect of setting up an SFO. Ideally the CEO candidate should be identified first (if this task has not already been completed). Because the CEO of an SFO must work closely with the family, the office staff and with a wide array of outside service providers, the CEO must have excellent organizational, management and people skills. Choosing a CEO purely because of his or her technical expertise in investing, or in accounting, or in tax planning, is generally a mistake. Often, families will give this important position to a trusted advisor or the controller of their operating business who has been loyal for many years. This can also be a mistake if the trusted advisor or controller is not scalable into the CEO role. Because the CEO carries out a high-level executive function and serves as the family’s face to the outside world, candidates should have proven experience leading, managing, and communicating successfully in a wide variety of complex situations. It is a critical role to fill, since once identified and hired, the SFO CEO will take on the role of carrying out the buildout of the SFO in accordance with the plan.

SFOs often hire investment team members with extensive prior experience at private banks, investment houses and hedge funds. Such talent is highly sought after; candidates often demand investment rights or bonus compensation based on investment performance. The SFO should take care in structuring such arrangements, particularly considering the Dodd-Frank Act’s requirement that family offices comply with RIA registration requirements unless they fit a very narrow exemption. SFOs, both new and established, should seek advice of experienced counsel when bringing on new investment team members or adding new benefits such as carried interest.

All staff members, at every level, should go through a background check and sign non-compete, non-solicitation and non-disclosure agreements. Whether the SFO is large or small, it should have an employee policy manual. The manual should be reviewed and updated at least annually by knowledgeable counsel.

The SFO should be overseen by a board of directors, which will meet regularly and be responsible for setting strategy and overseeing the CEO. Most families control the board of their SFOs, to ensure strategy is in line with the family’s wishes. Many SFOs are following the lead of private businesses and bringing independent advisors onto the board to provide outside perspective and expertise.

Contingency Plan

Planning for the SFO should include development of a contingency plan that outlines procedures to be followed in the event of a natural disaster, extreme volatility in the financial markets, theft, or technology breach or failure. At the most basic level, the contingency plan should include provisions for ensuring the safety and security of the family, its critical information and tangible assets, safety of the SFO staff, off-site backup of all information, and a plan for re-establishing critical office activities off-site as quickly as possible.

About the Author

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at Rice University and SMU Cox School of Business. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

By Marc J. Sharpe, M.A., M.Phil., MBA

Introduction

When you think about starting a family office or implementing a leadership change at your existing family office, the people you hire will determine to a large extent in what direction you go, and how successful you are. Of course, “if you don’t know where you’re going, any road will take you there.” George Harrison’s 1988 paraphrase of a famous exchange between Alice and the Cheshire Cat in Through the Looking Glass (1871) offers a cautionary lesson for any leader that does not have a clear vision for their organization.

Lack of direction can impact the most talented and competent teams, and result in a sub-optimal outcome for everyone. And it’s easy to confuse activity for results when you lack direction or key organizational objectives which determine your priorities. In such situations, mere survival is probably the most you can expect from your team.

Preventing a sub-optimal outcome requires an understanding of your organization’s purpose and the team you’ve built to serve that purpose. The tools you have at your disposal are your existing relationships, your financial resources, and the lens you use to perceive the world. These tools will lead you down a path that may or may not be ideal for what you ultimately want your family office to achieve. In economics and systems theory, the Cheshire Cat’s wisdom is expressed through the language of “path dependency” which describes this phenomenon. Simply put, decisions in the past shape the possible options and outcomes available to you in the future. ¹ Understanding the path dependencies that shape how information is perceived and managed is therefore vital to creating the team that is best designed to accomplish the objectives of your family office. After first considering some of the common path dependencies that shape family office team design, we will offer recommendations on how to manage these potential constraints. We will also provide some thoughts on how to incentivize and retain top talent once you select the right path for your organization to follow.

When it comes to structuring your family office, broadly speaking, there are three common path dependencies that family offices typically follow:

1. Trusted Informal Relationships

2. Trusted Formal Relationships, and

3. Professional Management.

These three paths describe the most common genesis points for any family office; and they typically predict the set of outcomes, strengths, and weaknesses that will define your family office, determine the road you are on, and the direction you are heading.

Trusted-Informal Relationships

With any major decision, our close friends and family are often the first people we turn to for help. The decisions that surround the formation of a family office are no exception. Frequently, the first hire at a de novo family office is a “Trusted-Informal Relationship”. Examples of such relationships include college roommates, in-laws, old friends, and trusted former co-workers. These relationships are based on trust and have often been built over the course of a lifetime. They are precious and often deeply treasured. But are they truly the best people to build or run your family office?

From a path dependency perspective, Trusted-Informal Relationships are the most varied and hard to predict because the individuals themselves represent such different backgrounds. Although their skills may be diverse, what remains consistent is an extremely high level of trust and personal connection to you and your family. In the best situations, Trusted-Informal Relationships have the skills you need to build your family office and can speak candidly and directly, especially when it comes to challenging your ideas in ways that others would not feel comfortable. The highest and best use of their trust is to act as a counterpoint to challenge your own ideas in ways that are helpful and productive. Inversely, these individuals can struggle and fall short when they lack the confidence to speak up or the skills needed to build a high functioning family office team.

Trusted Formal Relationships

This category typically includes your trusted CPA, trust and estate attorney, or the company controller from your operating business, as an example, that has faithfully served you for many years in a professional capacity. These are people that have earned your professional trust (although perhaps not the same level of personal and intimate trust as those in the prior category).

As it concerns path dependencies, one of the challenges of hiring these people to build and run your family office is that they are often specialists and do not have the breadth of skills needed to build out a multi-faceted singe family office. The proverb “if the only tool you have is a hammer, every problem is a nail” comes to mind. This phrase captures the very nature of path dependency relationships and is especially applicable when it comes to the Trusted Formal Relationships that make up a family office leadership team. An individual whose primary strength and expertise is in accounting will typically think about problems and solutions according to the logic of accounting. Similarly, a team that is primarily composed of private equity professionals will most probably apply a range of risk analysis and mitigation strategies to most aspects of the family office business. The ability to bring diverse backgrounds to problems is what generates new and better solutions, but it is easy to either push a team too far from their comfort zone; or worse, to miss out on practical solutions simply because it is outside the comfort zone of your team.

Trusted Formal Relationships can be most successful when they are empowered to engage outside experts to help in areas where they do not have the requisite knowledge and experience. Asking for help should be encouraged and finding ways to meaningfully expand the skill sets of your team will provide long-term value for your family office. In these situations, understanding the limits of your team’s knowledge and expertise is often more valuable than the knowledge itself.

Professional Management

Consider the professional backgrounds of your leadership team and how those backgrounds line up with the long-term vision and goals of your family office. Most often, professional family office managers come from the world of wealth management, private banking, and private equity. However, this category extends to a whole host of high level strategic operations and includes newly emergent professional roles, including Chief of Staff. In addition to a deep understanding of the investment landscape and financial world, the networks, and relationships these professionals bring are often their greatest asset.

While these offices excel in matters of due diligence, structuring, and packaging investments, they sometimes lack the ability to connect their expertise with the long-term vision of the family, especially if compensation packages are not aligned appropriately. A mis-alignment of incentives can also lead to family offices that are extremely transactional in nature and which operate like privately owned hedge funds or private equity firms. These kind of family offices sometimes appear to be extremely transactional in nature. However, with the right team in place, and the right incentives, it is possible to build a highly effective investment office. Encouraging and incorporating a generalist-specialist approach with special attention to intergenerational transitions, long-term views, and building governance around family mission statements and investment mandates will help.

Managing Path Dependencies: The Generalist-Specialist Approach

The various starting points, and the path dependencies that produce an infinite spectrum of family offices (“each one is a snowflake”), is also a function of the breadth of services that a family office can provide.² Every family office is going to have its strengths and weaknesses, and every family office will be called upon to undertake projects that are outside the comfort zone of the team. Understanding the path dependencies that shape your family office can help you identify the types of cross-functional roles that will be needed to support and enhance your team’s capabilities.

The various starting points and path dependencies that produce an infinite spectrum of family offices (“each one is a snowflake”) is also a function of the breadth of services that a family office can provide.³ Every family office is going to have its strengths and weaknesses, and every family office will be called upon to undertake projects that are outside the comfort zone of the team. Understanding the path dependencies that shape your family office can help you identify the types of cross-functional roles that will be needed to support and enhance your team’s capabilities.

For many, it’s impractical and unwieldly to hire a slew of full-time experts dedicated to different aspects of the business. And one might argue that the correlation between expert knowledge and success does not always lead to new and better solutions. This common cognitive bias is called “the expert myth.”⁴ However, more often than not family offices require cognitively flexible and dynamic individuals that can accommodate a broad and diverse set of challenges. In fact, the entire phenomenon of creative economic disruption is based around the assumption, and historical evidence, that bringing new ways of thinking to old industries creates an economic and organizational net benefit.

The path dependencies of family offices and the bias of the expert myth both point toward the same set of solutions: the best and most resilient family office teams are made up of diverse groups of individuals that all have different backgrounds and areas of expertise. Managing teams like this is especially difficult, because the teams themselves represent so many different styles of thinking and working. As such, the best approach in this context is to take a “generalist-specialist” approach. The generalist-specialist knows a lot about a lot of things; and would be equally comfortable speaking with private equity analysts, trust and estate attorneys, business operators, family office principals, and many more. These types of individuals are often difficult to find through recruiters who are more accustomed to hiring highly defined functional or industry roles (i.e., the proverbial square peg for the square hole).

The generalist-specialist resume and professional background by contrast will typically show a diverse set of experiences. Cognitive flexibility, adaptive communication and empathy, the humility to know when experts are needed, and the confidence to know when and how to push against conventional wisdom are the hallmark traits of a generalist-specialist.

Whether the generalist-specialist you chose to lead the family office has the title of CEO, President or Chief of Staff, the actual responsibilities of the role depend much on the trajectory of the family office itself. Every family office will have its own organizational biases and path dependencies. What’s important is being able to identify the path dependencies that affect your own family office, understand what areas need to be improved based on the current and future objectives of the family office, and to design the most resilient and durable team for your needs.

As you consider how to build out or enhance your family office leadership team, consider the path dependencies that shape your current team’s capabilities. Instead of simply identifying what kind of experts you need to hire, consider cross-functional “generalist-specialists” that will both contribute to the current team and evolve with the myriad needs and desires of your organization going forward. This not only allows you to retain top talent for longer, but it is also often more cost effective and organizationally efficient over time. The road is long, and great talent is hard to find, but identifying highly adaptive leaders that can grow alongside you is well worth the effort.

About the Author

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at Rice University and SMU Cox School of Business. Contact: marc@tfoa.me

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

Impact Investing: What Family Offices Must Consider

By Marc J. Sharpe, M.A., M.Phil., MBA and Seth Morton, Ph.D.

John D. Rockefeller retired in 1897, at 56 years old, having accumulated more private wealth than anyone in the history of capitalism. His retirement from for-profit enterprise made way for an equally vigorous career as a philanthropist. As a devout Baptist, he believed that it was his duty to continue working, but now instead of trying to make profit, he sought enterprises that would allow him to give his money away. What we might refer to as “The Rockefeller Model,” divides one’s career into two distinct halves: a career of wealth accumulation and a career of charitable activity. More contemporary philanthropic standards, like The Giving Pledge, and the rise of large foundations sponsored by family wealth, exist within, and expand upon the Rockefeller model.

While that model will continues to this day, with Bill Gates as the obvious modern day analog to John D Rockefeller, a new paradigm is emerging, with a set of practices that are reconfiguring how people think about business, capitalism, wealth accumulation, philanthropy, ethics, investments, returns, and value. Terms like “conscious capitalism,” “double bottom line,” “impact investing,” “environmental, social, & governance investing (ESG),” “sustainability,” “mutual aid,” “shareholder vs stakeholder outcomes” are introducing a new lexicon into the world of philanthropy and investing. The result is that the bright line between for-profit business and mission-driven philanthropy is becoming murkier and murkier every day.

In a generous reading of the situation, entrepreneurs and analysts are asking good-faith questions about the relative efficiency of capital. They ask, is it possible to structure a for-profit business in a way that would relieve the pressure for philanthropic activity altogether? Would that not be a more efficient use of traditional corporate capitalism? In a less generous reading, these activities greenwash (sometimes dubious) investments with marketing designed to pull at the heartstrings and make it appear a little more tolerable to allocate good money into questionable deals¹.

While it’s useful to keep the good faith and bad faith renditions of these arguments in mind, the primary purpose of this whitepaper is focused on understanding the landscape of impact investments, and defining what is often a vague and ill-defined nomenclature, in order to help family office investment teams navigate these murky waters. In the face of a rapidly changing environment, it’s all the more important to understand the ground you’re standing on. In the context of impact investing, that means being able to make distinctions between the major trends in impact investing in order to develop your own methodology for incorporating these ideas into your diligence process. It’s also important to maintain a bright line distinction between for-profit and not-for-profit activity. While the landscape around for-profit business is evolving, that is no excuse to simply collapse mission driven goals together with for-profit activity. At their root, these designations are important tools in your total balance-sheet, especially as you’re looking to optimize tax efficiency.

Defining Terms

The four most common terms used to describe these emerging strategies are Impact Investing, ESG (Environment, Sustainability, & Governance), Sustainability, and Conscious Capitalism. These terms overlap in many ways and differ in others. In casual conversation they’re often used confusingly and interchangeably. What these terms share is a commitment to a profitable outcome, measured financially, as well as a commitment to another set of values, measured according to a different set of metrics. Additionally, there is a shared belief across these philosophies that the consideration of non-financial factors should not come at an expense of the ultimate bottom line. To the contrary, the position that these investment philosophies uphold is that a more complete understanding of impact and investment outcomes will ultimately increase the value of the investment.

Impact Investing

The term “impact investing” is, in our opinion, the broadest, most all-encompassing, and least meaningful. Looked at from one angle, almost anything can be construed as an “impact investment.” This very article has used the term “impact” because of its capaciousness, not because it carries with it a special meaning. “Impact Investing” is a placeholder term. It shows that the organization using the word is either making a space for further definition or is trying to reframe (or greenwash) an existing investment or strategy in order to make it seem more impactful than it might otherwise be.

The problem with the term is that there are no standards or considerations as to what would make an investment an “impact” investment. As a family office investment analyst, you should engage with the term “impact” with care. If you’re evaluating an “impact investment,” be sure to drill down into the specific ways the sponsor understands and defines the term. In the best-case outcome, pressing this line of questions will reveal a more comprehensive strategy; in the worst case, the term will be revealed as a largely meaningless designator, like the word “unique.” In either case, it falls to you to evaluate of the true investment impact and the extent to which it aligns with your family office goals and values. Be aware that the term impact may not carry the weight you want it to. Expect that an engaged audience will ask you to further define what you mean by impact.

Sustainability

Although “sustainability” is a popular concept, in the realm of impact investing it is not much more meaningful than “impact.” A sustainable investment could be focused on a set of environmental outcomes, as in a company that is not degrading or damaging the local community or environment; or it could refer to a capital strategy that is “sustainable” in that the business has a low turnover, efficient with capital, and requires little from outside managers.

Whereas “Impact” is ambivalent and omnidirectional in its provenance, sustainability adds a sense of efficiency. A business might qualify as sustainable if it has a high employee retention rate, efficient capital management, or a low energy or environmental impact. In contrast to “impact,” “sustainability” also imparts a notion of maintaining the status quo. To sustain is not necessarily to change, and this might be the most important difference between it and impact.

One way that “sustainability” becomes more meaningful is through an organization like US SIF, The Forum for Sustainable and Responsible Investment. US SIF takes “sustainability” as their watchword, and underneath that term they build an understanding of environmental, social, and governmental metrics (ESG). The mission statement of US SIF is to “rapidly shift investment practices towards sustainability, focusing on long-term investments and the generation of positive social and environmental impacts.” US SIF expands this mission through its declaration of values; “environmental, social and governance impacts are meaningfully assessed in all investment decisions resulting in a more sustainable and equitable society.”² US SIF connects with international advocacy groups; offers education for asset managers, retail investment professionals, financial advisors, and community-based investment platforms; develops policy proposals for investments via the SEC; and acts as a central hub to build a network of investment professionals that are committed to a shared set of standards for sustainable investments.

While the US SIF is a major player in the space, it is not all things to all people. They work with some large family office foundations, however the major focus of their education and advocacy is directed toward retail investors and investment managers. Family offices often have more institutional needs and capabilities, as such these retail-focused offerings should be read through the lens of your particular family office needs, wants, and capabilities. If “sustainability” is the key word that is driving your family offices’ efforts in impact, be sure to carefully define the term according to your target outcomes.

Environment, Social, and Governance (ESG)

ESG Investing was one of the first technical approaches to frame this kind of thinking within the context of more traditional securities analysis. The CFA Institute uses ESG in order to mark a set of risk-mitigating protocols and considerations that any securities analyst or marketing firm should utilize in an effort to market or analyze a security.³ The terms themselves are meant to be somewhat open to interpretation, because the ultimate outcome that the CFA wants to cultivate is one focused on a more comprehensive risk matrix. As such environmental may refer to specific environmental risks associated with an energy plant or with the health and safety concerns within an oil refinery; social risk might refer to strained relationships between management and the labor force; and governance might refer to potential regulatory changes or shareholder activism.

In the rather dry landscape of risk-mitigation, it’s no wonder why an organization like US SIF is compelled to overlay ESG with their concept of sustainability. ESG on its own does not necessarily lead to an “impact” or “sustainable” outcome. While ESG is the most robust framework for analyzing and measuring various forms of risk analysis, it’s also the easiest to “greenwash” investments, because the metrics themselves do not require any special lens in order to qualify as a sound “ESG” measured investment. On their own, ESG considerations are helpful in producing sound analysis, but they are insufficient in underwriting an impact outcome on their own. When evaluating ESG opportunities, pay special attention to the values that are motivating these metrics. Is it coming from a well-grounded theory of sustainability or mission-driven objective, or is it merely a more comprehensive way to risk-mitigate the security or investment? Or something worse, an attempt to greenwash an investment by ticking the boxes on an ESG checklist?

Conscious Capitalism

In comparison to the three terms above, conscious capitalism simply introduces a new lexicon to what is an old conception of how capitalism, when done right, should be practiced. The term as its commonly used, refers to a set of practices that aim at achieving a broader and deeper understanding of capitalism as an economic endeavor. The intended result of these practices is twofold: First, the shift of focus moves from strictly maximizing (short-term) shareholder value to include optimizing outcomes for a broader set of stakeholders. These stakeholders may include anyone who is affected by the business’s activity. When decisions are made in light of stakeholder outcomes, then stronger (long-term) alignment emerges between the business, its owners, operators, customers, and the community. Second, the time-horizon expands to consider longer-term outcomes. Consciousness in this sense not only refers to an awareness of how decisions you make today have an impact today, but also how the decisions you make today will impact your stakeholders further out into the future. These two insights are intertwined, but distinctly refer to two different sets of analytical and operational practices.

Organizations such as Conscious Capitalism Inc., a non-profit organization, supports business leaders that want to incorporate these kinds of practices into their business culture. Other such organizations – like Good Business or Certified B Corporation – are similarly aligned non-profit organizations that hope to cultivate a new understanding of business. Their credo is as follows: “We believe that business is good because it creates value, it is ethical because it is based on voluntary exchange, it is noble because it can elevate our existence, and it is heroic because it lifts people out of poverty and creates prosperity. Free enterprise capitalism is the most powerful system for social cooperation and human progress ever conceived. It is one of the most compelling ideas we humans have ever had. But we can aspire to even more.”⁴

From this credo four core themes emerge: Higher purpose, stakeholder orientation, conscious leadership, and conscious culture. Unlike ESG risk analysis, or even the educational tools offered by an organization like US SIF, implementing conscious capitalism in your investing strategy requires a more holistic and philosophical approach. To put it bluntly, it requires that you take seriously the “conscious” part of the equation. The ultimate purpose of conscious capitalism is the development of a prosperous ecosystem, one that encompasses all of the terms discussed above. In some ways this is the highest bar to achieve as a portfolio manager, but it is also the most rewarding.

Conscious capital practitioners believe that private enterprise has an important role as a force for good in the world. If your family office is looking to develop a more sophisticated approach to ‘impact’ investing, we recommend this approach as one worth exploring further. Of course, as with all investment-related endeavors, the more you know about your desired outcomes, the more you can navigate these waters.

Final Thoughts

Impact advocates insist that there is moral and financial premium that is earned through impact investing. According to this view, impacting investing is not only good, but it is also more profitable in the long run. In some cases, this may be the case, and over time that may be easier to achieve, but more often than not there will be trade-offs and sacrifices that a Chief Investment Officer will have to make in order to achieve a desired impact target. Given the potential trade-offs, it is especially important to define what objectives and concepts are most important to your family office investment plan and to organize your portfolio according to how your current holdings line up with that plan. With that initial knowledge you can start to implement an allocation strategy that slowly incorporates more opportunities that achieve your desired impact outcomes while maintaining overall fund performance.

The world of capital is a lot more complicated than it was for John D. Rockefeller. While there is a temptation to think that the abundance of new terms related to investing with ‘impact’ is merely the clever proliferation of greenwashing tactics, the truth is that these terms point to a vigorous and ongoing secular shift, raising fundamental questions about best practice for a family office’s investment capital. This whitepaper only scratches the surface of a topic that is on the mind of every investment professional and institution today. The sheer breadth of the terms we discussed speaks to the many challenges that will likely cause this subject to remain ongoing and undecided for the foreseeable future. Looking ahead, we hope to see the emergence of more concrete standards and metrics. In the meantime, there is an opportunity for family offices to lead by example by simply initiating these conversations and beginning to implement specific strategies.

About the Authors

Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at Rice University and SMU Cox School of Business. Contact: marc@tfoa.me

Seth Morton, Ph.D. has served family offices in areas of investment diligence, execution, and management; governance; research; communications; and multi-generational, sustainable legacy planning. He seeks to improve team performance by cultivating learning-focused and communications-driven processes that deliver exceptional results. He and his family are currently based in Texas.

About TFOA

The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info

Disclosures

The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.