Nancy Curtin discusses best practice in managing investment governance in a single family office.
Nancy Curtin works with a number of multi-generational Single Family Offices. Now CIO of Close Brothers Asset Management, she shares her insights on some of the key things to consider when establishing the parameters of the family board and its investment governance. What is the most important thing any family needs to think about when starting an investment committee?
Firstly a family needs to decide if they want to manage the capital collectively. This requires that they come together and agree an overall set of risk, return and investment policy objectives. The advantages of a collective strategy and pooling of assets means potentially access to better investment managers, better power in negotiating fees and cost efficiencies in managing the SFO in connection with leakage costs such as legal, accounting and vehicle structuring.
Bear in mind, however, not all families want to work together. They have a choice, and they can distribute, splinter or manage assets collectively. This is the biggest step, first to agree that they have “alignment” and want to invest together. Once they have agreed in principle that they want to work as a unit, they then need to form a Family
Board to agree the details.
What detailed questions do they need to answer?
The Family Board needs to reach a consensus on what are they trying to accomplish in investment terms. This involves answering a number of questions.
What are the return objectives?
What risks are they willing to bear?
What liquidity is appropriate?
Tied to liquidity, what are the incomen and draw-down needs of the family?
What is the investment horizon and base currency?
What asset classes is the family comfortable with and how will they select managers or investments in these asset classes?
What risks do the family wish to avoid and how best to monitor these risks?
Underlying these questions is the need to agree along-term Strategic Asset Allocation with tolerance bands around different assets classes, and a mechanism either as a family or with an external adviser to make tactical asset allocation decisions in order to respond to changes in market conditions.
The family needs to decide whether they are going to employ a family member to do the investment work, or hire external professionals. These issues take a long time to agree collectively. Of course, it can help when families have a strong leader, normally a patriarch or matriarch or a financial specialist.
Once the family has agreed on these and a range of other issues, they should codify their agreed understanding by way of a Family Mission and Investment Policy Statement (IPS). The Family Board then needs to have regular board meetings to review progress against objectives set out in the IPS.
What are the most common investment models you see?
A popular model had been the so-called “Yale” or endowment model, but since the financial crisis, families have come to learn that this is not an investment panacea and needs to be adopted to meet the family needs. The Yale Model is an investment strategy named after the university endowment that popularised the concept. The strategy produced superior returns over 15 years and made the Yale endowment the envy of large institutional and family investors. The idea of the model is that large investors such as SFO can achieve superior returns by shifting a significant portion of investments away from traditional stocks and bonds and into carefully selected illiquid asset classes such as hedge funds, private equity, real estate, and other alternatives. The theory is based on capturing a premium return by investing in high conviction illiquid assets.
However the model proved to be a challenge for many large SFOs, particularly during the financial crisis for two reasons:
1. The model requires access to the best investment talent, and hence strong manager selection skills across a complex range of asset classes. This is a critical driver of performance as the difference between the first and fourth quartile manager performance is much more significant than the long-only world. Many SFOs were not set up with these skills.
2. The Yale model by definition requires a longer term time frame as private equity commitments use leverage and need to be committed to in size and drawn down over time. Many hedge funds have long lock up periods and many turned out to be much less liquid than promised. Many SFOs in 2008 found out that they had too much exposure to illiquid assets and were forced to fire sale assets, at exactly the wrong time.
So families have come to refine the Yale approach. Many have returned to just investing in long only, traditional asset classes such as stocks and bonds. Others have reduced their allocation to illiquid investments to ensure that they can weather difficult times. Families have also focused illiquid investing where they have a core competence, in sectors or assets related to where they made their money as a family. This way it’s more likely that they will find more interesting investment opportunities that are often less complex, less fee heavy and where the family can add value.
What is the key thing to consider when choosing in-house or external investment management?
Cost is the most obvious factor. Can they afford to hire the right people and will those costs cover the efficiency savings?
How does the governance structure work?
In most SFOs there is an internal team responsible for tracking investment performance and monitoring external managers. This team is likely to be responsible for risk management as well to ensure an alignment between the portfolio and the investment criteria established by the family and codified in the IPS. Families do not make significant asset allocation changes quarter to quarter. They tend to be less concerned about day-to-day volatility. However, families do need to have a process in place to make tactical asset allocation changes to respond to significant changes in the market environment. The guiding principle of asset allocation is not only to optimise return but to avoid any permanent loss of capital.
The IPS should become the basis of the governance structure. The family is in essence monitoring how they are doing against their objectives. Everyone needs to understand the IPS. When managers, both internal and external, report to the Family Board they need to know the rules of the game.
Why do SFOs look to form MFOs?
Many SFOs establish considerable track records and expertise that they can then leverage on behalf of other families. Hence, a successful SFO can become a MFO. Many families do this to establish themselves as an investment business, take in incremental fees to support ongoing monitoring and infrastructure costs and potentially use size to access better quality investments. An SFO only makes sense if you have at least $100m in assets but actually, most are in excess of $500m. Commercial MFOs are generally used by families who don’t have that level of capital. Of course you have to differentiate between on the one hand commercial or asset gathering MFOs, who have quite a number of clients and on the other hand, more private MFOs, where families want to form an alliance with a few other families from a similar background. For private MFOs it’s important that when families do come together they do come from a similar background as they need to be aligned in their tax profile, risk profile, currency and possibly nationality. Even when interests are aligned the complexity of running an MFO can outweigh the benefits. You now have multiple families inputting into the strategy, or you have multiple strategies!
Be particularly aware that whether it’s an SFO or an MFO, family members may wish to opt out of these structures. Hence, it is important to have an exit plan if they do. You need an agreed buy-out strategy.
An SFO or MFO also needs to think about its succession strategy and/or its capability to change the leadership, if family members lose confidence in person(s) driving the strategy. As in any company or partnership, agreeing the rules of engagement and disengagement upfront can reduce the emotional factor of these decisions. Good governance needs to have a review process in place and an agreed means of altering or changing leadership, members of the partnership and a succession plan as and when the next generation comes to assume responsibility.
What do you think have been the most significant changes since 2008?
As mentioned, there was a major re-review of the Yale-model. Some families who adopted that model implemented it poorly or ended up with too much illiquidity to meet drawdown needs in the midst of the crisis. This meant they were forced into a fire-sale of assets just when the value of those assets had plummeted. 2008 was the real test: many SFOs realised the deficiencies of their organisation when the investing environment became so challenging. When returns came under pressure, some families splintered. This means that those that remained together, refined and reviewed their strategy in light of lessons learnt from 2008 are now stronger than pre-crisis.
In summary a few tips:
• Get family members to agree upfront how they want to work together. This means establishing and codifying the family mission and investment policy statement (IPS).
• Review the IPS annually as circumstances change.
• As part of the IPS, secure agreement on the appropriate longer term Strategic Asset Allocation and how best (externally or internally) to execute the investment program.
• Establish a Family Board (usually with independent external advisers) to review performance against objectives and institute a regular meeting format – quarterly is ideal.
• Monitor “leakage”: the cost of external manager, tax and the costs of the office versus the benefits.
• Agree an upfront exit and succession plan for family members.