Insights
An investment strategy to fit wider family objectives
That is the clear conclusion of Stonehage Fleming’s research report ‘The Four Pillars of Capital’, a conclusion which is strongly supported by practical experience.
Families are hence adopting a more structured and detailed approach to setting their broader longterm objectives, both financial and non-financial, and the management of their investment portfolios needs to reflect this perspective. The broader wealth of the family can usually be broken down into four elements: Financial Capital, Intellectual Capital, Cultural Capital, and Social Capital. Financial Capital will rarely be sustainable if the other three are neglected.
It is therefore difficult to develop an appropriate investment strategy without first addressing the wider family issues, and in particular agreeing the purpose of family wealth and a framework for the management of total risk – financial and non-financial.
Private client investment managers now compete so fiercely to claim superior investment performance that, in many cases, their offerings have become relatively standardised, with limited scope to adapt to the particular needs and circumstances of individual client families, especially in addressing long-term considerations.
By comparison, ‘wealth managers’ or ‘family offices’ are there to take a broader view and must look beyond the pot of money for which they are directly responsible. They therefore place more emphasis on developing the skills to understand the context much more fully and to deliver an investment approach which is an integral part of a broader family strategy.
While the optimisation of performance will usually remain the prime objective and there will be a core role for mainstream investment strategies, factors other than financial return will affect most major investment decisions, often quite significantly.
THE PURPOSE OF THE WEALTH
It is interesting that large companies are now moving on from the traditional ‘shareholder value’ model towards a management approach based on a ‘statement of purpose’, which includes the need to serve the interests of wider stakeholders and the community in general. This trend is already well advanced in wealthy families, who have for some time realised the value which a statement of purpose brings to decision-making across all aspects of their affairs, including the management of investments. The statement may be quite detailed and will directly feed in to the wealth management strategy.
RETENTION OF HERITAGE ASSETS
For those families whose wealth is concentrated in a heritage asset, a family business or in a narrow sector, the purpose of this concentration needs to be explicitly stated. They also need to outline circumstances which may, at some future date, necessitate a change of policy.
Some families, for example, maintain a very strong commitment to keeping their core heritage assets and business in family ownership, through the generations, because they see it as part of their identity and their role in the community, rather than just a driver of financial returns. They often see such a legacy, and all the responsibilities it brings, as a tool of risk management, by comparison to handing down cash and liquid assets with no sense of purpose attached.
Others are far more open to diversifying their wealth when the circumstances are right, as a purely financial appraisal will often conclude (advisers invariably recommend diversification unless there are good reasons for wealth being heavily concentrated in a single asset or sector).
Either way, the existence of a family business throws up numerous considerations which affect the construction of an investment portfolio. This is an ongoing process, as the investment portfolio will need to respond to any significant changes in the business, including strategy, profitability, cash flow, dividend policy, currency and geographic exposure, leverage and market sentiment.
This will apply particularly where the risk profile of a family business is changing through acquisitions, major investments or shifting exposure to different markets and currencies. The investment portfolio needs, at the very least, to avoid replicating the risks being taken in the business and may have the opportunity to offset some of those risks.
Even among those who have sold their family businesses, some believe they owe it to their heritage, to themselves and to the community to use a portion of their wealth to encourage innovation and support growth companies, which benefit society as well as the family itself. They see this as a core element of their purpose and they want to invest in businesses rather than markets, which may suggest a limited role for so called ‘passive’ investments.
FAMILY VALUES
Cultural capital
The statement of purpose will articulate the values of the family and the way they use their wealth to contribute to society, which will significantly affect their investment decisions. This means that, for some families, their expectations go beyond investment returns to include non-financial aspirations or ‘impact goals’.
For some, these issues are dealt with under the heading of ESG (environmental, social and governance) and dedicated ESG funds are now widely promoted by investment managers in response to growing demand. For other families, however, they want to use their wealth far more proactively and individually to finance ventures, projects and companies, which match their values and purpose.
This may mean high levels of commitment to impact investment and private equity, but can also involve concentration of investment into certain sectors favoured by the family, to support wealth creation.
ENGAGEMENT WITH COMMUNITY
Social Capital
Some families describe in their statement of purpose the way the family uses its wealth to engage with society and in particular with the communities in which they operate. The relationships and reputation, which can take decades to build, will contribute to the preservation and growth of family wealth in its broadest sense and to achieving its stated objectives.
Again, this may suggest a particular approach or concentration of investment in specified sectors or geographies where the family wants to play an active role in society. Some have a desire to be active in their local communities or in the sector where they made their wealth, even if their core business has been sold.
FAMILY INVOLVEMENT
Intellectual Capital
For most families, it is crucial that family members, in particular the family leaders, develop the competence to take full charge of all aspects of their inheritance, both to see that it is prudently managed and effectively used to support family objectives. This includes the active, informed, hands-on management of their investment advisers to ensure a healthy two-way relationship. Selecting and developing competent leaders for the future is probably the most important risk management priority for any family and has a direct bearing on the management of investments, as does the family’s awareness of any gaps in its understanding of this subject.
Furthermore many families, particularly those who have made their wealth in business, believe they have significant ‘intellectual capital’ in the form of knowledge, skills and experience which they wish to pass on, both to subsequent generations of their own family and to the wider community. Their intellectual capital is often deployed alongside their financial wealth in support of family objectives.
Intellectual capital has to be nurtured and developed. This is most obviously done through continued involvement in directly held business interests, but increasingly through tranches of capital being used to support the development of business and investment skills in the next generation. Capital is allocated to help introduce them to various forms of investment, often including private equity, from which they gain the experience to become effective stewards of family wealth. The precise workings of such an arrangement need to be carefully thought through.
Those with specialist knowledge in certain sectors, will often want to utilise and nurture that expertise by being actively involved in the management of certain elements of their investment portfolio. Such an approach would normally be limited to an agreed proportion of the portfolio, with performance and returns calculated separately.
The wish for family involvement stems from all the factors mentioned above, perhaps most importantly the view that the successful preservation of wealth depends, more than anything, on being able to pass on the assets to successors who are competent and motivated. Furthermore, wealth without purpose or without a role can be very destructive, leaving individuals with diminished ambition to achieve in their own right.
Of course it is understood that not all family members wish to spend their lives in business and finance and that some may have other career aspirations which they wish to fulfil, but this should not preclude them from active participation in decision-making and leadership.
HOLISTIC RISK MANAGEMENT
Investment managers use volatility as the prime measure of risk, but for wealthy families this is just one of their risk management tools. Risks need to be assessed and measured not just in terms of financial values, but with reference to the broader purpose and objectives described above.
The risk management of investment portfolios should take account of and compensate for other risks inherent in the family and its wider assets. Some families actively use a portion of their wealth to help manage these broader risks, particularly in preparing the next generation of leaders.
It must also be understood that there are many different definitions of risk, according to your perspective, and the risk management approach of entrepreneurs is often diametrically opposed to that of traditional investment managers. Entrepreneurs tend to manage risk by concentrating investment in sectors they know and understand, whereas investment managers mitigate risk by diversifying across a wide range of sectors, of which they can only have limited direct knowledge.
MANAGING TRANSITION
At some stage, families may find themselves in transition between the entrepreneur’s approach and the investment manager’s. After accumulating substantial value in a concentrated portfolio, the family wishes to diversify, partly to spread their risks, but also because changes in family leadership mean they no longer have the expertise for highly focused investment and thus become more dependent on professional advice.
In these circumstances, a wealth manager or family office will be adding true value if they are able to facilitate the transition, by understanding and balancing the different risk perspectives of the entrepreneur, the next generation of the family and the conventional approach of professional investment managers. The exercise will often involve the gradual realisation of directly held business interests and this process must be managed in an integrated way alongside reinvestment in a more diversified portfolio.
It must be appreciated that the transition will challenge deeply embedded views and that facilitating changes of mind set between one approach and another requires substantial interpersonal skills, as well as the knowledge and experience to bridge the gulf between the two.
CONCLUSION
Strategic investment decisions must be aligned with the wider family purpose and strategy. This may influence the construction of an investment portfolio in a number of ways:
- The portfolio must reflect the broader purpose and objectives of the family, including family values
- The overall risk management of the portfolio must be set in the context of a wider risk management framework covering all the family’s risks, internal and external
- There may be significant concentrations of wealth in individual companies or particular sectors
- The rest of the portfolio, and the risk management, must take full account of such concentrations and adapt continuously to changing circumstances
- There may be higher allocations to direct private equity, impact investment and ESG, than in a more conventional portfolio
- Some families will wish to have disproportionately high allocations to growth companies and new ventures
The active involvement of family members in a number of areas should be encouraged and seen ina positive light, even when it entails a significant departure from the investment manager’s standard or ‘model’ portfolio. The contribution this involvement makes to long-term risk management must be understood by all concerned.
For a wealth manager or family office, running a portfolio on a ‘partnership’ or ‘co-pilot’ basis, as described above, is obviously far more challenging than an approach based on a series of model portfolios with relatively minor deviations for individual preferences. It means building strong relationships with the family, which enable joint decisions based on frank exchanges of views and a decision-making framework which clearly defines ongoing responsibilities.
The total wealth approach demands a breadth of business and investment knowledge which is challenging for any wealth manager to provide. It also requires strong interpersonal skills to debate issues with family members who may have strong views of their own.
There must, however, be limits as to what the wealth manager will accept and as one client put it, ‘I want you to let my kids have their heads, but I don’t want you to let them lose their shirts’.
