We assist families in all matters relating to the ownership of family businesses, including succession planning and governance, structuring and fiduciary services, risk management, and a breadth of corporate finance advice.
Passing the business to the next generation requires the consideration of numerous issues. These include the commercial risks and prospects, the competence and willingness of family members to take over the responsibility, the need to balance financial and non-financial factors and the desire to divide the wealth fairly.
It necessitates a detailed plan, starting with the purpose of continuing family ownership, the role of the family in management, suitable processes and criteria for decision making and safeguards to protect the interests of minority shareholders.
Alternatively, if the decision is to aim for a full or partial sale of the business, rather than passing it to the next generation, this also requires careful planning, both to prepare the business for sale and to prepare the family for a transformational event.
The family will also need to decide what to do with the sale proceeds, whether they should simply be distributed to family members, or held and managed collectively. If the latter, the purposes of collective arrangement need to be defined, with suitable structures and family governance.
Stonehage Fleming helps families plan the successful transfer of the family business to the next generation and will help to put in place a strategic governance framework which will meet the needs of the family for the longer term.
Our approach depends on the circumstances, but it may involve the family developing a shared vision and objectives. In many cases, this results in a written family agreement, often referred to as a family constitution.
Many family businesses reach a stage at which they require external capital either to finance expansion or to reduce the family’s exposure, enabling them to diversify part of their wealth into other assets. Bringing in an outside investor has huge implications for a family owned company, inevitably forcing the family to adapt to new requirements and expectations.
We support families in defining the need, in searching for the right investor and in negotiating the transaction. We also help manage the transition from being a wholly owned family business to a company with responsibilities to external investors.
The decision to sell any business requires extensive analysis, good judgment and careful planning. For a family business, it can also be further complicated by family considerations. Once the decision is taken, both the business and the family need to be prepared for the sale, identifying key objectives for family members and positioning the business to achieve those objectives.
Stonehage Fleming is able to assist in facilitating the initial decision, through to the planning, structuring and execution of the deal itself. We will also help manage the impact on the family and will advise on the management of family wealth post the sale
With the backdrop of continuing low interest rates and periodic bouts of extreme market volatility, private capital has attracted increasing attention and investor demand in recent years. The key attraction of the asset class has been its returns, with the industry consistently out-performing public markets by a meaningful margin as shown by Chart 1.
Within the asset class, there are of course a multitude of segments, some showing returns substantially above the average and some substantially below. Another attraction has been the ability to invest in high quality private companies. This feature has had particular resonance for entrepreneurs and families whose own wealth typically originated in a successful private business.
The two principal options for investing in private capital are investing directly in companies or investing via funds:
Whilst highly attractive in theory, investing directly in companies is frequently much more of a challenge than it might initially appear. The key consideration is the extent of a family’s available resources, both financial and human.
Many families in business believe they can harness their business knowledge, skills and contacts to generate higher quality deal flow and opportunities than a typical private equity house, but most of them have found it challenging to convert this theoretical advantage into practical reality. They also come to realise that the portfolio management skills required for investing in businesses which they do not manage or control are not the same as the business skills required to run their own company.
Building a portfolio of direct investments requires not only a significant amount of capital, typically $50-100m as a minimum, but also requires one or more family members or a third-party professional, plus a supporting team, consuming significant time and/or cost.
Typically, a private equity team will look at about one hundred proposals for every investment it undertakes and the amount of work required to progress and monitor these transactions is substantial.
The reality therefore is that among business-owning families there are many who have:
For these reasons, many families conclude that while they rightly wish to utilise their own skills in the sectors they know best, they also frequently seek exposure through funds or other professional channels designed to:
Where investing directly in companies is not a viable option, the best route is to invest via private capital funds. In some cases, families may choose to combine these routes, investing in particular private opportunities directly but accessing other opportunities via funds.
Families have two main options for building a portfolio of funds: they can invest directly in funds or they can invest via an access vehicle such as a fund of funds2. Similarly to investing directly in companies, a family’s choice is likely to be driven principally by the extent of their human resources and the amount of capital they have to deploy.
The key to success is a disciplined approach. There are four golden rules of fund-investing outlined below:
It should be understood that selecting the right managers is even more important in private capital than it is in public quoted investments. The reasons for this are that performance records of private capital managers are much more widely dispersed and because the best performing managers establish a competitive advantage in accessing deals, they tend to sustain their advantage over a lengthy period.
There is significant dispersion of returns from one year to another and we therefore recommend that clients phase their fund investments over a number of years, thereby achieving diversification over the entire economic cycle. The objective is that, having built up an initial portfolio spanning three to four years, a family’s private capital portfolio will become self-sustaining and they can use the distributions generated to fund future commitments and capital calls.
The extraordinary post-crisis economic conditions have led to an erosion of returns in private capital, whilst continuing to out-perform public markets. However, this has not affected the whole asset class equally. As may be seen in Chart 3, falling returns have disproportionately hit the largest end of the market where returns for top quartile managers have fallen closer to 15%, reflecting intense competition among managers for the largest, high profile transactions. This is not the case for mid-market managers or smaller managers where returns have remained, on average, well above 20%.
In part, these higher returns reflect a degree of additional risk associated with smaller businesses, but also reflect the fact that private equity managers can add greater value to smaller and mid-sized investee companies. In addition, the returns in these segments are less driven by financial engineering since leverage is less prevalent than at the large end of the market.
As a result, families wishing to invest directly in private equity funds should be careful to consider a broader range than the large-cap funds which frequently market directly to them. In particular, accessing smaller funds will allow them greater scope to capture the higher returns available.
The life of an average private equity fund is ten years and may, in some cases, be longer. For many wealthy families, this kind of time horizon does not pose any problems. However, it should be pointed out that recent studies highlight a mismatch of liquidity horizons as being the single largest risk in private capital funds4.
Families and their advisers should therefore make absolutely sure that they will not need to access the money they are committing before the end of the fund-life.
So, what are the options for families seeking to access the asset class via investing in funds?
The most obvious route is to invest directly in those funds. This avoids an additional layer of fees and gives the family direct access to the managers. For families looking to follow this route, we would recommend they consider the following:
FINANCIAL REQUIREMENTS: Whilst the minimum investment allocation for building a portfolio of funds is less than for building a portfolio of direct private equity investments, it remains high. The minimum investment that most leading private equity managers will consider is $5m or higher. If a family is to build a portfolio of ten funds, this will require an allocation of $50m.
HUMAN RESOURCES: Whilst not as intensive as for direct investing, the execution of a strategy focused on private equity funds requires one or more family members to dedicate all or a significant part of their time to researching and accessing such managers or to hire a dedicated resource. Given the estimated 5,000+ private equity managers, this is not a task to take on lightly.
ADMINISTRATIVE BURDEN: The administration of such a portfolio is also relatively labour-intensive, which should not be overlooked.
One option is to use the feeder funds put in place by many of the larger private banks. These routinely offer their clients the ability to invest in several of the largest ‘brand name’ private capital managers. This has the advantage of being a relatively easy way to access some of the higher quality managers with a significantly lower minimum investment amount.
The principal disadvantage of this route is that such offerings are typically very expensive (in some cases, prohibitively). Furthermore, in addition to charging higher fees to their investors, the banks also charge as much as 4% to the underlying manager for all money raised. Many of the best private equity managers view this as exorbitant and therefore refuse to work with the banks. This tends to mean that the managers who do work with the Banks are the large, frequently listed private capital managers - the very managers for whom returns are falling, as mentioned above.
Families should therefore examine the potential fee drag carefully in order to determine its impact on returns.
For families who do not have sufficient available capital to invest directly in funds, the best route is to use an access vehicle such as a fund of funds or similar. These vehicles will typically build a portfolio for a group of investors, thereby reducing the minimum capital requirement per investor.
Fund of funds managers offer a number of advantages. They are typically highly professional groups with good experience of constructing portfolios and therefore significantly reduce the risk for their investors. Most importantly, they normally have good access to the top tier private capital funds, an important consideration as we have seen above.
When examining this route, there are a number of considerations:
COSTS: Access vehicles and fund of funds will charge an additional layer of fees. These may be more or less significant and in all cases, investors should try and minimise the drag from these additional fees. For funds of funds in particular, fees are commonly charged on the basis of an investor’s total commitments rather than on the value actually invested at any given time. As with bank feeder funds, this will have a significant drag on the ultimate performance.
DIVERSIFICATION LEVELS: A criticism that is frequently made of funds of funds is that they are over- diversified. A typical fund of funds will frequently contain 30 or as many as 50 underlying funds. As a result, it will have exposure to 500-1,000 companies. We believe that this is over-diversified and that, as a result, the returns will rapidly mean-revert rather than capturing the fullest potential of the top-performing managers. One way around this is to select a vehicle with a more focused portfolio.
INVESTMENT STRATEGY: Whilst there are a growing number of niche fund of funds focusing on specific niches or sub-segments of the private capital market, many of the largest fund of funds are having to deploy several billion dollars annually. In these cases, their ultimate investments are likely to be with the largest brand-name private equity funds and subject to the lower expected returns we referred to above. Families should therefore look carefully at the investment strategy and expected portfolios of funds of funds to ensure that they will be gaining exposure to some of the higher returning segments.
FLEXIBILITY: Fund of funds are frequently like oil-tankers, it takes them a long time to get moving (capital is typically drawn over a 7-yr+ period) and when they do, they are difficult to stop! The challenge for a family is therefore that they are required to make a firm commitment to invest over a number of years. A number of fund of funds now offer annual programmes which we believe offer a structural advantage to investors, enabling them to have greater flexibility in adapting their commitment levels to their own changing circumstances.
We believe that private capital returns have justified the recent attention that the asset class has received in recent years. For investors with a sufficiently long time horizon, private capital can play an important role in achieving their overall return target. However, given the illiquidity associated with the asset class, it is important to give thought up-front to the most appropriate route for an investor’s individual circumstances. The most important factor here will be a sensible evaluation of the resources that a family can realistically dedicate to this sector.
For some families, especially those with relevant business expertise, direct investment may be the preferred route. However, this often proves more difficult than anticipated and the option of investing at least partially through funds should always be considered.
Where families do choose to invest in the asset class via funds, there are a number of options as well as golden rules which should be respected in order to avoid disappointment and to achieve the best returns from their investment.
For those who choose a combination of direct, funds and funds of funds it is obviously important that the investment strategy and implementation is properly coordinated to avoid excessive concentration of risk.
1 Source: Cambridge Associates LLC U.S. Private Equity Index is compiled from 1,231 U.S. private equity funds (buyout, growth equity, private equity energy and mezzanine funds). Returns are net of fees, expenses, and carried interest. Bloomberg: S&P 500 Total Return Index. All data as at 30.09.2015. Past performance is not a reliable indicator of future returns.
2 For Professional and HNW investors subject to suitability
3 Source: Cambridge Associates US Private Equity Index & Selected Benchmark Statistics 30.6.15. Data label refers to the difference between upper and lower quartile performance. Past performance is not a reliable indicator of future returns.
4 British Venture Capital Associate study, Risk in Private Equity - new insights in to the risk of a portfolio of private equity funds - (BVCA October 2015).
5 Source: Preqin . Benchmark data as at 04/01/2016. Data relates to average performance of first quartile buy-out funds globally for period 1999-2015. Past performance is not a reliable indicator of future returns.
Thirty years ago the term ‘Homme d’Affaires’ was well understood, describing a true adviser with real wisdom drawn from deep and broad experience of the world. The trend towards specialisation has caused us to forget the supreme importance of an individual who is able to look at the whole picture and pull together the advice of all the specialists.
Wealthy families are rediscovering the need for such individuals and in an increasingly complex world, they are not always easy to find.
It is not quite clear why the English had to borrow an expression from French to describe the role of a trusted adviser to the wealthy, but until thirty years ago, the term ‘Homme d’Affaires’ was well understood and in common usage. It is strange that there was no equivalent in the English language the closest being the Italian word Consilieri.
The essence was that such a person was a true adviser with real wisdom drawn from deep and broad experience of the world, including business, investment, families, the law and even philanthropy. The Homme d’Affaires was thus a reliable and impartial sounding board for nearly every major decision his client had to take. This might range from business acquisitions and investment to succession and inheritance, from personal relationships to dealing with awkward situations such as divorces within the family, where the parties involved are directors and shareholders in family businesses.
This does not mean that he would advise on the technical detail of every issue, but he would know enough to apply his experience, wisdom and common sense to ensure the decisions made were not only based on sound technical advice and on a proper understanding of the overall context.
Over the last 30 years, the term Homme d’Affaires has pretty well disappeared from our vocabulary, as the remorseless trend towards specialisation has caused us to overlook the generalist. This generalist is someone who pulls it all together, is able to look across all aspects of a situation and make judgments and recommendations which bring together the advice of all the specialists.
It can indeed be argued that the focus of the specialists has become so narrow that they are less able to appreciate the broader context in which they operate or the relevance of their advice to the overall picture. By their nature, specialists tend to complicate their own fields of activity to the point where they create barriers to entry for newcomers, thus increasing their own market value. This makes it more and more difficult for their advice or their contribution to be evaluated by others.
It is therefore argued that the trend to specialisation has gone far enough. In the words of the late Kenneth Williams specialists “know more and more about less and less and eventually someone will earn their living from knowing everything about nothing!”
This is indeed one of the many lessons of the banking crisis, where the boards of great banking groups have allowed armies of specialists to develop huge areas of business which are far beyond the understanding and control of the board itself. In the past, the boards of banks had some direct understanding and appreciation of ALL the major risks to their business, but this can never be the case again.
To some extent, the same applies to wealthy individuals and families. Their affairs are complex by nature, because they frequently mix the highly sensitive issue of family relationships, succession and inheritance with the ownership of one or more businesses, the management of investment portfolios, property and leisure assets, all overlaid with tax planning and efficient holding structures.
Complexity is increasing as tax authorities become more aggressive and we live in an increasingly regulated and litigious society. The cost of professional advisers is thus rising at a rate which is simply unsustainable. The complexity of risk means all major decisions are inter-related and it is almost impossible to give sensible advice about one part of a client’s assets, without considering the knock on impact elsewhere.
In other words, it is now not just desirable, but increasingly essential that all advice on major issues is channelled through someone who really understands the whole picture. Not only is this essential for proper coordination and risk management, it can also help reduce costs as the sophisticated generalist can much better commission, coordinate and evaluate the more detailed advice required from specialists.
Take, for example, the case of a family which owns a substantial family business, where the cash flow has been under pressure and bank finance hard to come by during the recent crisis. Do they sell investments in a bad market to finance the business or are those investments intended precisely as a nest egg for a rainy day when the company ran into trouble? Furthermore, if you use family investments to support the business, how do you protect the interests of family members not involved in the business?
Of course, ideally, the wise man and his advisers will anticipate these problems and have put in place structures and governance designed to achieve the right balance of risk and ensure all family members are treated fairly. The wise man will also have looked at the detailed risk correlations between the family business and the investment portfolio, to ensure that the market risks in the business are not replicated in the portfolio and that the potential liquidity needs in a downturn are fully assessed and anticipated, before committing to long-term equity investments.
There are however many other types of risk. Some are ongoing, such as monitoring the success and direction of the business, the performance and calibre of family directors and keeping an eye on family relationships, looking for potential sources of friction which might turn into major disputes, with catastrophic consequences. Then there are the one off occurrences, such as an acquisition of a new business, perhaps financed by significant debt, or a divorce where the ‘in-law’ is chief executive of a family company.
Increasingly the management of risk means looking at the interrelationship between all aspects of the family finances and of the family itself – segregating risk into different compartments each overseen by a specialist is no longer enough.
Then there is the matter of ‘strategic vision’. Who helps the family decide where it is heading, what the purpose of the wealth is and what their broad objectives are over the next generation. And again, how to pass on the baton from one generation to the next, ensuring that healthy rivalries in the business or other family concerns (such as a philanthropic foundation) do not spill over into family relationships, or vice versa.
The notion of resurrecting the Homme d’Affaires is not entirely new. Very rich businessmen have usually found an individual from among their advisers or employees who steps up to the role. Lower down the market, private banks and wealth managers have for a long time been marketing the concept of a trusted adviser (often using the medical analogy of general practitioner), but they have too often undermined their own promotional literature by fielding relationship managers who lack the experience or gravitas for the trusted adviser role and are clearly trained and motivated as salespeople rather than advisers.
It is one thing to articulate a need and another to meet it. Partly because of the product sales approach of many private banks and wealth managers, there is a massive shortage of people who genuinely merit the Homme d’Affaires title. It is not just a case of re-inventing a role that existed 30 years ago – in a much more complex world, the knowledge and experience requirements to fit this role have expanded dramatically, so they are likely to be outstanding individuals who command a very high price.