While the concept of Family Offices may appear relatively nascent in regions like India, its origins can be traced back to the Renaissance era, with the establishment in 1581 of the House of Medici in Florence, Italy. Serving as a dedicated office for the illustrious Medici Family, this innovative governance structure was devised to meticulously manage the family’s wealth, make strategic investments, augment art and culture, and fund inventions and creations that would shape the future of society.
Remarkably, more than half a millennium later, the family office structure remains just as relevant, to extend the life cycle of a family's wealth and immortalize its legacy. In this article we explore six key decision-making frameworks that family offices need to adopt to have a robust wealth governance framework for their investments.
Because of the substantial impact of their wealth on internal and external stakeholders, Family Offices, often, have a very clear objective about what they want to do with their wealth. At the center of the investment philosophy sits the all-seeing, all-governing Investment Policy Statement (IPS). The IPS guides the investment decision process for the family and by establishing suitable boundaries, prevents significant deviations, limits ad-hoc investment decisions and sets the guidelines for asset allocation and performance evaluation. Its governance powers play a significant role in conflict resolution. A family can have multiple IPS for different pools of capital. For example, there may be one IPS for the larger family investment portfolio managed by the family principals, and different IPS for individual family members based on their risk appetite, return expectations and liquidity requirements.
Driven by Purpose
The fundamental purpose of a family office is to act as the custodian of the family’s legacy and to work tirelessly to ensure it is immortalised. Most evolved family offices define the purpose of their investments as it helps to highlight the family’s multi-generational story, reflect the family’s values, and gives an identity to the family’s back story. Family offices can drive significant societal change through their choice of investments. I remember reading the purpose of Yamauchi No. 10, the family office of the Nintendo Family in Japan. It said, ‘We are determined to create a society that encourages people to nurture their unique creativity’.
Several purpose-driven family offices have aligned their investment philosophy with their family values. Some avoid sin industries while others may want to make up for the fossil fuel emissions of their previous generations through impact investments in renewable energy. What is clear is that you can’t build a legacy without having a purpose.
Risk Pool Management
Risk pools form the foundation for wealth management within a family office's investment portfolio, allowing the family to balance risk tolerance with potential returns and their overall wealth objectives. Risk pool management introduces the concept of creating investment portfolios across three risk buckets: Personal, Market, and Aspirational Risk Pools. Personal risk ensures that the family’s basic standard of living is not jeopardized. Market risk strategies aim to maintain the family's lifestyle and preserve purchasing power, while Aspirational risk considers investments that have the potential to exponentially enhance a family's wealth. In most cases, Family Offices allocate capital to fixed income instruments to manage the Personal Risk Pool. They use a combination of equities, fixed Income, ReITs, InvITs, commodities and mark-to-market instruments to manage the Market Risk Pool. The Aspirational Pool comprises of largely illiquid investments primarily in private markets, through direct investments in companies and/or Private Equity and Venture Capital funds.
The importance of asset allocation as the holy grail of decision-making frameworks used by family offices cannot be overstated. It brings discipline, consistency and is designed to weather volatility. A strategy to invest across un-correlated investments such as equities, bonds, real estate, commodities, and alternatives helps to balance risk and returns, whilst managing volatility, potentially enhancing returns, and protecting the portfolio from market downturns. A typical asset allocation process starts with understanding the family’s financial goals and risk tolerance, followed by choosing the right mix of asset classes in the right proportion. This plan is at two levels – a strategic asset allocation, which is reviewed annually and a tactical underweight / overweight asset allocation to capture market dislocations, risks, and opportunities. Each asset class / sub-asset class tends to perform differently every year, hence the need to diversify across asset classes. For example, Gold gave -0.2% returns in FY21, but was the best performing asset class in FY23, giving an overall 13% return. Asset allocation acts as a shield to an investor’s impulse.
Fund Manager Selection
Once the asset allocation has been finalised, Family Offices must then engage with multiple fund managers for the investment. Over the years, family offices have honed the art of fund manager selection and this singular skill has had a disproportionate impact on portfolio performance. They have also come to realise that portfolio outcomes tend to improve through fund allocations as compared to direct investments, despite the higher cost of investment (i.e., fund management fees) associated with allocating to fund managers. To evaluate managers, family offices use both quantitative and qualitative metrics. While there is much more publicly available information for listed investments, for unlisted investments, the stability of the team, a proven exit track record, access to deal flow and an exit strategy become key. The family office eco-system of single and multiple family offices often interacts with each other to exchange ideas on fund manager selection ensuring a meritocratic approach.
Cost of Investment
Family Offices, by their nature, must be mindful of the cost of investing. This is crucial to ensure the compounding of returns over the longer term. The total cost of wealth management is the sum of investment costs such as advisory fee, brokerage and transaction costs, fund management fee, performance fee; and non-investment costs such as tax and estate planning, accounting, etc. There are two key factors that can significantly increase costs in wealth management. These are wealth structuring strategies and alternative investment strategies, which often involve significant management fees paid to Private Equity and Venture Capital funds. An understanding of the complexity of the required services and economies of scale at play is crucial when assessing wealth management costs; and the careful management of costs can significantly enhance net returns.
When viewed in isolation, each of these frameworks provides an insightful approach to a specific facet of decision-making within a family office. However, their true strength emerges from their integrated functioning. Together, they create a dynamic, robust decision-making framework for family offices. This integrated approach equips family offices with the strategic acumen required to navigate black swan events as well as regular market volatility. By balancing risk and return, aligning financial strategies with family values, and managing the practicalities of investment, family offices can ensure the resilient and sustainable stewardship of wealth. This not only fortifies their economic contribution but also strengthens their role as custodians of legacy and prosperity, a testament to their vital part in our global economy.