Numerous family offices are growing given macroeconomic policy with the need for non-investment related services becoming ever more prevalent as fintech improves.
Family offices (FOs) are wealth advisors for individuals or groups of related individuals that wish to preserve and grow their accumulated wealth. They often pair with investment banks to access their functionality and advisory services. FOs are smaller institutions, a recent survey by Goldman Sachs showed that 50% of offices have fewer than 5 professional investment advisors. FOs have become increasing popular have become less reliant on investment banks due to the macroeconomic backdrop and competitive pressures.
Traditional traits
The motives of FOs are distinct and originate from the founders of the operating firms. Obviously, there are commonalities in rationale including objectives to preserve and grow the wealth that they have generated or inherited. Otherwise, some families want to pass wealth down to future generations through trusts, decide to partake in philanthropy if there are few/no eligible heirs to the wealth or reinvest in their operating business as part of a corporate strategy boosting confidence in the health of the business, likely appreciating the price of equity if public. In essence, FOs want to maximise their return or utility with their wealth. Frequently, philanthropic projects not only aim to prioritise environmental or social goals but positively shape the family's image. FOs also tend to dislike the public scrutiny risk and avoid assets that cannot withstand economic downturns or rely on herd behaviour mentality (with the recent exception of cryptocurrencies). If these conditions aren't met, they are likely hedged to ensure their wealth and increase flexibility if a threat materialises. In terms of size, family funds are recognised as offices if they have total investable assets in excess of $100M although single or multi-family funds can range into the billions.
FOs tend to have similar values as other family-run businesses looking for venture capital or private equity funding, as trust is formed in the same way through family blood. FOs are willing to hold assets for extended periods of time because they are preserving wealth for generations ahead. Fewer investment decisions need to be taken with this strategy (meaning fewer transactional fees too) and it may yield higher returns because projects with higher NPVs, rather than lower payback periods can be targetted. Internal investment professionals have less incentive to act with myopia as there is smaller scope for promotion. In addition, FOs may have the intellectual capital to boost their attractiveness to the private equity issuer.
However, concentration in one firm is dangerous. Therefore, FOs diversify with hedge funds, commodities, cryptocurrencies, and real estate. Although, their portfolios are extreme, arguably holding too much cash with unreasonably large exposures to short-dated bonds. Conversely, another large percentage of the portfolio is concentrated in highly illiquid assets such as real estate, private equity and artwork. FOs would argue that the lack of liquidity premium means their returns aren't eroded, the investment is secure within another firm and the excess cash is to increase agility to capitalise quickly on public markets. In addition, the lack of institutional boards, regulation or no one to impress means that investment ideas can be approved and executed quickly, allowing the wealth conservation mandates to be met.
Important relationships
Traditionally, FOs maintain close relationships with wealth management divisions of investment banks, which usually offer customised advice on investment strategies to retain clients. As office teams are small there is not enough scope for the division of knowledge or specialisation. Therefore, FOs have to access investment banks for tax support, auditing, IT resources, cybersecurity, physical security, and health advice - all of which erode alpha.
Office numbers are growing at a record pace. Mordor Intelligence reported a 38% rise in FOs in the 24-month period between 2017-2019 to 7,300 worldwide, Credit Suisse has labelled its upper-bound 2021 estimate as 10,500. Training programs and technology is now streamlined in investment banks in response to the demand signal, crunching management fees. UBS reported average fees of 117 basis points in 2019. Specifically, Europe and Asia-Pac reported higher management fees and North America reported substantially lower fees around 105 basis points for investable assets under management. Furthermore, the demise of traditional merchant and retail banking services suggests wealth and asset management services are popular due to the capability of charging management and performance fees at any time in the business cycle. Also, FOs are more willing to pay the management fee from a single provider due to efficiency increases and lower administrative burdens compared to a pick and mix strategy. Employing additional professional family advisors come at a marginal cost of around $300,000 per annum including bonuses as estimated by UBS. Note it is difficult for established FOs to detach themselves from wealth advisors due to their relationship-specific assets and the knowledge secured in the bank. However, synergies could be created in collaboration with the family's operating business.
FOs see new opportunities through the investment bank's network. Firstly, increased IPO and M&A activity since April 2020 have allowed investment banks to communicate with more frequent investment opportunities to FOs. Secondly, FOs are open given access to debt and equity issuings in capital markets through investment banks. Lastly, if the FO wants to partake in collateralised borrowing (e.g. for LBOs or low-yielding philanthropic projects) they can do so from the investment bank likely at a low rate due to the bank's eagerness to control their assets. Investment banks have specialists for all aspects of investments, including in foreign exchange, alternatives and risk management; advisory services are likely to yield higher fees. Although this knowledge is becoming more common in advisors alongside the advances in fintech improving information asymmetries; generating returns has become easier with a higher selection of investments positively yielding.
This means investments banks have to provide additional services to keep their wealth on their books which is often a very profitable activity. Investment banks continue to streamline their advisory fees and integrate them more efficiently with other parts of the business to capitalise effectively from their scale.
Changing dynamics
The macroeconomic environment of low rates, higher underlying inflation, and the increased allocation into ESG and EM assets are all in the eye of FOs. Holding overweight cash or negative-yielding bonds is becoming undesirable; non-investment grade bonds push edge closer to negative real yields. Real estate and equities have a large allocation in family office portfolios, 11% and 31% respectively according to Goldman Sachs; catalysed by the slashing of interest rates. Currently, both carry a significant risk of pullbacks given the bubble that has been created by large volumes of government purchases throughout the pandemic. A sell-off in one will cause a sell-off in the other due to animal spirits and the composition of equity indices weighted with construction, banking and retail which all have stakes in real estate.
More FOs are starting to become established in the Asia Pacific region - 370 additional billionaires were created in the continent in 2020, bringing the total to 1,149 according to Forbes. Therefore, there is an inflating bubble forming in the Asian property market. For example, New Zealand's house prices spiked 25.5% this year, the government only installing additional demand-side measures such as providing larger grants to younger, low-income families to buy houses. The boom in house prices is positive for FOs at the moment but if there is a credit crunch or supply-side shock yields will collapse. Earlier this month, it was projected via overnight index swaps that three 25 basis point rate hikes in New Zealand would occur by February 2022 with an 86% probability, increasing variable mortgage lending rates which may consequently increase default rates. Evolving Chinese regulation and the Evergrande risk may erode returns in real estate. A survey by Deutsche Bank also stated that a 58% majority of analysts expect a 5-10% pullback in US equities by year-end.
Despite these risks, the long-term time horizon that FOs aim to preserve their wealth tolerates deviations from the trend, either positive or negative. Over multiple generations, the size and flexibility of FO wealth, motives and experience are likely to always generate alpha or at the very least real returns.
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