Family Office – The Internal-External Conflict
One of the biggest conflicts that can arise within a family office is that between the family or families that own the wealth (the principals), and the fund managers and external providers (the agents). The Family Office Survey indicates that family businesses are not new to such conflict between principals and agents, with families typically encountering such problems as their business develops. But concerns about tension between principals and agents in family offices bring with them issues that are unique to delegated asset management.
A feature of this potential conflict is that principals and agents face different utility curves with respect to investment results. Most wealth owners face a diminishing marginal utility curve, which means that they value the next dollar slightly less than the one they already have. This is why investors typically derive more pain from losing money on an investment than joy from making a profit. But fund managers will tend to take more risks in their portfolios in order to beat benchmarks. This is because managers have more to gain from outperforming a rising market (through asset gathering) than they have to lose from underperformance in a declining market, since there are far fewer inflows. This mismatch of expectations means that wealth owners setting up family offices may face agency costs, and should set up appropriate monitoring and compensation mechanisms to mitigate agency problems.
An increasingly common area of concern for family offices is how their third party investment advisers are compensated for their advice and services. Setting up a family office, or hiring an internal Chief Investment Officer, is often motivated by the family’s need to ensure objective advice on specific investment strategies that is independent of any compensation the adviser might receive. This concern has led to the growth of registered investment advisory (RIA) and investment consulting (IC) firms, which charge an advisory fee for asset allocation; third-party manager search, selection and ongoing due diligence; reporting and rebalancing, with no remuneration from the managers recommended and selected. This need has also contributed to a trend among larger wealth management and brokerage firms towards offering advisory only fee structures to their family office clients, as well as to their institutional and high and ultra-high net worth clients.
Investment Horizon Conflicts
The length of investment horizon also imposes concerns about tension between principals and agents in family offices. While family offices tend to have a longer-term investment horizon, bonuses and other forms of compensation are typically determined more frequently, often once a year. This gives family office managers an incentive to ensure that the portfolios they manage perform well over that time frame, and can often discourage managers from making long-term investments that may perform differently from performance benchmarks.
Even if the incentives are pegged to the outperformance of benchmarks, the selection of appropriate benchmarks itself is a challenging exercise for many family offices.
How fund managers think they will be evaluated also imposes decision-making constraints. In a highly outsourced family office setup, there is usually a long chain of investment decision-makers between the principal and the agent, with each layer bringing additional agency costs (and additional fees) for the principal. As one moves further away from the principal in terms of asset management, the principal carries less weight. As a result, the external managers may prefer short-term safer investments to longer-term investments that could be volatile in the short run. The principal/agent conflict is not helped by the fact that it is often suggested that assets and funds managed externally tend to underperform those managed internally.
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