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Family Office – The Investment Process (4)

How do family offices invest their principals’ money? Family offices tend to follow their own individual investment policies, because unlike banks and other financial service providers, they are generally subject to the more relaxed regulations applicable to companies, trusts and foundations. However, the degree of freedom enjoyed by family offices is reduced in proportion to the level of services provided by third parties and the number of families served by the family office.

Stress testing and modeling
Once an initial portfolio shape is in place, several further exercises can be useful, such as stress testing the return profile of the portfolio to demonstrate to family members how the portfolio might behave during periods of volatility. In performing this type of analysis, it is sensible to examine all the family’s wealth, not just their investment portfolio. Modeling the core business holding of a family as a form of private equity or direct equity holding, and then analyzing and optimizing other components of a family’s wealth with respect to this, is a difficult but necessary task.
In the context of family businesses, one common outcome of this part of the process is to show that the initial investment portfolio of the family office could be better diversified, since it often has a large holding in the underlying family business or, in some cases, legacy investments that tend to be over-concentrated in certain asset classes (e.g. private equity). There are several ways to achieve a more diversified portfolio for the family office, helped by looking at projected total return and volatility data.

Family offices are different from other organizations in that there is often a greater and more irregular call on the investment portfolio. Family members request funds for business-related or private equity stakes, philanthropic and impact investments, or ongoing expenses. In this respect, being able to model the impact of cash flows on an overall investment portfolio is important, and experience suggests that the focus on yield and cash flow tends to be higher for family offices than for other organizations. Accordingly, families should consider their overall liquidity needs carefully during the portfolio construction process.
Implementation and governance
Implementation and governance quality is crucial. From an investment point of view, how a portfolio is implemented must be consistent with its objectives and structure. Having a formal investment policy statement in place is important for maintaining an appropriate governance structure. In addition to reviewing the family’s goals and objectives, it is vital to review asset allocation. This can be done by running asset allocation diagnostics on portfolios at least once a year, in order to ensure that they perform as initially prescribed. Transparency is also very important, and regular meetings and contacts between principals, the family office staff and external advisers will help to clarify broad macro views, turning points in strategy, and issues relating to implementation.
In summary, while the family office space is growing and evolving quickly, several building blocks can be identified as forming the key components of a family office investment process. These are:

  • Consideration of how legacy issues determine the starting point of the fund.
  • Objective setting and creation of an investment policy statement.
  • Mapping risk tolerances.
  • Building a portfolio structure across all liquid and illiquid assets.
  • Implementation using strategic and tactical investment tools to ensure that investment solutions fit the goals and objectives and meet cash flow needs.
  • Governance.
  • Rebalancing.

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