Families with significant wealth are continually challenged by next-generation transitions and various wealth management-related matters.  Whether it’s establishing trusts for newborns, training young adults for leadership within the family structure or closely held business, or educating younger generations on the concept of stewardship, charitable giving, and financial responsibility, there are many issues to consider.  There is a frequently heard saying in working with the ultra-high net worth crowd, “Shirtsleeves and to shirtsleeves in three generations.” This statement, attributed to philanthropist Andrew Carnegie, refers to the cycle of building wealth initially and then having proceeding generations blow it. It is informally predicted that by the third generation, 90 percent of wealthy families may lose their wealth.  However, wealth “evaporation” can also be the result of poor planning around wealth transfer, estate, and gift taxes, in which case two generations may be the appropriate number.  Either way, wealth can be squandered quickly without proper preparation, planning, and communication.  Which brings us to the topic of family governance.  While proper financial planning, investing, and wealth strategy is a baseline for wealth preservation and tax management, family governance provides a structure where shared and differing values, as well as the actual numbers and strategic wealth planning implementation, may be addressed with greater transparency across generations.

When to Focus on Family Governance

In working with ultra-high net worth families for well over a decade, I have yet to see a standard in what the term “family governance” means or how and when it’s applied within a family.  While there are many attempts at defining it, and perhaps an ideal framework to consider, it rarely evolves in an ideal way. This makes perfect sense because families are so different, generational wealth can be “old” or “new,” and family members have very different perspectives and personalities. As family assets grow in value and complexity, babies are born, others pass away, and marriages, divorces, and dysfunction occur, the need for some type of governance and oversight related to education, transparency in investment holdings, trust and estate updates, philanthropy, and family leadership (“patriarch or matriarch”) becomes more apparent and, frankly, more important.  Families often take note of this as generation two or three reach adulthood.

How Families Execute Family Governance

In some cases, a family may develop a “mission statement,” which is a summary that states the shared values, vision, and purpose of the wealth across generations; or it states the core legacy values and vision of only the wealth creator(s) who hope to instill these principles across generations.  Is a mission statement required?  Not necessarily, and families sometimes get too hung up on getting this statement exactly right at the expense of focusing on what they want to accomplish through the family governance process.   If a mission statement doesn’t come easily, start by answering this question:  What do you want to accomplish by establishing “family governance” now?  Answer that question first, then decide the best format and timing of how to proceed. Here are several examples of how the governance process evolved within several families.  None are alike and only one had a formal mission statement.

Driven by Philanthropy

A first-generation wealth creator in his 60s established a family foundation that supports a variety of highly specific local causes.  The wealth creator brought three of the four adult children together to discuss the oversight and the goals of the foundation.  All other topics related to estate planning, trusts, wealth transfer, etc. were off the table.  One initial, in-person meeting was held and several one-on-one phone calls.  One adult child took the lead and expressed interest, and the other two were mildly interested and were unfamiliar with some of the concepts and ideas discussed.  Although there wasn’t a lot accomplished at first, it was the effort by the wealth creator to communicate what was important to him that changed the dynamic of the family in a healthier direction.  Eventually, other topics were addressed.

Operating Company Update Focus

A privately held $2 billion family-owned company is run by one of three members of the second generation.  The other two do not participate in the management or operations of the company but receive an equal share of distributions and proportional ownership.  Meetings are held quarterly with the siblings to review the company and the financials, but each family line determines how they will educate and train their children in financial management and stewardship.  One of the three siblings takes advantage of the training available to them through their advisory firm.  The others do not because they have younger children who are not yet ready for more education and preparation.

Investment, Trust, and Foundation Focus

A divorced first-generation wealth creator with four children and twelve grandchildren meets in person bi-annually over a weekend in a neutral location with the children and in-laws.  None of the grandchildren, some of whom are young adults, are included.  The main topic of the discussions is a review of family trusts and legacy, the investment allocations, and the family’s donor advised fund.  The charitable allocation from the fund is rotated each year by family line so that all children and in-laws are involved in charitable activities.

Old Wealth

Heirs of an early 20^th century industrialist (five lines of cousins) meet for a family reunion every other year in the town where the wealth was originally created.  Some family members consistently attend, while others do not.  At this point in time their only connection is the inherited, smaller “pockets” of wealth passed down through several generations, and the connection to the original family homestead, which is no longer occupied by any of the family members.  They spend the weekend together, review family history and legacy, catch up with one another, have a picnic, then go their separate ways.  A handful of family members remain involved in several family foundations.

Single Family Office

A multi-billion-dollar family with four living generations holds an annual family meeting. Every family member over the age of 18 attends.  The highly structured meeting with a firm agenda is held over a weekend and is focused on legacy and trusts, charitable giving, investments, and educating the younger generation on all aspects of the oversight of the family wealth structures and expected stewardship.

Five different families and five unique attempts at family governance.  There is no standard “formula;” however, a good advisor can greatly assist a family with developing goals, objectives, and a format that works with the unique style and approach that best serves them.

“I can talk with my kids about anything.”

“Money?”

“No, not that.”

First, A Story

Nearly a decade ago, I was meeting with an elderly couple who were revisiting their estate plan for what would prove to be the final time. They were both in their mid-90s, clear-minded, and fully aligned with their gifting and inheritance goals for their family. The patriarch was long since retired and one of his five children was running the family business. Trusts had been established, a detailed gifting and inheritance plan for each child was long in place. But when it came time to discuss what each of the children was going to inherit when the parents passed away, the patriarch pushed back. He was concerned that wealth would be squandered by one of their children who had been a bit irresponsible in their youth. It was only after much back and forth that the matriarch finally put her foot down, saying, “For goodness’ sake, he is 70 years old! He needs to make sure he can complete his own estate planning” that we finally made any progress.

After some hesitancy, the patriarch realized somewhat that he was being overly zealous but still had a hard time letting go of control and fear. And there is the real issue—control and fear.  He had never shared the family’s full wealth picture with any of his kids, even after seven decades. I finally got permission to proceed.

Anyone who has spent any meaningful amount of time in the multi-family office space has a similar story to tell, but there is much to learn from situations like this. The need to control, coupled with fear of the mistakes that the next generation might make, can be a major hindrance to building and communicating the kind of multi-generational plan that helps ensure legacies and sets future generations up with the tools and resources they need.  Difficulty starting conversations with children about trusts, spending, family wealth, and inheritance is very common.

When the kids are, well, kids, the process can be relatively easy. No need to talk about it in any significant detail.  The “revealing the numbers” anxiety begins kicking in during the teenage years. In some states, informing children of funded trusts and balances is required at the age of majority (18, 19 or 21, depending on the state), so in those instances, the wealth discussion and any stewardship training should begin before then.

Typically, many parents are terrified they are going to ruin their children’s incentive to be productive if the children know that they will receive a large inheritance down the road or will gain access to a funded trust at 25 or 30 years of age. Conflicts between the parents at this stage are common, and usually related to four factors:

• The amount to leave to children in trust or outright at death;
• When to tell them;
• How to tell them, and
• What to tell them.

If there are stepchildren or stepparents in the mix, things can get even more complex. Again, at the heart of these challenges are fear and control. As often as I’ve been asked how to help families through this issue, there is no single answer or solution for how families should handle these matters, but there is a common thread in all those scenarios where things go smoothly: effective and timely communication. Every family is different, and every child is different. The fear and control factors aren’t usually directly about preserving the family wealth because there are many good planning solutions for families to consider in protecting assets across generations. Parents often want to control what their children will do, the decisions they will make, and how they may react to a potential “windfall.” While understandable, the last thing a family should do is nothing. Communication is key, albeit difficult.

Assuming the parents want to begin talking to the children regarding these matters, a good place to start is for each to first address any fears or hesitancy so that it’s acknowledged. Each party should try to avoid criticism and irritation, even if the fears seem ludicrous. Although they may very well be, in that person’s mind they are real.

In addition, conversations may very well differ by child, so that should be addressed as well. Parents must fully embrace and understand that they cannot control all outcomes. Every person, including their children, is ultimately responsible for the decisions they make about their life, good or bad. Most parents understand this logically, of course, but fear and control born out of love typically override the pragmatic side of things in sensitive matters.

After the fears and concerns have been laid bare, the next step must involve working on developing a plan as to how and when to proceed with the conversation(s). Make sure both spouses are on board, even if their approaches are not exactly the same. In some cases, a meeting with the entire family may be ideal. For others, a two-on-one, or a one-on-one conversation with each child works better. Parents who have a hard time working through the discussion can work with a trusted advisor to assist them, either by preparing the parents or by facilitating a meeting. Multiple meetings are likely appropriate if children need education on various aspects of trusts terms, investments, philanthropy, or wealth strategy and planning. But no matter how long it takes, the initial goal must be to get started. Rest assured that while parents cannot control all outcomes, preparation and honest discussion with their children is critical to well-grounded legacy planning and shouldn’t be avoided. The best outcomes that I’ve witnessed are when parents have prepared and communicated well with their children on these matters at appropriate times.

Preparing the next generation for inherited wealth can be very challenging but can be successfully accomplished by identifying the hurdles that hold parents back from proceeding with this important step and encouraging them to find a way that works best for them and their children. My story of the 90-year-old father afraid to talk to the 70-year-old child about inheritance details may be an extreme example, but regardless of the ages of those involved, waiting will not help families achieve their desired outcomes.

Whether you accumulated wealth over a lifetime of hard work or suddenly came into it via a business exit or inheritance, one of the most common questions within the ultra-high net worth space is what is a family office, and do I need one? A family office is an organization that assumes the day-to-day administration and management of a family’s personal and financial affairs. Though investment oversight is a significant component of their responsibilities, what differentiates them from traditional wealth management firms is all the additional services that they offer.  Having a family office allows the affluent to rely on a team of objective subject matter experts to oversee all the critical aspects of their lives so that they can focus on what really matters to them.

1) What services do we require?

• Investment Management & Oversight
• Manager Selection & Due Diligence
• Alternative Investment Access
• Aggregated Reporting
• Bill Payment & Bookkeeping
• Concierge & Lifestyle Services
• Tax, Legal & Insurance Coordination
• Family Governance & Education
• Strategic Philanthropy Advice
• Financial & Estate Planning

If you determine that you require more than 3 of the services on this list, chances are that a family office might be right for you. There may be services that you do not currently require but may need down the road.  Many families who are busy enjoying their wealth have not yet begun to think about estate planning, family governance, next-generation education, or strategic philanthropy but will probably need assistance in all these areas at some point during their life.  For this reason, it is important to evaluate a firm’s total platform and service offerings to make sure that they can handle both your existing needs as well as future ones.

2) Should we create our own Single-Family Office (SFO) or join a Multi-Family Office (MFO)?

Once you have decided that you need a family office, the next critical choice is whether you should form your own Single-Family Office (SFO) or join a Multi-Family Office (MFO). For most families, this decision comes down to your net-worth and the level of customization that you require.  Typically, a family with a net worth of $1 billion or more will choose to establish their own SFO, while those with between $25 million and $1 billion prefer to take advantage of the scale and shared cost structure of an MFO. Though it can be tempting to have an organization that exclusively looks after just your family’s needs, keep in mind that the cost of operating your own SFO can be deceiving.  By the time you factor in office space, technology, and several experienced professionals, it can easily be millions of dollars per year to support.  To keep costs down, many matriarchs and patriarchs serve as the head of their SFO.

3) What will it cost us?

A good rule of thumb is that a family should expect to pay about 1% of their assets per year to run their own family office. With a $10 million annual budget, a family worth $1 billion should have no problem setting up and running a high-end operation, where a $100 million family office would barely be able to afford one senior investment professional and office space with a $1 million. This is exactly why most families under $1 billion embrace joining a multi-family office as the cost savings associated with shared infrastructure, technology, and team, enables them to offer a larger team of domain experts at a price below 1% of assets per year.

4) Should we go with a large firm or a smaller boutique?

A popular industry joke is that if you have seen one ultra-high net worth family, you have seen one ultra-high net worth family. From the way each family amassed their wealth to the industry where they were successful to the way they spend money to the charitable causes they support; each family is truly unique and will require different services and support. There is a direct relationship between how custom an offering is and how much it will cost you.  As mentioned before, a single-family office will be 100% dedicated to its sole family but the costs, both monetary and your time, can be very high.  On the other end of the spectrum are family office services provided by large investment and trust banks.  Due to the sheer size and scale of their organization, they can offer these services at a low price, but this assumes that the client fits into their existing model with little customization.  For this reason, many clients choose to partner with a boutique MFO that can offer bespoke services at a competitive price.

5) How should we evaluate a Multi-Family Office (MFO)?  Questions you should ask:

• Compensation
  – How are you compensated?
  – Are you paid strictly for your advice or do you also get paid to sell products and/or accept soft dollar arrangements?
  – Are you bound by a fiduciary standard or are there conflicts of interest I should know about?
• Expertise
  – Can you tell me about your team?
  – What are their backgrounds and specific areas of domain expertise?
  – Who will we be working with on a day-to-day basis?
• Firm History
  – What is the history of your firm?
  – What is your ownership structure?
  – Can we please get a copy of your latest ADV?
  – Have you ever had any issues with the regulators?
• Clients
  – Can you please tell me what your other clients look like when it comes to net worth?
  – What industry backgrounds do they have?
  – Where are they based from a geographic standpoint?
• Privacy
  – How do I know that my information will remain private and confidential?
  – Can you walk me through your security protocols from a physical and cyber perspective?

If done correctly, a family office can enable you to truly enjoy the benefits that your wealth brings. In addition to conducting thorough due diligence on several potential firms, make sure you also enjoy working with them as you will be in constant contact with them. From adding new family members via marriage or birth to contemplating a new investment or business opportunity to considering a major purchase or charitable gift, your family office should always be your first call.

What are the private markets? What are the different types of private investments? How do private markets differ from public markets? What is the importance of due diligence?

The private market includes a variety of alternative investments such as private equity, private credit, and/or private real assets. The private markets differ as they are not listed on a publicly-traded exchange. The private market has grown almost three-fold over the past decade and globally, stood at $6.5 trillion at the end of 2019.(1) The demonstrable growth of the private markets can be attributed to many factors including the absence of regulatory burdens in the private markets, the massive liquidity that was created by nontraditional monetary policy over the past decade, the lack of daily volatility swings, and the extremely profitable IPOs of companies that were backed by private equity (e.g. Facebook, Alibaba, Salesforce). In fact, the number of private companies grew ~9% per year (from 2000-2018) while the number of publicly traded companies declined by more than 2% per year over the same period.

Some commonly known private market investments:

1. Private equity – The most commonly known portion of the private market is private equity. While select investors may invest directly into a private company, most investors gain access to private equity through a well-seasoned private equity fund and/or separately managed account. Typically, the fund is run by a general partner (GP) who gathers capital from investors and these investors become limited partners (LP). Examples of well-known private equity strategies include:
   — Buyout funds typically utilize leverage to obtain enough capital to acquire a controlling stake in a company. These companies are typically mature companies and the goal is to restructure the companies to become more profitable.
   — Venture capital funds invest small amounts in startup companies with the hopes of making outsized returns when the company matures. The funds typically carry more risk than other private equity funds. Most venture capital funds are either early stage where they are taking a bet on future growth (most of the time betting on an idea or intellectual property) or late-stage venture capital that may have the infrastructure in place but need help maximizing their earnings stream.
   — Growth funds typically invest in more mature companies than venture funds and carry less risk but a lower return profile as well. Typically, the companies they invest in are looking for expertise to make the business more profitable to potentially spin-off and/or look for merger candidates.(2)
2. Private credit – Private credit funds have grown substantially over the past two decades. One of the major contributors to growth in this space is that investors are desperate for income as yields in the public bond market remain near record lows. Private credit funds typically offer attractive yields as they lend to smaller companies that may be unable to access the public funding market at affordable rates. There are many areas within a company’s credit structure that private credit funds invest in and the level of return is highly dependent on the amount of risk associated with the debt in the fund. Some common private credit funds include:
   — Mezzanine and senior debt funds typically make loans to lower and middle-market borrowers as either senior or subordinate loans. The structure of the loans varies as senior loans may sit higher in the payout structure in the event of default while subordinated debt sits a bit lower (but still before equity ownership).
   — Distressed credit funds are funds that invest in the debt of distressed companies. They look for discrepancies between how the debt is pricing and compare it to the ultimate recovery rate in the event of default and/or the underlying value of the loans in the event of restructuring the company’s debt. This type of private credit can be highly speculative and dependent on expertise in bankruptcy laws and legal corporate structures.(3) These funds carry more risk than mezzanine or senior debt funds but also can offer a better return potential.
3. Real assets – Real asset funds access a variety of investments that carry the characteristic of having a tangible value. An investment is considered to have tangible value because there is something physical that backs it up. In addition, because it has a tangible value it is also expected to keep pace with inflation and some investors utilize it for a long-term inflation hedge. Some of the common types of real asset funds include:
   — Real estate funds are private funds that can invest in a pool of real estate offerings or into a direct real estate structure. Real estate funds vary across investments in office space, apartment buildings, warehouses and shopping malls. As with most private investments these represent long-term investments with capital locked up for different periods of time depending on the project. Investors are drawn to private real estate for its steady cash flow and historically negative correlation to publicly traded real estate investment trusts.
   — Infrastructure funds are private funds that may participate in a public-private partnership to spur infrastructure. The need for infrastructure is a global phenomenon. It is estimated that the world needs $3.6 trillion in annual spending for infrastructure. Given the limitation of government budgets to fill this void, there is always the need for public/private partnerships.(4) These types of funds may offer both capital appreciation as well as steady income.
   — Natural resource funds invest in companies that focus on the extraction, drilling, production and or refining of commodities, chemicals and/or timber. Since these funds invest in the physical commodity, chemical, etc. they are considered another way to hedge against inflation. These funds are long-term investments and carry risk as they are heavily correlated to the economic outlook.

How do the Private Markets Differ from the Public Markets?
There are advantages to investing in both the public and the private markets, especially for a well-diversified portfolio. Some differences investors should be aware of include.

• Barrier of entry: With the development of mobile apps and the increasing number of online brokers, the ability to invest in publicly traded stocks is open to nearly all Americans regardless of their knowledge or individual financial situation. However, in order to access the private markets, you must be classified as an accredited investor (e.g. high net worth individual).
• Reduced regulatory burden: Private companies are not constrained with regulatory hurdles and scrutiny like public companies. Regulatory filings, registrations, annual reports, and highly reviewed earnings reports are some of the items that cost money for public companies but not for private companies. A public company is sold to the public, so it is forced to accept more regulations. However, a private investment is typically sold to a smaller pool of accredited investors, and not required to adhere to the same regulatory environment.
• Daily volatility swings absent in private markets: Public equity markets have always been subject to daily price swings. However, in recent years these daily volatility swings have been exacerbated by algorithmic trading. Since private companies are not listed, investors do not have to see daily price swings or accept massive changes on frequent investment statements.
• Liquidity differences: Investments in the public market offer daily liquidity for investors that need to sell or want to buy. However, private investors are forgoing daily liquidity and willing to lock up their money for prolonged periods of time in exchange for the potential of a better risk-adjusted return.

Due Diligence is Crucial in Private Markets

The information to value a private company is not as readily available as it is for a public company that is forced to disclose financials, so the due diligence process is more complex and even more important in the private markets than in the public markets. The efficient market hypothesis states that a publicly-traded company should reflect all available public information. It should be a fair playing field for all investors because anyone can obtain the same public information. However, that is not the case in the private markets. It takes deeper due diligence and market analysis to determine the appropriate value of the private investment and the price a buyer may be willing to pay for it in the future. An example of the importance of due diligence is evident in the dispersion between returns in the public market and compare it to the private market. Over the past 10 years those investors that invest in a publicly-traded equity manager saw a very narrow dispersion in the returns (10.3% for best managers and 7.8% for worst managers). This is because all managers had the same information. However, you can see the dispersion in returns between the best managers in the private equity space (20.1%) compared to the lowest quintile managers (1.9%).

Private Investments can add to a Well Diversified Portfolio with Less Volatility

Volatility in public equity markets is typical and should be expected by investors throughout any long-term investment cycle. However, the violent daily swings that investors have had to absorb this year brought back memories of the Great Recession. In addition, a traditional portfolio of stocks and bonds has not recently been offering the same diversification benefits as it may have historically offered. This is because the Federal Reserve has been a more prominent player in the public bond markets resulting in bonds not pricing in underlying fundamentals, instead, prices are manipulated by the Fed purchases. In addition, artificially low interest rates result in excess risk-taking and may drive equity prices higher than fundamentals warrant. Therefore, it is important for investors to look at alternative ways to add diversification to their portfolios. The private markets not only offer the potential for attractive long-term returns and diversification benefits but also less volatility for investors to absorb.

The Bottom Line

Taking advantage of the private markets through a less liquid investment can provide investors with the ability to generate excess returns over time and eliminate the stress of daily price movements of a public security that may have no fundamental impact on the actual value of the business. In an environment where finding value in the public equity and bond markets is starting to entail taking on more risk, the private markets look even more attractive. In addition, the demand for good quality private investments has had investors chasing too few deals in recent years. This can be seen by private equity funds coming into 2020 with $1.5 trillion of “dry powder” or money that can be deployed.(5) However, the market conditions and dislocations over recent months have resulted in attractive opportunities for that massive amount of money to be deployed and history suggests that private investments can outperform public investments at the turn of an economic cycle. While every client’s financial situation and investing goals may vary, the ability for a wide array of investors to access the private markets through different structures is growing. Therefore, we will continue to look for attractive private investments that offer our clients the opportunity for a good risk-adjusted return, can enhance income opportunities, and offer attractive diversification benefits.

As always, if you have any questions about our perspective, please do not hesitate to reach out to your advisor.

1. Mckinsey Global Private Markets Review 2020 – A New Decade for Private Markets. McKinsey and Company, February 2020. Three times estimate comes from the Mckinsey report and is as of 2010.
2. Private Equity Interviews: The Official Guide. Published by Andrew Chen.
3. Private Credit Strategies: An Introduction. Cambridge Associates. September 2017.
4. Mckinsey Global Institute, JPMorgan Asset Management, Data as of May 31, 2020.
5. Private equity has $1.5 trillion of unused funds and is looking to raise more. Fortune magazine. January 2020.

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