Typically this occurs as a result of the sale in whole or in part of the family business, or the business generating a free cash-flow that does not require to be reinvested in the business itself. However, before rushing to invest, the ‘family office’ needs to develop a strategy that is directed towards ‘risk’ management rather than ‘diversification’ of asset ownership itself.
A great deal depends upon what stage the family are at in relation to the main operating business itself. Has the business been sold and the proceeds applied towards the new diversified investment pool? Or does the business still exist and if so, is it self-sustaining or will it require access to the ‘liquid pool'? If it is self –sustaining can the family’s investment strategy rely on additional investments, by way of dividend or other after-tax capital?
In the latter scenario, the family’s risk capital is often the business itself. Here, the family office does not mitigate risk around the capital invested in the business but is the vehicle to accumulate capital outside the business in the event of an untoward event. Therefore what is the level of capital that the family will look for the family office to have created as a bare minimum in the event of a ‘business’ worst case scenario occurring and by when?
Understanding the relationship of the business to the investment pool is important when determining the level of risk that the family wishes to bear in defining the objectives for the family’s pool of wealth.
As the vehicle for managing the family’s capital the stated purpose of a family office is typically to “grow the family’s net wealth, by growing and protecting a separately designated pool of assets”. The two purposes could be seen as being in opposition, that is by seeking to grow assets, the family office must necessarily take on ‘risk’ and to the extent it does so, it may not necessarily ‘protect’ that capital.
Faced with a similar dilemma other families have talked of setting capital floors (e.g. not to reduce the capital base below) or establishing a bare minimum of capital that is required to remain intact (e.g. that the value of the portfolio should be in 15 years at least $ [ ]).
By defining these ideals as qualitative measures, the family office’s investment strategy can be tailored to achieving these objectives in a financial sense. For example, in 15 years time the family’s investment pool will have the capacity to provide each family (branch/individual?), as a minimum, with sufficient capital to enable that family to live in an unencumbered home, finance an education (of their choice) through to post tertiary level for each child. In doing this the family office can estimate by projection of family members, inflationary targets, a target base level of liquidity of ‘protected’ capital.
Some families have set an audacious target for the family’s capital and then mandated the responsibility for generating that target to their family office, and commonly, a member of the family with most experience in managing investment risk. Here there is a cautionary tale. By setting an audacious target, the level of risk required to be adopted to achieve that target is often outside the potential for a well diversified portfolio to consistently achieve. Being overly aggressive at first instance, carries not just the inherent investment risk and heightened volatility but also the potential ‘political’ risk for the family member who fails to meet targets or worse actually loses capital.