Solutions for Small Family Offices ^Featured

Let’s discuss the unique challenges that small family offices face in managing portfolios and assessing investment risks. Recent data of 2023, suggests that the wealthiest 1% of individuals in the United States own about 32% of the nation's total wealth, while the top 0.1% holds around 15%. So, what is a ‘small’ family office? It depends on their geographical locations.

Family offices in the USA come in various sizes, with huge differences in assets under management (AUM) and staff numbers. A smaller family office in the USA usually manages assets in the range from $50 million to $500 million and often operates with a small team of professionals, typically fewer than five individuals.

European family offices differ from those in the US in several ways. In Europe, family offices are typically smaller, both in terms of AUM and the number of employees. This difference can be explained partly from the history of family wealth in Europe, where there are fewer ultra-high-net-worth families compared to the USA. As a result, European family offices often oversee smaller portfolios and have fewer staff members. It's common to find European family offices managing between $5 million to $10 million, often with only one investment professional wearing several hats of a portfolio analysis, risk manager, and fund accountant.

Today, we're looking at small family offices, which manage just a few tens of millions of dollars and are often run by a small team. Despite their size, these boutiques invest in a wide variety of assets which makes their portfolios unique from the asset diversification perspective. Typically, many high-net-worth and ultra-high-net-worth families invest about half of their assets in traditional liquid options like stocks and bonds traded publicly. The other half of the portfolio is allocated in alternative investments such as hedge funds, private equities, and cryptocurrencies. Such an enormous diversification across different asset classes, each requiring separate risk valuation and portfolio construction frameworks, presents two challenges: the need for highly skilled asset managers familiar with all these asset classes, and the need for an all-in-one investment platform capable of handling both traditional and alternative instruments.

Resolving these two challenges within a relatively limited budget of small family offices could be difficult.

Staffing Problem: Multi-asset Investment Managers

Small family office boutiques may have several options to address staffing problems:

• Investing in top-tier investment professionals. This can be costly, as experienced multi-asset portfolio and risk managers command high salaries. On the other hand, hiring separate experts for each asset class also adds up in expenses. Large institutions address this problem by establishing multiple departments or teams, each specializing in specific asset classes, and narrowing expertise of individual managers. Obviously, such a strategy is hardly doable for small firms.
• Hiring entry-level investment analysts and portfolio managers. This solution might seem appealing, but it risks compromising the quality of the investment portfolio. By focusing on immediate cost savings, it may result in inferior investment choices and a lack of expertise in effectively managing complex portfolios. Finding a balance between cost-effectiveness and the quality of diverse family office portfolios can be vital for its survival.
• Outsourcing routine management operations and/or portfolio management. This seems to be a logical solution to address both budget constraints and investment expertise. However, while there are several firms offering cost-effective accounting services offshore, finding a reputable company providing advanced risk management and portfolio construction services can be quite challenging. Moreover, outsourcing these functions to established fund management firms may end up being more expensive than hiring in-house managers.
• Flexible outsourcing. The emerging trend entails combining the skills of entry-level investment managers or analysts with outsourcing key aspects of portfolio construction and risk management to a third party, typically the same software vendor providing analytical and portfolio management tools. Such a balanced approach allows family offices to optimize their resources by leveraging external expertise while retaining control over key investment decisions.

Technology Problem: Comprehensive Multi-asset Investment Platform

Choosing the right software for a family office is not an easy task because there are two dominating types available. On the one hand, the market is flooded with dedicated family office platforms that provide reporting, taxation, project management, and general ledger accounting functionalities. Unfortunately, these platforms often lack robust portfolio construction and risk management tools. On the other hand, top-tier institutional risk management platforms provide comprehensive features for portfolio analysis and risk assessment but can be costly and may not address the specific needs of high-net-worth family portfolios. This creates a problem to find a solution that strikes a balance between affordability and sophistication.

Setting aside basic reporting or project management functions, which are often presented as ‘family office solutions’, an advanced all-in-one investment platform for family offices should include the following key functions;

• Complete Asset Coverage: The platform must handle all asset types, including illiquid and alternative investments, to provide a thorough overview of the family's portfolio.
• Integrated databases of diverse asset classes including not only traditional instruments, but private equities and alternative investments. These databases should provide up-to-date pricing and performance information.
• Sophisticated Risk Analytics: The platform should offer advanced tools for assessing risks across all asset classes, portfolio construction, and optimization - enabling families to make well-informed decisions and mitigate risks effectively.
• Advanced Stress Testing: Given the unpredictability of markets and the complexity of alternative investments, the platform should offer sophisticated stress testing capabilities. Stress testing estimates portfolio performance under different macroeconomic scenarios replicating historical extreme events or modelling new devastating scenarios that never took place in the past.
• CRM, Due Diligence and Document Management: The platform should integrate robust CRM functionalities alongside efficient document management tools. This integration streamlines communication and documentation processes, promoting efficiency and organization within the family office.
• Full-Scale Portfolio Management and Shadow Accounting: Not just a general ledger accounting, the platform should incorporate multi-asset portfolio management and shadow accounting capabilities, enabling NAV calculation, liquidity and exposure analysis. To effectively manage investments across diverse asset classes, family offices need to consolidate single asset class sub-portfolios into a main holding portfolio. This enables them to assess the risk of each sub-portfolio individually while also evaluating the overall risk of their entire investment portfolio.
• Tailored Support and Risk Management Consulting On-demand: Vendors of wealth management platforms should provide customized services and expert risk management consulting, to address unique requirements and challenges of each family office. This personalized approach ensures that the platform meets the unique requirements and goals of the family.

The Expertise Challenge: Staffing and Software Selection

This challenge arises from the fact that many family office principals are not investment professionals. Having generated wealth in diverse sectors like mining, shipping, or food chains, they have a limited knowledge of institutional investment practices required to handle their complex investments. While office principals may excel in their own business, they often struggle in assessing the expertise of hired staff and evaluating the functionality of the investment platform. Outsourcing staff recruitment to external agencies isn’t always the most effective solution due to their formal ‘pattern-fit’ selection process and lack of expertise in complicated finance sectors.

Not surprisingly, many family offices rely on their connections and word of mouth to fill in investment management positions. Given their close ties to legal and tax advisors, the latter often recommend people they work with, such as accounting professionals. We are not suggesting that the described scenario is always the case, but it helps explain why we frequently encounter accountants working as investment analysts or portfolio managers in small family offices. In the past two decades we’ve been conducting hundreds of product presentations for family offices world-wide. In the small-to very small family office category, about 75% of investment professionals were certified chartered accountants. While we respect the role of accountants in the investment process, managing highly complex and diversified portfolios demands a different skill set, which chartered accountants typically do not possess.

In our opinion, the minimum required skillset for family office investment managers should include:

• Good knowledge of different risk assessment frameworks for diverse asset classes: traditional equities and fixed income, hedge funds, private equities and real estate. All these asset classes require specific risk valuation frameworks.
• Advanced knowledge of portfolio construction and optimization techniques, not limited to the conventional mean-variance methodology, which is hardly applicable to alternative investments.
• Expertise in conducting stress tests for illiquid instruments, multi-asset portfolios, and fixed income securities.
• Knowledge of alternative investment space and quantitative asset selection models.
• Experience in conducting due diligence on fund managers and familiarity with industry due diligence questionnaire (DDQ) standards.
• Fund NAV calculation methods.
• Advanced risk assessment models of private equities including KSPME, Direct Alpha, Index IRR, and Yale Cash Flow forecasting.

Typical Investment Mistakes of Small Family Offices

Family office operations can encounter various pitfalls that lead to investment portfolio failures and financial losses. Some common mistakes include:

• Lack of Diversification: Overconcentration in a single asset class or investment type exposes the portfolio to heightened risk. Failure to diversify across different asset classes, industries, and geographical regions can amplify losses during market downturns or economic crises.
• Emotional Decision-Making: Family offices may succumb to emotional biases such as fear, greed, or overconfidence, leading to impulsive investment decisions. Emotional trading can result in buying at market peaks or selling during downturns, eroding portfolio value over time.
• Inadequate Risk Management: Ignoring risk factors or underestimating their impact can lead to significant losses. Family offices should employ robust risk management strategies, including stress testing, scenario analysis, and portfolio optimization, to mitigate downside risk and preserve capital.
• Lack of Due Diligence: Failing to conduct thorough due diligence on investment opportunities can expose the portfolio to fraud, mismanagement, or underperformance. Family offices should perform comprehensive research and analysis before committing capital to any investment, ensuring alignment with their investment objectives and risk tolerance.
• Neglecting Long-Term Goals: Short-term thinking and a focus on immediate returns may lead to neglecting long-term investment objectives. Family offices should develop a clear investment strategy aligned with their goals, time horizon, and risk appetite, avoiding reactionary decisions based on short-term market fluctuations.
• Overreliance on External Advisors: Relying too heavily on external advisors or investment managers without maintaining active oversight can result in suboptimal investment decisions or conflicts of interest. Family offices should maintain a balance between internal expertise and external advice, actively monitoring and evaluating investment performance.

Summary

Family offices represent one of the most discerning investor groups today, given the complexity and diversity of their investment portfolios. Unlike highly regulated institutional investors, they have the freedom to invest in any securities without regulatory limitation. This entails high requirements for both the staff and the investment management platform. Additionally, small family offices share the same expectations as large ones but are also constrained by budget limitations. When selecting a right investment platform, family offices need to ask themselves a few simple questions. Can that platform provide extreme event stress testing of our portfolios? Can it assess risks of hedge funds and private equities? Can it also optimize portfolio allocations using advanced models suitable for alternative investments? Can it calculate real-time NAVs and estimate liquidly forecasting for complex redemptions? Can it allocate better assets by screening multiple databases? If the answer is No to any of these questions, perhaps a more appropriate family office solution should be considered. Join our coming webinars to discuss advanced family office solutions.