From the June 2007 issue of Wealth Manager Web • Subscribe!

The Perils of Entropy

Consider the mind-boggling possibilities of compound interest: If the Lenape tribe of Native Americans had invested the 60-guilder ($24) proceeds from their sale of Manhattan island to the Dutch in 1626, in a bank that paid 6.5 percent interest compounded continuously, that investment would be worth $1.3 trillion today--providing more than enough scratch to repurchase Manhattan, the four surrounding boroughs, and a good chunk of New Jersey, too. But history reminds us that such long-term wealth management is the rarest of exceptions.

Indeed, taxes, war, inflation, devaluation, pandemic, political collapse, obsolescence, competition, debacle and new technology can all wreak havoc. And on a micro level, wealth has been routed by bad management, apathy, hubris, entitlement and profligacy. These macro and micro pathogens ultimately lead to entropy, a term used in physics to describe the degradation of matter and energy to an ultimate state of inert uniformity.

To be sure, financial entropy is as real as the physical kind; hence, the incisiveness of Andrew Carnegie's likely apocryphal crack: "...from shirt-sleeves to shirt-sleeves in three generations." Once arrived, entropy is a fait accompli. The goal, then, is to slow the journey.

The most obvious entropy accelerant--one that absorbs an inordinate amount of wealth--is taxation. In the United States, the federal government is tantamount to the wealthiest family member. To lessen the loss, sundry legal devises are employed--trusts ranking high in utility because of their ability to mitigate not only the government's grasp, but creditor and divorce claims as well.

In addition to shielding wealth against unwanted claimants, trusts can impose controls over disbursement, often through quid pro quo dictums. "The trust term governs the payout, and I've seen incentive trusts designed to govern a wide range of possible behaviors with payouts tied to a desired goal of the trust writer," says attorney Kathryn G. Henkel, a partner at Hughes & Luce in Dallas and author of Estate Planning and Wealth Preservation: Strategies and Solutions.

Infusing the trust document with incentive-laden language would seem a plausible strategy to achieve constructive outcomes, but that can easily invoke the law of unintended consequences. "I've had attorneys tell me that no matter what box you put someone in, there is someone who can unlock that box," says Keith Whitaker, director of family dynamics at Calibre Advisory Services in Boston. "You put people in chains, and then they will spend all their time trying to slip those chains."

And sometimes the chains are remarkably easy to slip. Thomas Frank Manville Jr., heir to the Johns-Manville asbestos fortune, was a minor celebrity in the 1950s--achieving notoriety for notching a baker's dozen marriages to 11 different women. Manville's unusual approach to matrimony was encouraged by an oversight in his father's will: Manville Sr. transferred the family fortune to a trust from which Junior was only entitled to the interest, although he could withdraw a million dollars from principal when he married. Because the trust did not stipulate the windfall for a first marriage only, Manville Jr. enriched his coffers by engaging in legalized serial monogamy.

Lack of family governance is another leading destroyer of wealth. Passing the family business to uncommitted, unprepared or incompetent family members can lead to quick and irrevocable losses.

Kevin Ellman, CEO of Wealth Preservation Solutions in Ridgeway, N.J., provides an illustration of the difficulty in passing on the family business to subsequent generations: "We have a client with two brothers in business, and there is no one in the next generation who can manage the business. We are trying to develop a plan where one of the key managers can stay on, and one of the heirs from the next generation can develop into a competent manager. You have the financial aspect and the family and managerial aspects. It's an intricate process."

And a frustratingly entropic process as well. The likelihood of second- and third-generation progeny successfully managing the family enterprise is remarkably low. According to research by Gary Becker of the University of Chicago, the correlation between a father's and son's income is only around 0.15, suggesting that if a father's income is twice the average, his son's expected income will be 15 percent above average, and his grandson's just 2 percent above average.

The Family Firm Institute of Brookline, Mass., provides equally dismal statistics on the business acumen of subsequent generations, noting that "nearly 70 percent of all family firms fail before reaching the second generation, and 88 percent fail before the third generation; only a little more than 3 percent of all family enterprises survive to the fourth generation and beyond."

T

he Ford Motor Company is an excellent example of the difficulty heirs may have in managing the enterprise as competently as the founder. Through Ford's 100-year history, the company has been led by a succession of Ford descendants--with the occasional outsider providing a brief interregnum. Until recently, contemporary scion William Clay Ford Jr. served as CEO, with a tenure that could best be described as "disappointing." In 1999, when Ford Jr. took the reins, Ford's stock was changing hands at $35 a share and paying an annual dividend of $1.05 a share. The family's stake was worth $2.25 billion. Today, Ford stock is trading around $7.75 a share and paying no dividend. The family's investment has shrunk to $600 million.

Thus, whether the Ford Motor Company progresses to the sixth generation and beyond is far from certain. The company is fighting fierce competition and will likely burn $17 billion in cash over the next three years. In late November, the company negotiated $23.4 billion in bank loans and bonds convertible to shares. The company pledged a dozen U.S. factories, its 100 percent stake in the Ford Motor Credit consumer finance unit, and its blue oval logo as collateral.

Selling the family business and diversifying the wealth is one obvious solution to the family management conundrum, but one not without shortcomings. Selling the business and diversifying the proceeds means less risk, to be sure, but it also means less wealth. Dynasties are created by concentrating energy in a specific industry or endeavor. Successful, concentrated investments are virtually guaranteed to provide higher returns than Markowitz-efficient portfolios.

In turn, lower returns provide more fuel for entropy's most insidious accelerant--demography. In normal evolution, each family member produces two or three children. These children repeat the same reproductive pattern, and gradually, more family members become heirs to the same fortune. The financial assets must grow to encompass the needs of an expanding community.

Many advisors unwittingly aid entropy's progression. According to James Hughes Jr., author of Family Wealth: Keeping it in the Family, wealth advisors often fail to follow through once the initial planning mechanisms are devised and implemented. "Most advisors appear to think that their work is done with the creation of the new legal entity," says Hughes. "Suddenly, the family members who have never been family-limited-partnership members or beneficiaries and trustees have to take up the mantle, but they are unprepared to accept the responsibility, so they fail."

Almost all families have rivalries and disagreements, which invariably become focused on the issue of wealth. An effective means of resolving family conflict, while judiciously allocating capital and educating subsequent generations, is by establishing a "family bank" that promotes real application processes for grants and loans. To work effectively, family banks should adhere to standards that are common to all financial institutions so that the borrowers--in this case, family members--will understand and accept financial reality.

According to Steve Braverman, managing director at Harris myCFO, few devices work better in disseminating family wealth. "The patriarch becomes the chief investment officer with support from other family members and, if needed, outside counsel," he says. "Family members seeking capital must create a business plan and make presentations to the family board. If you have a viable activity that allows you to pursue and expand your horizons, it will get funded. I've seen the family-bank concept used effectively for foundations, charities, and businesses."

This family bank approach works because wealth is maintained cohesively in one entity, and therefore, is more easily supervised and managed. Funds can than be successfully re-allocated from the hands of the oldest generation to those of the younger generations based on economic viability and personal enrichment--not entitlement. In fact, the family bank tempers the sense of entitlement and dependence that great wealth often engenders.

The Rothschilds are yet another illustration of family banks as a successful strategy for maintaining wealth through time. One of the few families that has perpetuated its wealth through several generations; the Rothschild strategy has been to adhere to the following family bank triptych:

1) they loan their heirs money, which is expected to be repaid;

2) they share their knowledge and experiences with other family members; and

3) they gather annually to reaffirm their virtues and intentions.

The demand for salient wealth transfer advice is expected to swell over the next decade, thanks in large part to overall global prosperity. "There has been significant growth in major liquidity events," says Braverman. "People are going from being comfortable to becoming very wealthy overnight. There is an amazing number of new first-generation wealth." The numbers appear to support the assertion.

According to a study by Merrill Lynch and Capgemini Consulting titled "World Wealth Report," the number of people classified as high-net-worth is expanding--globally--at an unprecedented rate. Key findings of the report show that globally over the past decade HNW wealth grew at an annual rate of 8 percent, expanding from $16.6 trillion in 1996 to $33.3 trillion in 2005.

The Merrill/ Capgemini report also reveals that there are 8.7 million people around the globe who hold more than $1 million in financial assets (excluding their primary residence)--an increase of 6.5 percent over 2004. The report states there are approximately 2.9 million households in North America whose net worth exceeds $1 million.

The ranks of the world's ultra-HNW investors--those with individual financial assets in excess of $30 million--also made headway in 2005. The total number now stands at 85,400, a 10.2 percent increase over 2004. What's more, many of the nouveau riche express serious concern over the low level of involvement in managing the family wealth that they see in the next generation. They worry that their children--accustomed to an affluent lifestyle--lack the same drive, entrepreneurship and interest in managing the family assets as their predecessors had in amassing them.

Of particular importance to advisors, the Merrill Lynch/ Capgemini study found that HNW clients often bypass their advisors when seeking wealth-transfer guidance, turning instead to trust and estate attorneys, tax attorneys and accountants. Perceptive wealth management advisors are capitalizing on the rebuff, taking steps to position themselves as a trusted wealth transfer source. These advisors are putting a new twist on compounding interest by not only preserving a client's wealth, but also by developing long-term relationships with future generations.

Stephen Phillip Brown, CFA, a freelance financial writer based in Brighton, Colo., has written for Barron's, CFA Magazine, The Financial Journalist, the Denver Post and Rocky Mountain News. He can be reached at sphillipbrown@consultant.com.

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