Editor’s note: There are many good reasons for very wealthy client families to explore forming a family office. Wealth managers can help those clients decide whether this is the right path for the family and which structure and services will help them to achieve their goals. Contributor Michael Faber, an attorney who advises families as CEO of the investment advisor NextPoint Management Company, Inc., has created a roadmap for wealth managers whose client families are considering this path.

Families with sufficient wealth to consider creating a single-family office (SFO) should also evaluate the suitability and sustainability of joining an existing multifamily office (MFO), where resources and costs are shared by similarly situated families.

Of course, first- and second-generation creators of wealth who desire to establish a legacy for future generations, and a structure that will allow those family members to more easily manage and preserve that wealth, are best served by creating and owning a permanent and well-managed family office (FO).

Investment management

Managing wealth (and wealth preservation and growth) is the most important role for the typical family office. Evaluating, selecting and replacing investment managers is more or less complex depending on the number and type of managers used.

Since few, if any, families allocate all of their assets to one investment firm, the FO must have access to the skill sets required to select and evaluate, at least quarterly, a large number of diverse third-party managers. Many families also become involved in direct investing strategies (investing directly in private and public companies), which requires additional and very different skills and often is poorly managed by FOs.

Family offices should maintain detailed investment guidelines relating to allocation percentages, diversification, liquidity, etc. and have some understanding of the variety of investment manager due diligence and evaluation tools, such as alpha, Sharpe ratio, etc., in order to accurately assess investment risk, portfolio risk and operating risk. It is no longer acceptable to rely only on the advice of third-party managers and funds of funds.

Most importantly, families must recognize the importance of hiring talented investment professionals, with the appropriate skills and at market rates of compensation, in order achieve their investment and risk management objectives. This is an area in which many FOs make avoidable mistakes by employing loyal but inexperienced professionals.

To create the wealth management framework, these questions must be thoughtfully resolved:

  • Who invests? One firm, multiple firms, a selection of third-party managers, FO managers (or some combination thereof)?
  • Who selects and evaluates managers? With what criteria, e.g., returns net of fees and after taxes, correlations to market, correlations to other investments, strategy drift, implied risk, market conditions? How often? With what external advisors?
  • Will there be direct investing or co-investing? Who decides and manages?
  • Who manages the “big picture” issues, such as portfolio risk, diversification, liquidity, performance, tax efficiency, and fixed and discretionary distributions?

Managing the owned or closely-held family business

Many families generate wealth through the creation of a successful business that some family members continue to own and operate, i.e., the family business (FB). In addition to liquid wealth, these families have a large illiquid asset that is both very valuable and very important to the family on a personal and emotional basis.

The FB is also very important as a source of increasing family wealth, and the ownership and management of the FB will have an impact on how wealth is created and distributed within a family, especially as the family grows from generation to generation. This is evident regardless of whether family members or independent professionals are managing the FB.

As an investment management matter, the FO must account for the existence of the FB, as both an asset class and as a risk factor, in its asset diversification, allocation and liquidity strategies as well as understand any ownership change across future generations. In so doing, the FO can insure that it is managing a large illiquid investment, in addition to all other investments, for the benefit of both existing family members and the designated beneficiaries.

The FO can also be very helpful in serving as a source of information and as an honest broker in offering answers to the questions that typically arise about the FB. This is especially true in the context of multiple generations and family members uninvolved in the FB.

Family businesses require special considerations:

  • Who owns and controls the FB and how will ownership and control change over time? What is the financial impact on family members? What role does each family member have in the FB? What role will future generations have and how will those roles be decided and by whom?
  • What resources are available to family members who create new family businesses or their own personal business endeavors? What financial and economic disparity exists for family members who either do or do not participate in the FB?
  • What role does the FO have in managing expectations about the FB, such as the roles of family members, the distribution of control and wealth, the impact on future generations, and its strategic plans and future disposition?