Family offices: the business of controlling non-investment risk
While advisers and banks alike are often of the opinion that family offices have much to gain from better a understanding and management of “non-investment risk”, adherence to such an approach among family offices remains patchy.
And amid the usual family rows, divorces and “key man” issues, there are other, perhaps less obvious, potential threats to consider, including the rise in the use of social media, as Paul Golden discovers…
Investment risk is often perceived as the greatest threat to a family office. Yet it is estimated that most family fortunes fail to get past the third generation because of poor decision-making elsewhere.
Some of the non-investment risks faced by family offices include: security of data; physical safety and health of family members; prepare the next generation to take charge; protection against divorce and fraud and embezzlement by family office staff.
Additionally, there is “key man” risk to manage, which could be at the level of chief executive or family principal. A well-structured family governance programme and clear succession plan for key roles can largely mitigate these risks.
Personal security risks extend to senior family office staff as well as family members and many of the areas of vulnerability for the latter include the extent to which they use social media.
If not carefully controlled, this can provide valuable information to someone wishing them harm as Jon Needham, global head of fiduciary services at Kleinwort Hambros – the private banking arm of Societe Generale that was created last year following SocGen’s acquisition of Kleinwort Benson – explains.
“Reputation risk is not necessarily obvious to family office principals, but they need to acknowledge that a poor choice in terms of business partner or adviser could negatively impact their perception as a reputable family office,” says Needham.
“Both in this context and more generally, applying appropriate levels of due diligence checks to the entities they engage with in any capacity will go a considerable way towards mitigating these risks.”
Robert Hille, general counsel and chief compliance officer at Laird Norton Wealth Management, pictured right, believes that some family offices are “insufficiently aware” of the risk factors that affect their operations.
“There tends to be a sense of complacency, with the prevalent mentality being ‘this won’t happen to us’ and that the family office has more important things to do in taking care of family financial matters,” he says.
Sandy Loder, founder of AH Loder Advisers, suggests it is “a mixed bag” at best, and warns that regulators will at some point start to look at family offices, since they can be managing the money of spouses and cousins as well as immediate family.
Some family offices fail to consider the implications of risk until it is too late, agrees Needham. “If they have not already done so, the family office should ensure that someone within the organisation has risk squarely on their agenda as a key responsibility. If this is not done the chances are that something will fall between the cracks.”
In a paper published by the Family Office Association, Samuel Won, founder and managing director of New York-based Global Risk Management Advisors, observes that family offices cannot have institutional quality risk management without the requisite infrastructure.
Examples of essential infrastructure as he defines it include risk analytics and connectivity of risk infrastructure to other key systems, such as accounting and compliance.
In a recent interview, Won elaborated. “We strongly believe that the key consideration for a family office should be to have actionable risk management,” he said.
“The starting point for a family should be to put in place a sound risk management framework, that includes key elements such as an investment policy statement that reflects the family’s approach toward risk management, risk policy guidelines that define the family’s tolerance levels and budget for risk, and risk management policies and procedures, as well as risk management processes and controls that operationalise how risk management will be executed, as part of the family’s key investment processes in areas such as asset allocation, re-balancings, and manager selection and redemptions.”
‘What risk means to them as individuals’
Charles Lowenhaupt, chairman and founder of Lowenhaupt Global Advisors, says it helps for the family, and its advisers, to understand what risk means to them as individuals.
“The risks a family must consider go far beyond investment,” he says. “They include health, safety, potential for dispute and dysfunction, liability, property damage and poor marriage.”
According to Lowenhaupt, a well-run family office should have a ‘risk officer’, whose job it is to compile a risk register – which should be reviewed with each family member alongside regular risk reporting.
Creating such a family risk register, he notes, requires promoting discussion within the family and its advisers around the implications of inaccurate reporting or poor tax and compliance work.
“There will be risks normally governed by insurance – liability, health and property – and more difficult risks of marital and family dysfunction, divorce and disagreements within the family,” he continues.
“There are also safety and health risks that are difficult to insure against. In addition to family members and employees of the family office, investment advisers, banking and insurance experts, lawyers and accountants all need to participate in building the risk inventory.”
Lowenhaupt says it makes sense to have the risk officer as a person in the family office or on its board, but not a family member or the chairman of the board or president. The qualities required to fill this role, he says, include organisational expertise and the time and capacity to follow up on each risk, maintaining a grading system to cover both the likelihood of it happening as well as the capacity to tolerate it if it does.
Technology and the risk management process
Opinion is divided on the extent to which technology (in the form of risk analytics software, for example) has impacted the family office risk management process.
According to Hille, the ability to analyse large amounts of data has helped identify trends and areas that merit a closer look or require greater controls.
“Testing of systems can be better accomplished with new software and this can apply to internal processes as well as vendor due diligence,” he says.
This view is shared by Needham, who suggests that analytics and risk control software increases risk management efficiency and opportunities to mitigate costly mistakes.
Yet Robert Jones, pictured left, managing director of the Hong Kong-based FCL Advisory, says he has never seen technology play any significant role beyond facilitating communications.
“I have never witnessed a family office installing complicated risk software or relying on complex risk assessments such as information ratio – even the Sharpe Ratio isn’t used that much,” says Jones.
“They prefer to rely on simple measures such as returns and volatility, as well as slicing and dicing their portfolio by asset classes, currencies, geography, liquidity, etc.”
Risk management’s bottom line
The sixty-four-thousand-dollar question, of course, is what impact, if any, does more effective risk management have on a family office’s performance? The bad news for those hoping for a quick – and cheap – win is that it appears to be something that has to be accepted as a cost of doing business.
“Risk control is an absolute cost to any business, and requires a certain level of investment,” says Needham.
“Under-invest, and the impact could be significant in any of the areas highlighted.
“But there is also a clear cost to getting it right.”