Leading Practices for Structuring the Family Office

Leading practices for families and their advisers identified through four structural attributes.

October 2011
by Eric Johnson/The Tax Adviser

As the economy slowly climbs out of the “Great Recession,” many well-run businesses have undertaken assessments of specific aspects of their operations to ensure that they will be properly positioned to withstand the challenging economic landscape and, at the same time, be able to exploit future opportunities.

While a family office may not initially come to mind as a “business,” as that term is commonly used, many family offices are indeed highly complex businesses, operated with the same disciplines that are hallmarks of the most admired publicly traded companies.

What Is a Family Office?

Broadly defined, a family office is an organization established to oversee (directly or indirectly) the financial matters of a family. This can include investment oversight and financial reporting as well as legal, regulatory, and reporting compliance. A family office may also provide other, more personal, services for family members (coordinating travel plans, overseeing household staffing needs, etc. — so-called concierge services).

Many of the earliest family offices served the wealthiest families in Europe. These offices oversaw multigenerational business holdings and served as the blueprint for many of the early U.S.-based family offices that were established as families in this country amassed great levels of wealth starting in the late 19th and early 20th centuries.

U.S.-based family offices exploded in popularity in the latter part of the 20th century. Indeed, for many of the wealthiest (and some not so-wealthy) families, having a family office became another indicator of economic standing. Even though the economy in general and various markets in particular experienced volatility during this period, the general trajectory of the economy was upward.

The economic tumult of 2008 and 2009 (what many have come to describe as the Great Recession) caused substantial reductions in wealth for many of the wealthiest families in this country. Moreover, many apparently safe investments were subject to restrictions that limited liquidity and further exacerbated financial uncertainty.

This experience has changed the appetite and appreciation for risk of many wealthy families. It has also changed the expectations of many such families regarding future returns. In light of these changes, many wealthy families with family offices are reassessing their role and structure in the current economic climate. Concerns over preserving net worth, maintaining sufficient liquidity, and realigning the family’s business and investment holdings for a more challenging future are testing even the most thoughtfully designed family organizational structures.

More recently, yet another factor that will likely lead to extensive changes in the family office structure is the recent issuance by the U.S. Securities and Exchange Commission (SEC) of a final rule governing exemption of family offices from regulation under the Investment Advisers Act of 1940 (Advisers Act), following repeal of the private adviser exemption last year by the Dodd-Frank Act. For key provisions of the final rule, click here.

This article explores certain structural attributes of the family office in an attempt to identify some leading practices for families (and their advisers) undergoing this reassessment process. These structural attributes are organized into four categories: (1) ownership and governance, (2) scope of services provided, (3) capital structure and funding, and (4) entity selection and taxation.

Ownership and Governance

Who Should Own and Manage the Family Office?

Family offices are most often established by founders of successful businesses, typically after the sale of that business or similar increase in liquidity. As such, the same generation that had previously owned the business commonly forms and owns the family office. Many family offices, at least initially, are managed as “cost centers” and require a significant capital outlay. Having the senior generation bear the economic burden of the family office seems logical — often they are the only individuals with the financial means to fund its ongoing activities. (This will be discussed in more detail in the section on capital structure and funding.)

Governance can be separate from ownership. Typically, the senior generation (in many cases, the creator of the family wealth) is looked to by the rest of the family for leadership and decision making, and it would seem to be a natural fit for this generation to also manage the family office activities. However, is such an arrangement optimal?

Consider a situation in which a family office is established after the sale of a family business. The qualities of the founder that contributed to the success of the family business do not necessarily translate into success in running a family office. The entrepreneurial risk taker who demonstrated expertise in a particular industry must now switch gears to oversee a more diverse portfolio (e.g., marketable investments, alternative investments, private equity, real estate holdings, and new business ventures) while balancing the potentially competing needs of the family members served by the office.

One of the most challenging hurdles for any family is to realize that there may be a need for expertise outside the family unit to better ensure success during the next phase of the family’s life cycle. This may involve employing an experienced family office manager supported by competent employees and third-party service providers. (This will be examined in more detail in the section on whom the family office serves.) For ultra-wealthy families, it may also involve forming a board of directors comprising both family members and outsiders. These decisions do not obviate the need for senior family leadership — on the contrary, the global direction of the family may still rest in the hands of the senior generation, but the day-to-day management and execution of the global strategy is often better left to experienced family office professionals and the third-party service providers supporting them.

Does it make sense for the junior generation to have an ownership stake in the family office? Like any good business succession plan, the answer is, “It depends.” From an ownership perspective, given the significant capital outlay of the operation, it is generally more advantageous for the senior generation to own the family office for as long as possible. However, if the family office has a long-term objective of serving subsequent generations, a succession plan must be designed to ensure that the office transitions along with the family.

Cultivating the Junior Generation

Another important consideration is whether there are junior family members capable of managing the family office, and, if so, whether they currently are being groomed for this responsibility. If not, what is the time frame for starting this process? If the family office does not currently employ capable junior family members, it may be time to develop a role for them, particularly while there is still an opportunity to learn from and work with the senior generation.

This can be a critical step in the overall succession plan for a family office, because the death of the family patriarch or matriarch will often test the value proposition of the family office. In that event, the next-generation family members will often re-evaluate the necessity or benefits of working and investing together through the family office. However, if the next generation has been empowered with a management role, the chances for continued family cohesiveness are significantly increased. A succession plan put into place well before the death of the senior generation family leaders, combined with a good governance structure and a well-run, professionally managed family office, is the better approach to ensuring long-term success. Such an organization can help attract and retain the best personnel to work for the family office, further increasing the long-term viability of the organization.

This article has been excerpted from The Tax Adviser. View the full article here.

Rate this article 5 (excellent) to 1 (poor). Send your responses here.