Ask any family office about risk management today and you’re likely to get a completely different answer than what you would have back in the halcyon days before the credit crisis.
When times are good, like they were pre-Lehman’s collapse, risk management is easier to get right – everyone’s making money and it is just a case of ensuring returns aren’t too much below competitors. Reputational risk is less of an issue, so too is reporting risk. Nowadays managing risk has been turned on its head. Most investors are either losing money, or making much less than they were pre-2008. Volatility in most of the big capital markets appears to be the new norm. Counterparty risk, rarely an issue pre-2008, is now a big concern, and reputational risk is much easier to stumble into. It’s clear that risk has become much more riskier for all groups working with money, not least family offices. If that isn’t enough for family offices to take in, most observers of the sector say those running these businesses don’t understand risk management.
Paul McKibbin, managing partner of the technology group Family Office Metrics, says in his experience most family offices have no formal way to comprehend the array of risks in either their investment portfolio or in the quality, control and security of their family office service. “They have no practical approach to identifying or addressing deficiencies in their risk management and most do not measure their risk controls through analysis of probability and the impact of functional risks,” he says. Generally speaking, family offices only deal with risk factors when a crisis presents.
Risk management through due diligence is one of the two important functions of the family office alongside delivering freedom from the burdens of wealth, according to Charles Lowenhaupt of the US-based Lowenhaupt Global Advisors, who believes family offices are not focusing on basic risk management.
“I have taken to asking every family office what percentage of their assets under management is devoted to due diligence and have yet to find one that can answer that question or has even considered it,” says Lowenhaupt. “If due diligence is a core function of a family office, why is that not a question that can be answered easily?”
Most family offices have money managed by external managers and are dependent on these people being aware of the asset allocation risks they are taking, says Simon Paul (pictured right), director of wealth management at UK-based SandAire.
“Non-financial risks are more difficult to quantify but we do look at these factors with our clients,” says Paul. “Operational risk is a key consideration – in 2008 we were very focused on the robustness of our custodians, where our clients’ cash was being held, what balance sheets this cash was sitting on. Operational risks were almost considered bullet-proof but there was suddenly a new focus on whether client assets were ring-fenced and understanding the implications of market turmoil.” Understanding the whole wealth of the family – especially the diverse risks and liquidity requirements arising from the ownership of a business – is integral to the management of the financial assets of any family, says Andrew Rodger, executive director at UK-based Stonehage. He adds that family governance and educating families on prudential wealth management are the most important tools of risk management.
“Ninety percent of family fortunes fail to get past the third generation because of poor decision-making within the family. By comparison, the risks in investment portfolios are relatively minor,” says Rodger.
He goes on to say there is often risk in the family business, not only the normal risk of concentrated holdings in a single asset, but also management, strategic direction and liquidity. “There is also the investment portfolio, where the standard risk management tools have to be adapted to take account of the risks in the family and in the family’s business interests,” adds Rodger.
Bruce Offergelt, SandAire’s chief operating officer, says it is vital to separate investment risks from non-investment risks. But he acknowledges that it is almost impossible to accurately quantify the impact more effective risk management has on a family office’s performance. “It is very difficult to apply a cost analysis to determine whether the value of risk management is reflected in the cost of providing it,” he says.
His colleague and head of operations, Laura Russell-Young, says speedy access to up-to-date information is vital and that many of the technology solutions available (such as risk analytics software) have limitations. “Most systems tend to be geared towards institutional investors rather than family offices. We have made some tweaks to the technology we use in terms of the kind of information we and our clients can extract from our core wealth management data system.” SandAire works with an external consulting company that reviews its risk strategy twice a year and one of its investment team has responsibility for producing risk analysis for the rest of the team.
Meanwhile, the asset management division of British multi family office Fleming Family & Partners established a committee last year specifically to monitor its own and its clients’ risk exposures, says chief executive Simon Peck. “This committee [which meets fortnightly] includes me, our chief investment officer, our head of operations, our investment performance analyst, a risk specialist from our investment team and our head of implementation, who is responsible for ensuring that our client portfolios reflect our investment policy.”
He adds: “We consider management information from all parts of the business and maintain a risk register, which highlights the likelihood of a particular risk, how severe an impact it might have on our business if it happened and what steps we have taken to mitigate against it.”
The committee is also responsible for monitoring counterparty risks and approving the appointment of counterparties, such as brokers. Peck adds that his firm makes extensive use of risk analytics software and reckons there are enough specialists available to advise family offices on investment/portfolio risk, although that is not a route FF&P Asset Management has gone down.
“There are very sophisticated tools available to assess ex-ante risk, for example,” he says. “But there are many other risks outside of portfolio risk that need to be managed and in many areas we have had to develop our own solutions for managing these risks. We have not engaged an external consultant, as we are confident that we have been able to identify the key risks we and our clients are exposed to and, wherever possible, have taken appropriate steps to mitigate these risks.”
Graham Reeve, managing director of Myer Family Office in Australia, agrees that investment risk is not the only risk an astute family office focuses on. “There is risk in family continuity, lifestyle management, investment, taxes and business continuity,” he says. “Each of these risks is vital to a family office, yet investment risk is generally the only one many people outside the family office think about.”
He reckons family offices are probably more aware of investment market risk than some other investors as it is their money at stake, and says there has been a lot of work done by sophisticated family offices on the full range of risks they face. “The global financial crisis in particular raised awareness,” says Reeve. “When all investment markets/asset classes correlated to one and so-called hedge funds failed to deliver the promised capital protection, awareness improved.” He adds that long- term trends are now examined more closely and the unusually high bubble growth in the two decades before the crisis is now viewed as an abnormality to long-term investment returns, not a new normal.
Robert Hille (pictured, right), general counsel and chief compliance officer of the US-based family office Laird Norton Tyee, reckons finding the right employees is crucial to managing risk and that family offices are aware that someone needs to be continually thinking about market and other risk factors since awareness of risk, or at least the willingness to do something about it, fluctuates with the market.
“Family offices tend to look for excellence in their investment professionals and their legal and tax advisers,” he says. “They should do the same for their risk managers, even if this means turning to third-party providers for an independent review and ongoing consulting.”
But specialisation means that external risk advisers don’t really go beyond their area of expertise, says McKibbin. “Accounting firms, for example, can provide agreed- upon procedures, insurance consultants and brokers can provide risk mitigation analyses, and investment advisers can provide statistical views of risk in securities and portfolios. What family office executives and governing boards need is an enterprise- wide view of business risk tailored to the family office.”
Technology has had some impact but it is no substitute for sensible analysis of investment markets, according to Reeve. “As Warren Buffett has shown, most of the important analysis can be done in your head. Software can over-complicate the blindingly obvious.”
He is also wary of the value of risk specialists and external risk advisers. “The question is ‘are there specialists who deliver real value rather than just another set of software reports and recommendations based on pretty maths’. I heard of one family who paid over $500,000 [€407,600] for a very complex investment strategy based on sophisticated risk analysis by a specialist risk adviser and threw it in the bin within a year as it was useless in practice.”
Richa Karpe (pictured, left), co-founder and executive director of the Mumbai MFO Altamount Capital Management, admits the concept of risk management is still relatively new and underdeveloped in India, where families in the main still employ intuitive techniques in assessing risks on an investment portfolio.
Awareness has increased marginally over the last decade, but technology has done little to help, she adds. “India is not a market where too many risk analytics platforms have been deployed. Also, the value of any of these tools is only as good as the information fed into these systems and historical data integrity is not high.”
Robert Jones, managing director of Hong Kong-based investment adviser FCL Advisory, says that family offices are sufficiently aware of market risk and other risk factors that affect their operations as a result of “numerous public fiascos”, ranging from lawsuits around a particular mis-sold product to market-wide crises that are often not systematically and thoughtfully addressed, which can cause unnecessary blow-ups, he says. More effective risk management typically results in reduced downside risk on the one hand and higher returns resulting from re-balancing and other active risk management techniques on the other, says Jones. “Technology has affected the risk management process for families that invest in direct public equity and debt markets, invest in separately managed accounts and trade or hedge using derivatives,” he adds. “For families that only invest in funds, risk management software may not be helpful if transparency from underlying funds is poor.”
Lowenhaupt says in the current era of outsourcing chief investment officers, few family offices are developing standards for selection of the function that will lead them to institutional strength and due diligence. He adds similar conclusions can be drawn with respect to designing governance structures, setting operational standards, resourcing insurance and real estate advice and educating children and grandchildren.
“Overall, due diligence and risk management in family offices seem inadequate,” he says. “The lack of effective due diligence is an issue that family offices around the world need to address more thoughtfully for the long-term benefit of their families. This should be a priority for everyone who manages significant wealth.”
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