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Last updated: October 2020

Best Practices in
Family Office Setup

Introduction

High-functioning family offices handle complex responsibilities, but the staffing and structure of those organizations can still be simple.

In this paper, we describe a family office model that we consider to be best practice. It contains a small number of key employees and a significant amount of outsourcing to exceptional service providers. We believe this approach reduces risk, optimizes information flow, and maximizes the level of talent brought to the primary functions of the office.

The approach we describe is scalable. It can organize and handle seemingly disparate functions, including but not limited to:

  • Investments
  • Philanthropy
  • Tax & Accounting
  • Oversight of Operating Businesses
  • Bill Pay
  • Real Estate Management
  • Trust & Estates
  • Cash Flow Management
  • Insurance

If executed well, the family office can improve quality of life for family members by eliminating surprises and even reducing friction around difficult decisions. On the investment side, the decisions made can have tremendous impact on future generations and philanthropic goals.

Thank you for taking the time to learn about our approach to family office setup, and please do not hesitate to contact us to discuss it further.

East Rock Capital

Family Office Setup:
The Best Practice for Most

We frequently encounter family offices that are extensively staffed and perform most functions in-house. A few stand out for their success, but many appear to under-perform their objectives and a number experience notable difficulties.

We believe that most families are best served by a simple structure that greatly reduces the risk of a significant misstep.

The goal of this setup is to allow family members to focus their time on the things they care about most.

Our recommended approach keeps internal headcount modest and instead focuses on accessing the very best external talent in key disciplines.

The model we propose optimizes transparency and the flow of critical information. We believe it can accommodate varying levels of participation by family members with respect to the investment function.

Ultimately, the goal of this setup is to allow family members to focus their time on the things they care about most. The setup process may be time intensive for an upfront period, but if done well, can function successfully for a long time with modest oversight going forward.

Model for Family Office Setup

Early Setup

It’s hard to overstate the value of making a major upfront investment to research and carefully consider options.

Early in the process of family office setup, we believe that families should focus on hiring a strong CFO, selecting a small number of key external service providers, and establishing basic parameters for governance and investment strategy. While the setup phase can be demanding on the family, it is hard to overstate the value of making a major upfront investment to research and carefully consider options.

During this early phase, families should consult with role-model families and trusted friends and advisors. It will often make sense for one or more trusted non-family members to join the effort to put the key early pieces in place. In some cases, the family may choose to create a formalized Board that includes one or more non-family members.

Model for Family Office Setup:
Family or Board

CFO in the Center

Active, control-oriented family offices are often built around a Chief Investment Officer (CIO). While occasionally successful, this approach is risky. There are few natural training grounds for investment responsibility that are both this broad and deep. CIOs are difficult to identify, assess, recruit, and properly incentivize. When CIOs do not work out, the results can be painful.

We have found that CFOs tend to be less territorial than CIOs.

The Chief Financial Officer (CFO) skill set, which in our view is a mix of accounting, finance, legal, and information systems, is more commonly available. We have found that CFOs tend to be less territorial than CIOs, which makes the CFO the ideal party to interface with the various functional areas that need to coordinate effectively.

Model for Family Office Setup:
Family CFO

Benefits

Communication tends to flow naturally and comfortably between family members and a trusted family CFO. Family members often report that their family CFO simplifies their lives and reduces surprises. A family CFO is positioned to advise family members on important decisions, such as major purchases, donations, succession planning, etc.

Family members often report that their family CFO simplifies their lives and reduces surprises.

High-performing CFOs often operate successfully with a small staff. Family members feel free to engage with family office operations at whatever level feels comfortable or appropriate.

A small headcount frees up the family and CFO to execute an outsourcing model that provides for access to the very best talent in legal, tax, cybersecurity, philanthropy, and investing. Many of these people would not work in-house at a family office but are available in an outsourcing format.

A Note on Cybersecurity

Cyber attacks are becoming one of the most significant risks, if not the most significant risk, facing organizations today. Whereas cybersecurity was once a concern primarily for corporate and governmental institutions, it has become a topic that we believe family offices need to be focused on. High-net-worth individuals and their family offices are the target of a variety of sophisticated cyber attacks, including, but not limited to: data breaches, phishing campaigns, and ransomware. Family offices need to seriously consider implementing a strategic and comprehensive plan to address cybersecurity, and we believe that partnering with exceptional technology consultants is an effective way to accomplish this. The plan should include a set of information security policies and a high level of coordination with a qualified cybersecurity consultancy.

Key Functions

The functions of a family CFO are broad and include:

  1. Summarizing reporting from operating businesses and investments.
  2. If there are important developments to address, organizing family discussions.
  3. Coordinating with a cybersecurity firm to play a safety and security role with respect to the movement of cash, commitments of capital, and monitoring of potential liabilities.
  4. Coordinating among the providers and consumers of key reporting, such as audit, tax, and entity information.
  5. For individual family members, helping assess future cash needs and availability.
  6. Executing major purchases and optimizing related financing.
  7. Facilitating, in coordination with external advisors, trust and entity formation and transfers.
  8. Helping during moments of major transition. We note that the role of assisting individual family members often grows rapidly as new generations come of age. This event can catch less professionalized setups wrong-footed.

Legal and Tax

We have noticed a lot of discussion lately about families potentially saving money by moving work away from top law firms and accounting firms.

We generally consider this to be a mistake, because the cost of their advice tends to be small in the context of family office assets and the benefits of better decisions can be large.

Exceptional legal and tax talent almost exclusively reside at firms—majors and boutiques.

Better decisions, in our view, are a product of two things that our model is designed to optimize. The first is information flow, so that the full picture of family circumstances can be taken into account. The second is exceptional talent providing advice and guidance on important decisions. In our experience, exceptional legal and tax talent almost exclusively reside at firms—majors and boutiques—where they are best positioned to keep their skills on the cutting edge.

Model for Family Office Setup:
Legal and Tax Advisors

Philanthropy1

A strong advisor brings a combination of substantive knowledge, interpersonal skill, and ample experience.

For families with a desire to have a philanthropic mission, a philanthropy advisor can play a critical role. A strong advisor brings a combination of substantive knowledge, interpersonal skill, and ample experience, and provides value in a variety of ways:

  1. Acting as an agile facilitator who will set ground rules for mutual respect, careful listening, and progressive issue resolution.
  2. Helping to establish how family decisions are to be reached and what civic roles family members will play (volunteers, trustees, advocates).
  3. Identifying role-model families whose philanthropic track records and operating styles are worth examination, maybe even emulation.
  4. Collaborating with the family to ensure grant decisions are directed to worthy causes and institutions.

Model for Family Office Setup:
Philanthropy Advisor

Philanthropy:
Key Questions to Address

We believe answering these questions in collaboration with an experienced advisor is a great place to start:

  1. How extensive and generous will your family’s philanthropy become over time?
  2. What fields of interest will it address?
  3. What mix of a donor-advised fund, foundation giving, and estate planning is envisioned?
  4. Is the contemplated program in perpetuity or time-limited?
  5. How many family members will be involved in grant decision-making?
  6. To what extent will charitable funds be directed to support the voluntary activity of the individuals involved?
  7. Is it an aspiration to use philanthropy not only to address important societal challenges, but also to strengthen relationships among family members and to collectively express agreed-upon values? Will second- and third-generation members be invited to engage in the philanthropic process?
  8. Who outside the family will be invited into the formal decision-making circle?

The more clearly these questions are answered, the better positioned the family will be to avoid key mistakes.

The more clearly these questions are answered, the better positioned the family will be to avoid key mistakes. One mistake we often see is that the patriarch or matriarch inadvertently dominates philanthropic choice and fails to leave decision space to other family members. In other cases, time horizon, fields of interest, and roles and responsibilities are not clearly addressed.

With these basic issues resolved, the family can then focus on recruiting key expertise to help guide and execute the effort. In some cases, it may make sense to add a Chief Philanthropy Officer (CPO) in-house to lead the effort. In other cases, a small number of external advisors can help drive the next phase of the process.

Investments

The creation of an investment function is a major decision and merits a substantial commitment of time to put the right pieces in place.

While we generally favor an outsourced model of investment management, some families may choose a more hands-on method. This tends to work best when family members make a full-time commitment to investing with clear decision rules, and the family makes a substantial commitment to recruiting and empowering investment talent.

It is important that a number of family members develop sufficient investment literacy to properly assess underlying investment managers and sponsors.

Regardless of the level of family involvement, it is important that a number of family members develop sufficient investment literacy to properly assess underlying investment managers and sponsors. In tough times, the ability of family members to review the investment process, rather than results, is the key to making good decisions at the most important moments.

University endowments often adhere to a “policy portfolio,” meaning that they set specific targets for how much capital is allocated to stocks, bonds, real estate, hedge funds, private equity, etc. While we do not advocate a strict policy portfolio for families, we do think families should set general parameters for how capital should be allocated among the major asset classes.

Model for Family Office Setup:
Investments

Investments:
Traditional Stocks and Bonds

Once a set of asset allocation guidelines have been set, stock and bond portfolios can be established in coordination with a trust company or private bank.

For this portion of the portfolio, we advocate a simple and passive approach.

For this portion of the portfolio, we advocate a simple and passive approach. Cost and tax efficiency should be taken into account. There may be opportunities to improve after-tax returns with tax-managed funds.

Criteria for selecting a trust company should include the ability to offer a robust platform for secure wire payments, custody services, and reporting. Other services may include lending, hedging, and block trading services. Some families may also appreciate access to research, conferences, and networking opportunities.

Model for Family Office Setup:
Trust Company/Private Bank

Generational Investments

We think of the stock and bond portion of the investment portfolio as likely to return 5-8% annually over a long period of time with significant volatility along the way. The benefit of stocks and bonds is that they offer great flexibility. They can be sold or pledged as collateral easily, and once appreciated, they can be donated with substantial tax benefits.

For higher long-term returns, but with less flexibility, we look to “generational investments.”

For higher long-term returns but with less flexibility, we look to “generational investments.” Long-term private investments offer the highest returns we are aware of and tend to be highly tax-efficient. Absolute return investments offer protection against capital loss and a way to “stay invested” as a private portfolio ramps up or seeks to reinvest after a major sale.

We recommend grouping private and absolute return investments because both functions succeed or fail based on whether there is exceptional talent making the key decisions. A single manager handling both private and absolute return investments can coordinate the flow of capital between the two and create synergies between these functions.

Model for Family Office Setup:
Generational Wealth Manager

Generational Investments:
Assessing a Manager

What we would call a “Generational Wealth Manager” goes by a variety of names and provides services in a number of different formats.

There are many factors to consider when selecting a manager, but we would highlight three primary questions to keep in focus:

Is your money only touched by exceptional investment talent?

  1. Is your money only touched by exceptional investment talent?
  2. Is there a high level of alignment running through the system?
  3. At any time in which you accept illiquidity (e.g. lockups or difficult to sell positions), is it reasonably clear that you are being compensated in terms of higher expected returns and/or less risk?

Conclusions

Family office setup is not easy, but it can be simplified and de-risked by maximizing the use of proven firms for key functions.

The model we propose relies significantly on proven firms but can be extended and modified to take desirable risks and add new functions.

For example, it is not uncommon for a family member to execute a specific investment strategy in an area of personal passion alongside the two broader strategies we outlined in this paper. We often find family members drawn to sectors with a tangible quality to them, such as impact investing, real estate development, medical therapeutics, or consumer goods. Moreover, services can be extended to many different areas, including medical, concierge, security, family counseling, education, etc.

Starting with a strong, simple foundation is of utmost importance.

Because of the myriad directions a family office can go with rising demands and complexity over time, starting with a strong, simple foundation is of utmost importance.

Model for Family Office Setup

Important Disclosures

This presentation is intended as an indication of interest for exploring opportunities and is for discussion purposes only. This presentation is not intended to be and does not constitute a legally binding obligation of any party hereto and no individual or entity will have any rights or obligations of any kind whatsoever relating to the terms and proposals contemplated herein unless and until definitive documentation with respect thereto is executed and delivered by such party.

This presentation does not constitute, and should not be construed as, an offer of advisory services, securities or other financial instruments, a solicitation of an offer to buy any security or other financial instrument, or a recommendation to buy, hold or sell a security or other financial instrument in any jurisdiction. The provision of information in this presentation does not constitute the rendering of investment, consulting, legal, accounting, tax or other advice.

Certain information contained herein is based on or derived from information provided by independent third-party sources. While all the information presented in this presentation is believed to be accurate, East Rock Capital, LLC (“East Rock”) makes no express warranty as to the completeness or accuracy of the information appearing in this presentation.

The information presented in this presentation reflects East Rock’s current views as of the date of this presentation. As facts and circumstances change, East Rock’s views may change as well. East Rock has no duty or obligation to update the information contained herein.

TO THE FULLEST EXTENT PERMITTED BY APPLICABLE LAW, EAST ROCK EXPRESSLY DISCLAIMS ANY AND ALL LIABILITY WHATSOEVER FOR ERRORS AND OMISSIONS IN ANY INFORMATION OR MATERIALS, AND FOR ANY USE OR INTERPRETATION BY OTHERS OF ANY INFORMATION OR MATERIALS, CONTAINED IN THIS PRESENTATION.