While cost, performance and talent issues are key drivers to outsource investment management, intangible factors may also enter the decision-making process.
In an increasingly complex geopolitical, investment and regulatory landscape, family offices (FOs) are becoming more and more professionalised, in order to navigate rapidly changing market conditions, the great wealth transfer and the digital/AI revolution.
Many of these institutions, which manage assets and personal affairs of ultra-wealthy families, have been recruiting professionals with diverse skill sets, including investment analysts, financial planners, legal brains and technology experts. But they are also increasingly turning to external providers to meet the needs and expectations of increasingly international family members, while also enhancing efficiency and cost-effectiveness.
While they seek external expertise in many areas, including reporting, wealth planning and family education, it is investment management where their search for partners can have big implications for the wider financial industry, given the rapid growth in numbers of FOs and assets they manage.
Most FOs (93 per cent) are private investment offices, with more than half relying on external partners to manage their assets. Fifty-two per cent of their assets under management are managed in collaboration with, or exclusively by external managers, according to Citi Private Bank. Ten per cent of FOs have an outright outsourced chief investment office (CIO) solution.
But what are the key factors driving FOs’ decision-making process about whether to outsource or manage services in-house?
“The main driver for outsourcing is the cost to set up a good quality family office,” says Euan Finlay, head of Emea at Partners Capital, a global outsourced investment officer firm managing more than $50bn in client assets, serving institutional clients as well as wealthy families.
Families need to reach at least $2bn in assets before it becomes cost effective for them to insource investment management and hire quality investment professionals, while also adhering to regulatory changes, states Mr Finlay.
Moreover, a large, international investment firm can produce higher returns than those generated by a small internal team within a FO, meaning “outperformance completely dwarfs any cost, making the maths even more in favour of outsourcing”, he claims.
Investors today have greater visibility of how various investment firms are performing, benchmarking is easier and more sophisticated and therefore “underperformance gets caught pretty quickly”, he adds.
Negotiating leverage
Scale is also crucial, as bigger investment firms enjoy greater “negotiating leverage” with asset managers and service providers than afforded by a single family office. This makes the service cheaper, argues Mr Finlay, raising further the threshold for a FO to start insourcing, on a cost basis.
The desire to avoid human resources (HR) issues also comes into the equation. Many families have become ultra-wealthy by owning a large business themselves, having to face significant HR issues. Some may be reluctant to go down that route again and employ more people, he says.
Recruiting and retaining talent is one of the biggest challenges for a FO. While a $10bn FO has a good chance to attract the interest of a high-quality individual for a CIO role, relatively small FOs find it much harder, adds Mr Finlay.
While some large families have built significant capabilities in-house, employing excellent teams and generating “fantastic performance”, there is a whole spectrum of models, all the way down to smaller families, where one person dictates outsourcing of mandates.
Families often farm out a sleeve of their portfolio to an outsourced investment office, which acts as a benchmark and source of ideas for the internal team. FOs may also decide to outsource specific asset classes or admin functions.
Private ownership
Alternatives such as hedge funds and private markets are the most popular outsourced asset classes. “Family offices have become much more interested in private markets over the last 10 years, so it's quite rare that sophisticated family offices don't have a relatively large allocation of private markets,” states Mr Finlay. “Many of them have made their money owning a single private business and are very comfortable with illiquidity and private ownership.”
Alternatives are also the asset classes where the difference between average and good returns is the widest, so it can be worth paying to outsource to try and generate outperformance, he believes. This requires a network, sourcing capacity, access, due diligence, as well as co-investment rights alongside managers.
“Scale is not only about weight of capital, but also ability to access talent and to partner with third party managers,” he concludes. Yet, families may desire to manage their investment in-house for reasons that go beyond costs.
Internal expertise
Generally, FOs decide to run services in-house when they feel they have good internal expertise or when functions are considered core to the family, like reporting. They employ external providers to fulfil tasks where the volume or scope of work does not justify a full-time hire, so they can perform better and more efficiently. This is more likely to be the case with a small family office than a large one, as pointed out by the RBC/Campden Wealth study
“But the decision to outsource is not a spreadsheet-only exercise for families,” says Ben Persofsky, executive director of the BBH centre for family business.
A very important “intangible” factor is the desire to control decisions made on behalf of the family. Privacy, confidentiality, and desire to be directly involved in the family office activity “in some way, shape or form” are important considerations. Often, families want people to work for them exclusively, to avoid any agency issues.
They also like a hands-on approach when investing, especially in private markets. “Families love private market opportunities, particularly those who either own private businesses directly or owned them in recent memory,” says Mr Persofsky.
“They get very excited when they get an opportunity to deploy capital directly into private businesses,” where their investment timeline could be 10 years or longer.
More than three-quarters of family offices globally (77 per cent) engage in private equity direct investments, according to Citi Private Bank.
Yet, single family offices are falling short of private business owners’ expectations. The biggest area of concern is investment and manager selection (44 per cent), followed by estate planning (30 per cent), according to research on US private businesses by BBH.
To run a successful family office with a “captive investment group”, FOs need “to manage enough assets to attract investment professionals who need to do as good, if not better than those out there that do it every day,” explains Mr Persofsky.
“Unless families have billions in AuM, capital constraints are a significant challenge, leading to frustration around investment and manager selection,” he says.
Robust portfolios
Increasingly, family members have been successful in pooling their money, working as one unit, to create economies of scale, allowing access to better managers and deals. “With greater wealth, they can negotiate fees with third party providers and get access to funds otherwise inaccessible because of higher minimums,” says Eric Johnson, partner and US family office tax leader at Deloitte Tax.
Many private investment offices have become “very sophisticated” over the last decade, not only hiring professionals from the industry, but also devising sophisticated compensation packages to attract talent. Their portfolios are robust, diversified, with direct investments in private equity offering chance for “outsized returns”, says Mr Johnson.
The cost of hiring investment or legal talent is usually the highest cost for FOs, as they must pay “market rates” for professionals that would otherwise go to an investment advisory firm, a hedge fund or a private equity fund, or for legal talent that would work in a law practice, explains Don DiCarlo, president of Wilmington Trust Emerald Family Office & Advisory in New York.
Successful compensation structures allow professionals “to share in the ups and downs to make it more of a business venture for them, with attempts to create phantom equity”, says Mr DiCarlo. “It's very hard to find an investment person to come in just for a salary, who doesn't have upside or participates in the equity in some way.”
Career opportunities
“Family offices need to think about not only how to attract talent, but also how to retain that talent and allow them to grow,” says Rebecca Gooch, Deloitte Private’s global head of insights.
The biggest challenge is that they tend to be a “little bit flat” when offering career progression. “It's very common for family office leadership to stay in the role a long time, so for a young professional looking to grow up, there's simply more layers in a larger organisation,” says Ms Gooch.
What the FOs need, she says, is a focus on elements such as sustainable investing or philanthropy, which people can “buy into and feel passionate about”. Moreover, in smaller firms, employees have exposure to many types of investments and different experiences, which can also be attractive.
Almost two-thirds of single family offices are led by a family member, according to Deloitte research. In future, this percentage is going to fall to 49 per cent, once leadership passes on to the next generation, which points to further professionalisation of the family office, explains Ms Gooch.
“Family offices want to look around the world to get the best specialists, advisers and people around them to help retain this hard-earned money they've built. And so there is a definite push towards relying on outside service providers and also using them to scale up.”
Four out of 10 FOs are hiring additional staff, with financial services a core target industry for finding talent, followed by consultancies, accounting firms and other FOs, according to Deloitte.
Private banks may benefit from FOs’ increased desire for personalised services and partners who cater to specific needs. But they need to play it right.
“Family offices require independence and objectivity from private banks and their role with the family is to serve as gatekeeper,” says Deloitte’s Mr Johnson, believing private banks should provide wealthy families with a range of third-party providers, on the investment, tax or legal side.
“Family offices don’t like being pitched to and told what to do,” he says. “They like to be able to assess their options.”
