One of the great challenges families face when allocating capital for the long-term is determining the right level of risk and return and how that impacts family office growth in the long run. This is exacerbated further by the fact that many in the family office (FO) world believe that the investment strategies of families are roughly analogous to that of other long-term pools of capital, namely the endowment and foundation community.
Sadly, this analogy does not hold for a host of reasons – which have meaningful impacts on how the family choose to allocate its capital. Instead, I would like to propose a simpler framework that may be more helpful for families in calibrating their investment return targets.
First – let’s begin with the growth rate of the family itself. As you can intuit from any family tree, families grow at an exponential pace. Basically the family (non-including married-ins) doubles in size every 20-30 years. It has been well established that more economically developed societies tend to see slowing birth rates, in many cases quickly converging to replacement rate (i.e. 2 births / woman) or even slightly below (ala parts of Western Europe). Interestingly, data has begun to emerge that higher income families are seeing birth rates increase beyond the average family.
Numbers of children born by women with advanced education degrees has begun to climb. Anecdotally, I was speaking recently with a private equity executive based in New Canaan, CT who said that in his social circles that 4 kids is the new 2. Why this occurring – social signaling about wealth status is one possible theory – is beyond the scope of our inquiry today.
This rate of increase means that families have to assume a higher growth rate for their assets if they desire to pass along a level of wealth equivalent to what was received from prior generations. If we assume that the number of family members grows by 2.5x every 25-30 years, the family’s assets needs to grow by 3.4% alone each year to support the “population growth.”
After funding growth, it is necessary to ‘fund’ current generations. What I mean by this is that each living and active generation will desire some sort of financial benefit from the family’s assets. If the family in aggregate lives predominately off these distributions, that affects both the risk profile of the portfolio and the liquidity characteristics. Unlike endowments, the need for cash may prevent the family from having sizable allocations to real estate or private equity which are largely illiquid over short time horizons. For a starting place, let’s assume that 2% of the family’s assets are distributed in cash each year. A few other pieces on setting a distribution rate can be found here and here
What else factors into a target return calculation? The next thing that comes to mind is inflation. While this is certainly arguably out of the control of the family, it very much impacts what future generations will inherit. Let’s assume inflation will average around 2.5%.
The next important element to consider is fees. To generate these returns, the family will pay either in-house or third party investment professionals some fees to invest the funds on their behalf. It is reasonable to assume all-in investment fees of around 0.5% for a sizable portfolio.
Finally, we must add taxes into the equation. This is the primary difference between family investments and non-profit endowments. Modeling tax efficiency of a portfolio is incredibly complicated but is a paramount consideration for a family. Let’s assume that taxes represent a 1% drag on the portfolio’s return. See Greycourt’s excellent work on tax drag for the taxable investor here.
So mathematically, let’s look at all the factors that affect the target rate of return and its impact on family office growth:
- Family Growth – 3.4% per year
- Distributions – 2%
- Inflation – 2.5%
- Fees – 0.5%
- Taxes – 1%
Compounding these four together means a starting target rate of return of 9.8%
This rate of return is substantially higher than the targeted long-term returns of most pension plans which right now hover between 7-8%. There are many implications from such a lofty return target. Primarily it means that for continued family office growth, the family must continue to own equities as a sizable portion of their portfolio. But with exposure to equity comes volatility which the family may or may not be suited to weather.
If the family’s distributions are higher or if the family is entirely dependent on the cash flow from the portfolio, this will reduce the ability to stomach volatility. As well, if the family is not actively producing more cash through new business creation, the ‘static’ nature of the portfolio changes. University endowments are able to raise additional funds over time which increase their ability to take risk with their investment portfolios.
Disclaimer: This does not constitute investment advice or an offer to buy or sell any securities. It is provided for informational purposes only and represents the author’s own opinions