This is not a book about investing in its own right. However, in the context of a family enterprise, oversight of the investment of financial capital is a prominent family activity, which also makes use of and has an effect on the family’s qualitative capitals. As such, it behooves us to spend some time on investing as a human activity, and on some of the practices that we have seen families use effectively in their investing.
Investing has been going on as a popular pursuit since the eighteenth century, when certain government bonds became stable and marketable enough that they could be treated as “securities.” It was key to the growth of the middle class, first in Europe, then in the United States, and today in many other parts of the globe. The availability of global markets for buying and selling shares in companies has been crucial to the creation of many—if not most—families’ wealth.
There is a popular critique of investing today that it is a “loser’s game.” This line of thought argues that investing, as a mass phenomenon, undermines itself. People’s attempts to beat the market make the market. Such attempts are not only self-deluding but they also expose the individual investor to loss. Empirical studies bear out this prophecy: individual retail investors who seek to time the market usually do worse than the market.
This critique of investing has been around for several decades. One response to it is the popular rise of indexing. Such investing seeks to dispel the delusion and openly describes itself as not beating but being the market.
Of course, indexing still exposes the investor to significant loss, as those indexers who bailed in the 2008–2009 downturn demonstrate. The individual human being, with passions, especially fear, can find it very difficult if not impossible to “be” the market.
The critics who described investing as a loser’s game envisioned a different approach than indexing: one in which the investor steps away from focusing on financial return alone and sees himself as a human being—or representative of human beings—with human ends or purposes. To such a person, measurement by money or by money-averages makes no sense. Preserving financial capital—avoiding catastrophic loss—is one important goal. But there are innumerable other possible goals. Even the money-centered goal of “making a little bit of money every month” takes one out of the race of measuring oneself by a market average. It means being a person, not just with a point of view but also with your own purpose.
This critique of investing and this response—the response of seeking to “win the loser’s game” by separating your personal goals and point of view from the mass market and its measures—explain why the rise of index funds and the rise of hedge funds have occurred simultaneously. These strategies initially look contradictory: Index funds seek to be the market, while hedge funds seek to differentiate themselves from the market. But it makes sense as two responses to the same critique. In fact, the hedge fund represents the more consistent response, as it seeks to “take a stand” or “express a point of view” or achieve specific ends apart from or even athwart the market.
It is no surprise that families with significant financial capital, who can afford to diversify across various platforms, tend to eschew broad-based, retail mutual funds and instead combine indexing for “core” positions with a variety of hedge or private equity funds to grow their assets.
Even so, both these approaches to investing—indexing and hedging—represent only partial responses to the basic critique. For that critique requires that investors cease to see themselves solely as investors, that is, as measurers of means. It requires owners to take responsibility for their ownership and define their own ends. Consider, for example, the significant attention to Investment Policy Statements among institutional investors. An investment policy statement requires setting forth goals, risk tolerance, allowable types of securities, and so forth. Where does an investment policy statement come from? It is a product of a person, or a couple, or a family, or a committee. It is not a product of investing. That is, it is not a product of the science or art of investment management.
In other words, the contemporary critique of investing demands a reconsideration of oneself, one’s ends or purposes, and one’s relation to one’s means and to others. Naturally, this step is one that far fewer investors have found it possible to take. Even those with investment policy statements on paper tend to find themselves asking each quarter, “What was my return? Did I beat the benchmark?”
In contrast, families that can take this step—who can focus on the ends and not just the means—have gone a long way toward making sure that their financial capital truly serves their qualitative capital.
For those families who can take this human approach to their investing, there are two enduring practices that we have seen make a huge impact on their return, understood in the broadest sense.
The first we call “investor allocation.” Investor allocation is the allocation to each family member on the family balance sheet of that portion of the family’s financial assets most likely to assist the long-term growth of those financial assets while minimizing estate, gift, or generation-skipping transfer taxation.
Most of us are familiar with modern portfolio theory and its admonition that 90 percent of successful long-term investing lies in correct asset allocation. Families who are successful investors have elaborate asset allocation plans. All too often, however, the individual family members holding these investments were not chosen based on how far they are removed from estate or gift taxation but rather by “who had cash” when the investment opportunity arose. Unfortunately for long-term tax avoidance, it is often the oldest member of a family who is wealthiest or “has the cash” when the investment opportunity arises. The result over time is that the oldest family members often hold many of the fastest-growing assets on the family financial balance sheet. And yet, the older members of a family are often the most risk averse and would prefer to hold assets producing more income.
An investment program in which the oldest member of the family acquires growth securities brings a huge smile to the face of the Internal Revenue Service. The IRS knows that if it waits patiently, it will collect more than half of the stock’s growth as estate tax. The IRS, believe it or not, is sitting in the largest chair at the family table.
Investor allocation can reduce the size of the IRS’s chair year after year, until it is the smallest at the family table, by reinvesting each new dollar of family wealth in the following way. Each time the family’s investment adviser suggests a new investment, the family member, family office professional, or other adviser charged with investor allocation determines the investment’s projected long-term growth rate. The “investor allocator” then chooses the family member or members who will make the investment based on estate tax implications. Normally, this means the oldest family member buys the investments offering the lowest growth, and the youngest family member buys the investments offering the highest growth.
Two investment classes can act as examples. Suppose the family wants to invest $100 in bonds that will be held to maturity and on which the family will receive current interest payments. This investment offers no growth of principal—the investor expects to receive, upon maturity, the same amount originally invested. Now let us suppose the family wants to invest $100 in venture capital. Let’s assume the goal is to double the value of the investment over five years. The family will receive $200 for the $100 it invested, growing its principal by $100. Clearly the IRS would be delighted if Grandmother bought the venture capital investment, since the IRS will get upwards of $55 of that $100 profit upon her death. The IRS would be commensurately unhappy if Grandmother bought the bonds and a younger family member bought the venture capital investment. The IRS would be particularly unhappy if Grandmother bought the bonds and used them as collateral for borrowing by a grandchild who, without the loan, couldn’t afford to make the venture capital investment. Grandmother is doubly happy since she will receive current income from the bonds, whereas she wouldn’t ordinarily receive any return on the venture capital investment for five years. The family is delighted because Grandmother’s estate didn’t grow even though the family financial balance sheet grew by $100.
This example of investor allocation, while quite simple, makes the point. Obviously, there are many other types of investments, carrying varying degrees of risk, between the two categories we chose for the example. Every asset allocation program, properly made, will have investment classes throughout the risk universe. The point of investor allocation is to manage this risk universe by maximizing growth of the overall family financial balance sheet while minimizing the growth of the individual portfolios most likely to be the next to be subject to estate tax.
To obtain maximum benefit from investor allocation, here are some issues a family will need to address.
One way to solve the problem is with gifts. Unfortunately, gift tax law places low limits on how much can be given before taxes begin to accrue. The most successful strategy is for the oldest generation to make loans to the youngest generation—and in certain cases, after careful legal advice, to the tax-exempt long-term trusts—to enable acquisition of the appropriate assets. Intrafamily loans carry with them certain IRS responsibilities to ensure that they are arm’s-length loans and not disguised gifts. A lending strategy should not be developed without proper legal and accounting advice to ensure that loans are not recharacterized as gifts. An important additional benefit of this strategy is the receipt of high cash flows by the oldest generation through their receipt of interest on their loans while the growth of a portion of their assets is capped. The additional cash flow will meet their desire for cash and provide them with additional liquidity to make gifts to family and philanthropy and to make additional loans. As with any investment decision, careful analysis of the role of such loans in the family’s and the individual lenders’ overall investment programs must be made to determine what portion of an individual’s portfolio might be devoted to this program.
The family bank is a practice that often goes together with the practice of investor allocation. It provides a means for a family’s wealth to be leveraged by making loans available to family members on terms not available commercially. These are loans that would be considered high risk by commercial bankers but are low risk to the family because of their contribution to the family’s long-term wealth preservation plan. Loans from a family bank are usually for two purposes: investment, to increase the family’s financial capital; or enhancement, to increase the family’s qualitative capitals.
In the case of loans for investment, the family’s purpose is to take advantage of opportunities brought by individual family members. The loans afford the family opportunities to grow its financial wealth while enhancing the intellectual growth of individual members. These are frequently investments in businesses founded by individual family members. Such business loans follow these basic rules:
This process gives the family borrower excellent business training and the highest possible chance of a successful financial outcome.
With enhancement loans, the family’s purpose is to increase its human, intellectual, social, and spiritual capital by increasing the independence of individual family members. As with investment loans, proper lending procedures for enhancement loans are critical to the growth of each borrower’s human and intellectual capital. When seeking an enhancement loan, the borrower should be encouraged to state how such a loan will increase his or her independence and how the loan will add to the family’s human, intellectual, social, and spiritual capital. When family members explain to their peers and advisers on the family bank board how a loan will be enhancing, they must be certain that their individual qualitative capital will really be enhanced. With enhancement loans, repayment comes in the form of the increased independence of the individual borrower and his or her increased capital.
This may seem like a surprising point: that a loan could increase individual independence. The surprise is natural. Entered unwisely, a loan can create terrible dependence and eventual recrimination.
That is why families striving to preserve their complete family wealth quickly grasp that a family bank is not primarily about financial capital. While having a friendly lender gives an enormous competitive boost, it is the growth of intellectual and social capital that is the true reason for forming a family bank.
Because it is a delicate business, here are some guidelines for setting up a family bank.
It is particularly important that all family members who agree to participate in the family bank be given copies of all loan applications. Personal financial data may be withheld for confidentiality, but all members should receive the qualitative capital portions of the applications.