Family offices are an interesting species of financial intermediaries. Their perspective offers a window into the processes involved in the origination and reproduction of great wealth. Family officers are the fate of Winters’ oligarchs as they grow older. They’re the institutional embodiment of the mode of class reproduction for the financial elite. They allow us to examine micro-locally — at the unit level of analysis sensu Ken Waltz — Winters’ civil oligarchy. We see them embedded here in institutions that allow wealth reproduction in the face of demographic entropy.
This species of financial capitalism comes endowed with a natural clock which can be run faster or slower depending on the life history strategy of the family office. The natural life-cycle of this species is as follows. A liquidity event may take place, such as a sudden financial success of a new company, whose founders soon have to worry about what to do with their chips. Usually, a single founder of a successful long-term enterprise creates a family office as “a second career” upon leaving the business whose sale constituted the liquidity event. In all cases, as the family office matures, exposure to the business that created the original liquidity event becomes a source of unnecessary financial risk.
This means that, all surviving family offices must at some point diversify away most of the financial risk posed by the original business to their balance sheets. In later stages, a single family office stewards the wealth of a mass of multigenerational heirs of the original owner. At more advanced stages, a multi-family office pools the wealth of multiple families to achieve even greater economies of scale. There is an arrow of time in family offices that can be thought of as a life history parameter given by financial exposure to the business whose success generated the liquidity event that created the family office.
There are about 3,000 family offices in the United States. Your typical family office has $500m tied up in the original business and $1bn in other financial assets.
If the family office is founded by a sophisticated investor, she may or may not quickly diversify her exposure. Family offices run by sophisticated investors may combine liquid portfolios of investment grade assets with a portfolio of private placements as limited or general partners. In general, even if the family office continues to participate in direct investments, it must eventually treat the original business as just one direct exposure among others in a diversified portfolio of illiquid holdings.
The complication here is that two hiddens logics are entangled. One is appetite for making concentrated bets on a small number of high conviction wagers, which is partly a question of risk tolerance. The other is historical ties, perhaps accentuated by the retention of control in the hands of the heirs. We must distinguish between the appetite for making concentrated wagers and the historical weight of the original business. We’ll come back to risk tolerance presently.
One life history choice faced by the founder(s) of the family office is when to self-annihilate in the following sense: she must decide when, if ever, the family office will become independent of the founder(s) and heirs, and instead become a professionally-run machine for guarding the family interest. The real job of the family office is, after all, to guard the family interest.
What is the family interest? The family interest is created by replicating primogeniture in financial form. Primogeniture is, of course, an anthropological device to conserve wealth in the face of the constant force of the entropy generated by multiplying heirs. The raison d’être of the family office is to ensure that, even as the family itself grows in numbers, great wealth is conserved by keeping it under the control of a single center of power. So, the family office reproduces great wealth through financial primogeniture.
Some founders choose to put the life history parameter into the founding document — stating effectively that, after the founders’ deaths, the family office must hire an independent professional to act as the chief investment officer (CIO). Since this depends on when the founders die, it is a life history parameter that must be chosen.
Eventually, independent CIOs of all surviving family offices must seek to maximize return and minimize risk on behalf of the abstract family interest — and independent of the preferences of the heirs. At this mature stage, a family office emerges as a pure financial intermediary, disembedded from the idiosyncrasies of the founders and their heirs. As a buy-side intermediary run by professionals, a mature family office must carefully manage the risks posed their concentrated bets.
The easiest way to diversify away the risk posed by concentrated bets is to hold the bulk of your net worth in a diversified portfolio of highly liquid assets like blue-chip US equities, investment-grade bonds, and high-volume ETFs. If the family office is staffed in-house by experts in private investments, perhaps simply due to legacy or just as a matter of core competence, it may choose to hold a larger portfolio of concentrated private investments alongside a smaller portfolio of liquid assets. No matter the exact liquid-illiquid ratio, though, a mature family office must hold a diversified portfolio of assets.
The family office must choose another life history parameter. They must decide their investment horizon. As opposed to exposure to the original business, where the slowest life history is defined by immediate professionalization, faster life histories correspond to shorter investment horizons. Should the investment committee be tasked with survival over the next 50-100 years? Why not 500? Or in perpetuity? So, family offices with the slowest life history strategies have the longest investment horizons; those with the fastest life history strategies have the shortest.
The largest and oldest family offices guard the family interest of historical capitalist families. They are the servants of Braudel’s ‘great predators’. In Wall St parlance, they’re some of the largest whales out there. They may also be patient capital. Specifically, the oldest and wealthiest family offices also choose the slowest life history strategies — they compare themselves to patient intermediaries like pension funds, sovereign wealth funds and ivy endowments who, like Woody Allen, hope to achieve immortality by not dying. Some aim to further the interest of society as a whole, which is why many family offices are often merely the investment arms of philanthropic endowments. So, the biggest and oldest may be patient intermediaries.
There is yet a third way in which the life history perspective is relevant. We can think of risk tolerance as encoding information on life history strategy. A typical family office has a billion dollars of family interest to guard. We read in the Family Office Handbook that the goal of most family offices is wealth preservation, not growing capital. Campden Wealth notes that “family offices are known for their deep pockets, cash reserves, and patient capital.” So, risk tolerance may be not be very high at your typical family office. In terms of their desired equity allocation, in, say, a hypothetical stock-bond universe of investment grade assets, your typical family office may be as conservative as a 60-40 investor (the unconditional allocation of a reference investor with a target volatility of 10% per annum).
In the aggregate, US family office strategic asset allocation to liquid assets was only 48% in 2021 — of which 34% was allocated equities and 14% to fixed-income. Some 42% was allocated to private assets — real estate (15%), direct equity (12%), PE funds (10%), and hedge funds (5%). The remainder was held in cash (5%), commodities (2%) and crypto (1%). Private assets artificially suppress the volatility of reported portfolio returns because they can’t be market to market. But the aggregate portfolio does not suggest high risk tolerance for the typical family office.
There may be family offices with much faster life history strategies. Their risk tolerance may be very high. Their CIOs may face eviction risk from the family unless they deliver high returns — a case where the risk tolerance of the principal is higher than that of the agent. They may be noise traders. They face model risk; and it’s father, research risk. They face brute, blind risk — they may get in trouble for no good reason at all. Is it possible that a family office bankruptcy may pose systemic risks to the financial system? That seems extremely improbable. This is because the ones that are large enough to be considered for the job are patient intermediaries, while those that might get in trouble because of faster life history strategies are small enough to fail.
Family offices are not an important part of the dealer ecosystem. They’re systemically unimportant. And since there are 3,000 family offices with a total of just $179bn in aum, most must be of rather modest financial size compared to other financial intermediaries. Indeed, if the species of financial intermediaries are planets, the family office is Pluto — at risk of defenestration by size queens. Nonetheless, the humble family office offers a tidy solution to the problem of class reproduction for the financial elite. Family offices solve the problem of the intergenerational conservation of great wealth through financial primogeniture. They are at the epicenter of the birthing process of capitalism sensu Braudel. Paradoxically, they offer a window into both the Schumpeterian dynamism of capitalism and the conservative business of wealth preservation.
Q: With reference from Michael O Church, where does the "working rich", "skilled labor" and "gentry" fit into this model?
Q: "Life History" is originally used by biologist on fertility vs longevity tradeoffs. Is this comparable to the r/K or CSR strategies ala Anonymous Conservative's predictions (although he is more tribal)?
Not really primogeniture, as all family members may share in the wealth, but family offices really are (in part) a consequence of US tax policy, where the basis in financial assets steps up when passed to heirs or shifted to trusts. Replacing the estate tax with a capital gains tax at death (and on grants of shares to heirs or trusts before death) and eliminating the tax deduction for appreciated assets donated to a charitable foundation, DAF or charity/endowment (ie- the donor must pay capital gains tax on the gain and only then gets a tax deduction for the market value of the assets - just as a salary earner has taxes withheld but can get these back after donating salary) would at least reduce the steepness of the playing field between entrepreneurial tycoons with billions in near zero-basis stock and the salary-earning professional class. Well, that and raising capital gains taxes while replacing the corporate income tax with a tax on revenues (with deductions for domestic cost of goods sold and domestic salaries).
Great diagram, by the way!