Q4 2019 - From Hedge Fund to Family Office

December 09, 2019

By Stephen Campbell, Chairman, Citi Private Capital Group

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The transformation of hedge funds, some successful and sizable, into family offices has been the subject of popular press coverage in recent years. The reasons for such changes are undoubtedly numerous, and include both personal and professional factors. Increased regulatory scrutiny, fund outflows, perceived underperformance of investment strategies, and onshore position disclosure has altered the hedge fund landscape and provided greater interest.

Regardless of motivation, when a hedge fund morphs into a family office, several things occur. Most significant, the fund returns all capital balances to every investor who is not a direct familial relationship to the fund owner. This includes ultra-high net worth individuals, institutional investors, partners, and hedge fund staff. From a structural standpoint, this may entail “closing” the fund, or the principal may withdraw his or her capital along with their continued involvement and create a new, private entity.

Of particular note, the new entity affords the hedge fund principal a greater degree of privacy, flexibility and control over both their investment assets and personal affairs. Such autonomy and privacy is often the primary motivation for creating a family office.

While regulation of family offices or private capital firms is evolving globally, entities that solely serve the interests of a family are generally subject to considerably less regulation than hedge funds. For example, in the United States, the SEC allows families who wholly own a family office and share a common lineal descendent and comply fully with regulations to be exempt from registration under the Advisors Act. Regulatory oversight, while desirable, often carries significant overhead cost and disclosure obligations for fund managers.

While it is unlikely that this transformation to private entities will be widespread, hedge fund principals will undoubtedly continue to evaluate its desirability as part of a retirement or exit strategy. With that in mind, what factors might they consider?

Notwithstanding regulatory requirements that define what constitutes a family office, hedge fund principals have a clean slate when it comes to the design of their organization. For many, the entity will primarily serve as vehicle for the reconstituted fund. Teams will be scaled back, key analysts and portfolio managers brought across and strategies reassessed. While some very notable managers have continued to actively lead investments, others have taken the opportunity to pursue philanthropic, political, or arts pursuits and play an oversight role.

The design of the family office may entail other functions as well; typically four core functions – investment management, finance and legal, services (security, residence management., care providers, etc.), and special asset management (aircraft, estates, yachts and collections).
Whether all or some of these functions are already present, or to be created, is based entirely upon the needs and preferences of the principal.

At this juncture, it is often advisable to engage spouses and next generation family members in the design of the non-investment functions. Principals will often have a clear sense of mission for the investment function but less definition around traditional family office activities.

While understanding what others have done with their offices, families are well served to design their office from the “bottom up” and avoid simply replicating the organization based on the experience of friends and colleagues. Why? Personalization matters – people, culture, and operating practices need to be tailored to the preferences of the family to be ultimately successful.

Planning a family office and private investment company can be time consuming and potentially prone to problems when it entails spinning out of an existing entity such as a hedge fund or business.

What are some of the meaningful differences between a hedge fund and family office that a hedge fund principal may wish to consider?

Key stakeholders in the hedge fund, partners and key staff will likely have strong views, both in favor and not, with the decision to take the investment activities under a family office structure. Indeed, some may wish to join the new venture, and principals are advised to consider their long-term aims and objectives when building the new team. In short, not everyone is well suited to investing in a family office, and taking the opportunity to reinvent the firm, its strategies and resources, should not be overlooked.

Privacy and compensation are two key areas of difference that often emerge in such transformations. Few, if any, family offices will disclose portfolio performance publically. Principals should consider the implications of hiring and motivating investment staff that may wish to be part of such disclosure, particularly for those with ambitions to create their own firm.

Compensation practices vary greatly in family owned private investment companies and family offices. That said, there is a distinct bias toward performance compensation in family offices that is often less than what sell-side firms, hedge funds, and sponsors embrace. The transformation from a hedge fund that generates significant management and performance fees, to a private firm with no revenue model per se, may impact a principal’s views on compensation.

We know from experience that entrepreneurs and hedge fund principals who choose the family office route as their primary investment vehicle may face certain challenges. Capitalization and resourcing, culture management, and effective engagement and governance are a few of the potential difficulties often faced but easily addressed. By viewing this as a transformation as analogous to starting a new business, applying discipline and strategy from a principal’s original ventures will help create the right framework.


Engaging Alternatives – Q4 2019

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