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How family offices can broaden their risk mindset in a volatile time

A survey shows how leaders are focused on financial risk but are overlooking ways to gain agility and confidence before the next crisis.

In brief
  • Boosting liquidity is an understandable reaction to uncertainty. But many family offices lack what’s necessary to pursue other tactics effectively.
  • Across dimensions of people, processes and technology, we offer nine actions that account for operational and strategic risks more holistically.
Ernst & Young LLP (EY) and the Wharton Global Family Alliance (Wharton GFA), a world-leading research forum created by the Wharton School of the University of Pennsylvania and the CCC Alliance, formed a three-year collaboration to advance knowledge on issues and trends impacting multigenerational family businesses and their offices. This article is an output of the collaboration and represents EY’s views on the findings of the 2022 Family Office Benchmarking Report by the Wharton GFA.

After experiencing what feels like a generation’s worth of volatility in the past three years, family offices say their top priority over the next 12 to 24 months is managing risk, according to the 2022 Family Office Benchmarking Report authored by Raphael (“Raffi”) Amit, the Marie and Joseph Melone Professor at the Wharton School of the University of Pennsylvania and the cofounder and Chairman of the Wharton GFA. Yet further data points reveal how family offices are assuming a defensive crouch that is heavily focused on mitigating financial risks while ignoring operational and strategic risks.

How EY can help

For example, many family offices are moving more and more into cash in the face of financial risks: 32% have increased allocation to cash and cash equivalent, 12% reduced allocation to illiquid assets such as venture capital (VC) or private equity (PE) and real estate, and 14% increased allocation to highly liquid short-term fixed income assets. But this is a passive approach to liquidity management, constrained by what family offices often lack: real-time visibility into spending, tax liabilities and more, which would guide more strategic investment.

 

Understandably, family offices have felt pressure from geopolitical uncertainty, economic challenges such as rising inflation and interest rates, and persistent fallout from the pandemic. Against this backdrop, 59% of respondents have re-examined the family’s volatility and risk tolerance. Overall, 39% say that tolerance decreased, compared with 7% who say it increased (while the rest reported no change). To deliver holistic risk management, respondents say their main hurdles are financial and investment risks, information security and cyber risks, and financial fraud and identity theft.

 

“As the landscape of risk continues to take on new dimensions, it’s imperative for offices to take a more active and operational view — through the lens of people, process and technology improvements,” said Bobby Stover, EY Americas Family Enterprise and Family Office Leader. “Active risk management doesn’t just react to an oncoming storm — it mitigates the fallout from disturbances that aren’t even in the forecast yet, while equipping you with the tools and the insights to capitalize on evolving opportunities.”

 

Here’s how to position your family office to succeed.

Team of financial advisors planning with business colleagues during meeting at law firm, Team of financial advisors planning with business colleagues dur
1

Chapter 1

Asset management and risk and return measurements

Family offices may have bigger piles of money now — but fall short on detection and response capabilities and capital efficiency.

In the survey, wealth preservation proved to be the single most important investment objective, narrowly ahead of maximizing return on investment, and about 50% said their investment horizons were 15 years or longer.

“Over the past three to five years, most family offices in the survey have reported positive absolute returns,” Amit said. “But with that in mind, recent years have taught us that markets can suddenly shift: many portfolios struggled amid the turbulence of the second quarter of 2022, and the mixed signals of the economy since then presented much uncertainty, as well as opportunities.”

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24 Apr 2023 Mike Lee + 3

    Amid fears of losing capital and experiencing sudden downturns, family offices have understandably moved more toward cash, but these efforts reflect a narrow portfolio-focused view of how to respond to risk. When the economy is booming and markets return capital, investment and operational risk management often grows lax. This lack of rigor is suddenly exposed when the economy flips and returns contract.

     

    Actions to consider:

     

    • Identify and implement a technology platform for portfolio performance and risk that provides transparency into the liquidity of your family office’s portfolio, including an ability to model cash flows and investment commitments and support related planning. There are several such platforms on the market today.
    • Rebalance your portfolio at set allocation points instead of a date on a calendar. More family offices say they rebalance their portfolios annually (30.4%) than quarterly (29%), but regardless of the recurring time period, a calendar-driven approach creates the risk of rebalancing needlessly and incurring unnecessary transaction costs or investment fees. Ensure the operating model is supported by processes and controls that deliver real-time, accurate reporting enabled through technology. This positions a family office to set asset allocation targets, establish percentage variances from them that meet investment objectives, and then pursue rebalancing once those variances are exceeded.
    Diverse group having a meeting
    2

    Chapter 2

    Human capital practices and succession planning

    Family offices need to be vigilant about whether they have the right people in the right seats doing the right things.

    In terms of headcount, the most popular response (52%) among family offices was that they employ seven or fewer professionals. And these nonfamily workers tend to stay around a long time: five years or longer, according to 92% of respondents.

    While such an approach can have benefits, family offices often fall into the trap of “process by trust,” in which long-serving professionals are counted on for their institutional knowledge instead of backstopped through documented processes. A lack of documented roles and responsibilities and internal succession plans exacerbate the potential risk when key talent — even just one person — suddenly becomes unavailable. Documentation may exist with respect to legal agreements and service agreements, but not so much for core operational processes necessary to define internal controls and monitor compliance.

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    01 Mar 2023 Liz Fealy + 3

      Historically, family offices have relied significantly on outsourcing to minimize these key person risks and talent gaps. But the 2022 survey shows that the number of professional staff members has increased, reflecting the trend to internalize activities such as risk management.

       

      Actions to consider:

      • When evaluating whether to hire staff or outsource to a service provider, consider several factors, including privacy, cost and expertise. There is no one-rule-fits-all approach, and it’s often driven by a family’s ability to govern external processes and attract talent in a specific location, or by the desire for a family to keep information within its four walls. What is key, however, is that employees and service providers both need to be culturally aligned with the family in terms of goals, values and risk tolerance. To mitigate risk, it’s crucial to conduct a diligent selection process when choosing a provider or hiring staff. Family offices often use consultants for this purpose, given the specialist nature of the search and selection process.
      • For internal hires, support risk management through succession planning and documented roles and responsibilities. For those elements still being outsourced, put a vendor management program in place that periodically evaluates vendors against predetermined KPIs (from a service delivery standpoint). And because outsourced functions expand your information footprint and increase risk — cited as a key concern in the survey — you should also understand what key controls these service providers have to preserve confidentiality.
      Diverse businesspeople sitting on an office sofa having a meeting
      3

      Chapter 3

      Communications, privacy and information security

      Cybersecurity is a top concern, but family offices often rely on email instead of more sophisticated methods of communication.

      How EY can help

      Cybersecurity gets limited attention with respect to in-house expertise. On average, family offices employ an average of 4.6 IT professionals, but less than 1 is a cybersecurity specialist — even though half of respondents believe that if a breach does occur it will be somewhat costly, whether financially or reputationally.

       

      With cybersecurity in mind, it’s revealing that family offices rely heavily on email (93%) to send information to family clients and family members rather than via a website or intranet site (31%), and just 36% provide online access to accounts to family members for reporting purposes. Email is also prioritized for family office personnel and external vendors.

       

      This information is also quite personal. More than 90% of respondents report that their family offices share at least some detailed investment data with family members, while 70% believe that this includes at least some detailed information about general activities. It not only includes the amount of the family members’ wealth but also their tax positions, who lives with them, perhaps political donations — all information that creates possible reputation risk if revealed.

       

      Actions to consider:

      • Define what you need to keep private and create segments in whom you communicate that information to internally. What is it you’re protecting? Does the family care if anyone finds out what they invested in, for example? And who’s in the circle of trust for that information — all the family executives or all the family members? Or none?
      • When looking at outside IT vendors, use separate resources for managed services and cybersecurity. The latter is too important for one entity to also handle without the external validation. Also ensure that vendors have accredited cyber and data security protocols, with either ISO or SOC accreditation through a creditable auditor.
      Group of employees in team collaboration or communication in conference at the workplace
      4

      Chapter 4

      Governance, controls and fiduciary

      Encouraging signs emerge from family offices in the survey. Operating governance with strong preventive controls should be a focus area.

      Many survey results in this area indicate that purpose and governance is of key importance to family offices. For instance, 56.7% of respondents have a mission statement and 66.7% have a strategic plan. Furthermore, 90% have investment committees and 70% have management committees. Whether both are necessary depends on how a family office defines their responsibilities. But a management committee is vital for setting the tone at the top and translating its desires downward into controls and procedures — what is known as operating governance.

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      01 Jan 2023 Robert (Bobby) Stover, Jr.

        As noted, family offices often have limited headcount, in which the responsibilities flow upward to these committees, with mostly detective controls to be enforced at a lower level. To some families, this is a solution: they are the final safety check. But a lack of strong preventive controls as part of operating governance is its own problem because problems are left to grow until eventually they are escalated to the management committee level. For example, a small family office may not be able to separate cash disbursement from bank reconciliation from accounts payable entries. In this case, they shift check-signing up to the president or family members themselves.
         

        Actions to consider
         

        • Ensure that the management committee is empowered to set strategic direction on risk holistically for the family office. Their priorities should be inserted into the culture and enabled through preventive and detective controls, breaking down silos, with compensation set accordingly.
        • Put in place a framework to evaluate risk throughout the family office that measures results with scorecards (annually or biannually, for instance). Also ensure there is separation of duties between those designing and monitoring the risk framework and the family office staff executing it. Is risk going up or down, accounting for the areas we’ve discussed, across all functions?
        • If the family office is large or complex enough, consider forming a risk committee (which 30% of survey respondents have) with the remit of ensuring compliance for the issues we’ve raised above.

        Summary 

        Volatility has become the norm instead of the exception. For family offices, financial risk is top of mind — an appropriate response but also one that can push other risks off the agenda. Many family offices lack visibility into current performance because of outdated technology, rely on a small staff with unclear succession planning, and are better at reacting to potential issues instead of preventing them through strong controls and active risk management. Changes to people, processes and technology can untie your hands so that you are free to respond to market dynamics more quickly and proactively.

        EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.