Structuring a Single Family Office
Structuring a Single Family Office
An SFO is typically structured as a separate, stand-alone entity, such as a limited liability company (“LLC”), to limit its legal liability and protect the family’s privacy. For tax purposes, the SFO generally is structured as a pass-through to avoid two levels of taxation on any profits generated and distributed by the SFO. (Note that most SFOs, being service-providing entities, are not designed to make a profit, though there are exceptions to this rule.) Many SFOs are structured similarly to hedge funds, with a single management company serving a number of different family investment holding vehicles.
Delaware is a favored jurisdiction for forming domestic SFO entities, because of its well-established body of corporate law and its minimal disclosure requirements.
Ownership of the SFO entity depends on the family’s objectives. In many cases, the SFO is owned by one or more of the family investment entities or individuals whose assets it manages. In other cases, the entity may be owned by a family or non-family executive of the SFO, who typically is deeply involved in management of the family’s financial assets and may receive a fee or carried interest as part of the total compensation package.
An SFO typically is compensated for its services via a flat fee or payments based on assets under management, and/or a carried interest. As noted above, an SFO is not usually a profit-making venture; the fee income earned by the SFO typically is calculated to cover its costs. Care should be taken in capitalizing the SFO and establishing the amount and timing of fees and payments to the SFO, particularly during start-up, to ensure that the SFO has adequate cash to cover its operating costs. Fees and payments to the SFO made by the client investment entities may not be deductible for income tax purposes by the payor, and so a family setting up an SFO should consult with their tax advisor to discuss options for minimizing the tax “drag” of the structure.
An important step in structuring a single family office is RIA Registration. If the SFO provides investment advice to the family and its entities (rather than outsourcing this responsibility to an investment advisory or investment management firm), it may be required to register as investment adviser or make other disclosures or filings with the Securities and Exchange Commission (the “SEC”). However, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was signed by President Obama in July 2010, with rules set to become effective in July 2011, eliminates an exemption on which many SFOs have relied to avoid registration with and regulation by the SEC as an investment adviser. Even so, some SFOs may not be required to register with the SEC due to a new “family office” exclusion in the Dodd-Frank Act. Although the SEC has issued a proposed definition of family office, whether this exclusion will be applicable to a particular SFO will not be known until the SEC finalizes the definition, which will not occur until spring 2011 at the earliest. New and existing SFOs should discuss the current state of registration requirements with qualified counsel on a regular basis.
Services provided by SFOs vary widely, and the structure and staffing of the SFO should reflect its specific roles and functions. Almost all SFOs provide investment oversight and reporting services; many also provide accounting and tax advisory, risk management, trust administration, compliance and reporting services to family members and entities. Some SFOs pay bills and manage residential properties and staff for their families. As the family grows and members set up households of their own, the array of services provided by the SFO can become quite extensive and expensive, raising questions about how the cost of such services should be allocated among family members.
While SFOs traditionally have sought to hire the highest level of investment talent to serve in key positions, SFOs today are reconsidering whether it might be more cost-effective to outsource all or part of the investment advisory function or other responsibilities, thereby potentially reducing costs and increasing the SFO’s exposure to investment ideas and opportunities. SFOs are increasingly working collaboratively to share investment information and invest in unique opportunities.
SFOs typically require that staff members enter into employment agreements detailing responsibilities and compensation, including deferred compensation, carried interests, and co-investment opportunities. Such agreements also generally include detailed confidentiality and non-disclosure provisions.
Most family office entities are governed by a board of directors (for corporate entities) or managers (for LLCs) but actual governance activity varies widely. Particularly in light of recent market dislocation and volatility, and the uncovering of massive fraud committed by previously well-regarded fund managers, more SFOs are focusing closely on governance:
- Creating effective boards with experienced and independent outside directors,
- Developing or reviewing investment policy statements and asset allocations,
- Planning for short-, mid- and long-term liquidity needs,
- Establishing comprehensive due diligence procedures, risk management and compliance policies,
- Providing detailed, comprehensive and timely reports,
- Developing family leaders through education and active participation, and
- Developing effective decision-making processes at the family, board and SFO office levels.
SFOs for Business-Owning Families
Business-owning families often create SFOs within the corporate structure, reasoning that using business staff to manage family office tasks leverages already-existing resources. However, for a number of reasons families are well-advised to separate the family office from the business, and to hire separate staff who will focus solely on family office matters. First, the financial team for an operating business doesn’t typically have the time or skill-sets required to source, select, and manage a wide range of investments, or to provide the necessary accounting, reporting and tax support for complex portfolio investments. Second, housing a family office within the family business increases the risk that business and non-business assets may be comingled, or that the non-business assets will be plundered to fund business shortfalls (or vice-versa). Third, due to recent regulatory changes, if they share employees, the SFO and the family business may become subject to additional regulatory burdens. Finally, strategic issues for family offices are very different from those for operating businesses, and deserve separate consideration, planning and due diligence.
When the family business is a hedge fund, private equity fund or other investment firm, the issues raised by housing a family office within the business become still more complex. While the fund company’s investment and accounting teams will have relevant skill-sets, its investment focus is likely to be narrower than the family’s. Furthermore, a significant percentage of the fund principal’s assets is likely already tied up in the company’s funds, and so investment of the family office assets within fund vehicles will only serve to further concentrate, not diversify, the family’s wealth. Improperly commingling fund and private assets may also violate various state and federal regulations.
Family Office Association would like to thank contributing editor Amelia Renkert-Thomas, CEO, Fisher Renkert LLC
For more information on structuring a single family office, please see our seminal white paper on the topic.