Hedge funds and family offices both move in the rarified circles of high net worth (HNW) and ultra-high net worth (UHNW) families and individuals. Both manage trillions in private investments and assets around the world, and they often employ aggressive investment strategies to provide higher returns than the typical equity portfolio. But that’s pretty much where the similarities end and the differences begin. The reason that people are thinking in terms of family office vs. hedge fund is that hedge funds have been transforming themselves into family offices. Here’s a look at family offices and hedge funds, and an explanation of why we’re seeing more hedge funds migrate to the family office model of asset management.
As the name implies, the family office is essentially a private equity firm that manages the assets and, often, the lifestyle requirements of a high-net-worth family. The threshold for establishing a family office is north of $100 million in private wealth, as it can cost $1 million to $2 million a year, or more, to operate. But that’s just the price of admission. Most family offices manage billions of dollars in family wealth.
A family office is typically formed when the management of the assets and lifestyle of a HNW family exceeds the capacity of one individual. The key is complexity. Does the family’s wealth come from multiple sources (businesses, investments)? How many family members (spouse, ex-spouses, children, siblings) benefit from the family assets? How much real estate (commercial, residential) must be managed, and is any of it overseas?
Aside from financial management considerations, there are lifestyle management considerations. Children need to be educated. Travel arrangements need to be made. Household staff must be hired, managed and compensated. Large purchases (planes, yachts, houses) have to be executed.
And then there is the important issue of family governance. A family office bases its activities on a family’s vision and the set of values and principles by which all participating family members agree to abide. Participating family members should meet at least annually, and a subset of members – a family council – should confer regularly with the family office principals (family members most closely involved with the operating of the family office) and advisors.
As you might expect, the family office staff must have expertise in many areas to provide such a wide range of services at a high level. There will be investment advisors, fund managers, tax attorneys, CPAs, and other financial service providers, along with administrative personnel and maybe even a human resources person. And they all must receive compensation, often in the six figures.
Because of the expense and complexity of running a single-family office, the multi-family office has grown in popularity. A multi-family office is formed in one of three ways:
The threshold for entry into a multi-family office, about $50 million, is lower than for a single-family office, because families share the expenses.
One of the attractions of a family office is its regulatory environment. In 2011, the Securities and Exchange Commission (SEC) adopted what is commonly called the “family office rule.”
The law exempts family offices from the broad definition of an investment advisor. To qualify for the family office exemption, the family office must:
This level of regulatory oversight is likely responsible, at least in part, for the growth in the number of family offices, from roughly 1,000 single-family offices in 2008 to more than 10,000 globally today.
A bill introduced in Congress and approved by the House Financial Services Committee in July, the Family Office Regulation Act of 2021, would tighten the rules under which family offices operate. Even if it never becomes law, it could encourage federal regulators to take a closer look at family offices.
Like family offices, hedge funds are nonpublic investing entities. But hedge funds don’t keep it all in the family. Rather, hedge funds pool assets of individuals and institutional investors and pursue strategies that promise maximum returns for minimum risk.
The term “hedged fund” was coined in the late 1940s. Just as a hedge – a line of bushes – might protect a property, the hedge fund was originally designed to protect its investors from the ups and downs of the economy and stock markets. They did this by employing what is known as the long/short strategy. If you think a stock is going up, you go long. If you think it’s going to go down, you short it.
A hedge fund pools money from investors and then buys and sells investments following a strategy to maximize returns and minimize risk. If that sounds like a mutual fund, it’s not.
First, hedge fund investors must meet certain net worth requirements. The typical entry level is $1 million, or annual income of $200,000 or more over the previous two years. As they are considered “qualified” or “accredited” investors, there is less regulatory oversight on hedge funds than mutual funds.
In addition, a hedge fund can invest in pretty much anything, depending on the strategy it has adopted. Mutual funds invest in stocks, bonds and other securities. Hedge funds go beyond that, getting into land, real estate, derivatives, currencies and other alternative assets. Some of these can be very risky. Hedge funds got a bad rap during the Great Recession for investing in “collateralized debt instruments,” derivatives made up of unsustainable mortgage debt.
A hedge fund can also use “leverage,” or borrowed money, to increase the impact of its investments. That’s also risky. It’s definitely not for everyone!
With the growth of the stock market and investor net worth, the number of operating hedge funds has also increased. In 2021, more than 3,600 hedge funds operated in the U.S., a 2.5% increase over the previous year. They control close to $4 trillion in assets globally.
Hedge funds can have a variety of structures, but they always have an investment manager who determines strategy and makes investing decisions based on that strategy. The manager also ties up a significant chunk of his or her personal wealth in the hedge fund. Managers are paid a management fee and a performance fee if the fund exceeds predetermined benchmarks.
According to the CFA Institute, hedge funds are subject to the same trading, reporting and record-keeping requirements as other investors in publicly traded securities. They are also subject to additional restrictions and regulations, including a limit on the number and type of investors that each fund may have.
Investors must meet minimum net worth and income requirements, and the SEC can adjust those standards as it sees fit.
As you can see, there are significant differences between family offices and hedge funds.
A family office takes a holistic approach to managing the assets of a wealthy family or group of families. A hedge fund offers asset management to investors as limited partners who want to tap the expertise of the fund manager. (And you wouldn’t ask your hedge fund manager to book your next vacation.)
The regulatory environments in which each operates differ greatly. The family office is not regulated, does not have to register with the SEC, and does not have to meet disclosure requirements. This is all because it is prohibited from soliciting outside investors.
A hedge fund, because it can solicit outside investors, must register with the SEC as an investment advisor. It is subject to disclosure requirements.
Privacy, then, is a feature of family offices that hedge funds do not enjoy.
This doesn’t mean that the two are mutually exclusive. A family office can have a hedge fund in its investment portfolio, for example. And a hedge fund manager can become sufficiently wealthy to establish his or her own family office. For example, Jim Simons, founder of the hedge fund Renaissance Technologies, has an estimated net worth of over $21 billion. He established a single-family office, Euclidean Capital, that focuses on venture capital and real estate.
A trend developed in recent years of hedge funds transforming into family offices. The two are completely different asset and wealth management organizations, so it’s not a question of shutting down a hedge fund one day and turning it into a family office the next.
The reasons behind such transformations are varied and complex, professional and personal. Perhaps a hedge fund owner is ready to step away from managing other people’s money or raising new money. Maybe the increased regulatory scrutiny of hedge funds is a factor. Or perhaps the hedge fund is perceived to be underperforming.
In any case, there are basically two avenues for turning a hedge fund into a family office.
The first is to return capital balances to every investor who isn’t in a familial relationship with the fund owner. This includes the HNW and UHNW individuals, institutional investors, partners and staff. The fund owner, of course, retains his or her own funds, along with those of family members. This essentially closes the hedge fund.
The other avenue is for the fund owner to withdraw personal and family funds from the hedge fund. This allows the hedge fund to continue operations under a new general partner.
Whichever way the family office is created, the hedge fund founder or manager will find he or she has greater privacy and greater control, not only over investment assets but also personal affairs. This autonomy and privacy are often the prime motivators for switching to a family office.
But just because someone did a good job managing money doesn’t mean they’ll manage a family office well. A family office has many moving parts, and it provides far more expansive services than a hedge fund.
A hedge fund executive may not be prepared for the variety of tasks ahead, the time required, the coordination needed – or the expense involved. The result can be a sort of “junk-drawer” approach of hiring specialists (taxes, estate planning, succession planning, investment management) without the coordinating strategy.
If you think a hedge fund-to-family office conversion is in your best interests, you might want to consider whether building a family office from the ground up is the best option. Consulting with a wealth management firm that manages multi-family offices – and has all the resources at its fingertips – could be a smart first step.
Cope Corrales takes an integrated approach with its client families to understand their long-term goals and objectives, develop family governance, grow wealth, mitigate taxes and plan for the future with multi-generational wealth management strategies. All the while, they are giving back time to their clients to do the things they want to do, whether that’s travel, philanthropy, or family-centered activities.
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