A comprehensive system of financial governance is an essential tool for family businesses to efficiently manage their wealth. It can be seen as one of the binding elements between the family governance and the corporate governance, and includes measures both for private and corporate wealth. Considering the multi-layered construction that such a system requires, it is not surprising that establishing efficient financial governance in a family business is no easy task. Grégoire Imfeld, Senior Relationship Manager, Pictet Family Office Services and Allard Lugard, Regional Head Middle East for Pictet Wealth Management explain how financial governance can assist the family in managing its wealth and what are the particularities to be considered for family firms in the Middle East.
Exceptional levels of wealth in family firms often become extremely difficult to manage in a way that satisfies all family members equally. For wealthy families, it is therefore paramount to achieve financial objectives and to create an appropriate structure.Financial affairs and commercial affairs represent two of the most important components making up the wealth of families. Whilst in most cases wealth creation originates from commercial assets, wealth preservation is generally granted through the management of financial assets. Both types of assets behave differently though, and have their own characteristics. As a result, they should have different governance structures.
In the family governance concept however, family councils and/or boards must be created, covering both aspects of corporate governance and financial governance. The former is often well put into practice, whilst the latter less so. In that regard, advisers often hear the following kind of observations: “My financial affairs are unattended. I have too many bankers and I have no time to assess nor answer the many investment solicitations I receive. I cannot evaluate the true quality of my financial performance”. Such words are too often heard from busy and successful entrepreneurs, still heavily involved in their business.
This illustrates that successful family businesses that create large amounts of cash find themselves confronted with the task of wealth management, but with limited time and sometime interest, to dedicate to it.
The elaboration of a successful financial governance structure assumes that the family governance structure is established and sound. Developing a family strategy that defines values and objectives associated to a family business plan is important. It provides the prerequisite information for the creation of an investment policy, which should translate the family‘s objectives into financial objectives. Family objectives depend on where the family stands in the wealth cycle, on whether it is creating or preserving its wealth (Figure 1 below). One key advantage a wealthy family has is that its financial objectives can be set over several generations. That way, financial turmoil and periods of increased market volatility can be better endured. This unique characteristic shapes choices of asset classes.
The financial governance setup allows the creation of formal guidelines, which will guide the investment committee. The investment committee is set up to oversee the family‘s financial governance and is a crucial organ of the financial governance system. Furthermore, it offers the opportunity to truly understand the family‘s culture and dynamics while providing time also for interaction amongst family members. More importantly it should also unite the family with regards to financial expectations and consequently should result in the most appropriate, long lasting tailored solution.
Families generally have more than one asset manager or private banker. The role of the investment committee varies from an institutional approach to a private banking approach. The former rests on a delegation principal, which consequently requires a strong investment committee, whilst the latter offers more flexibility and customisation, with a more controlling responsibility.
With an investment policy created and agreed upon, the implementation can begin, from the RFP (request for proposals) to beauty contests, right through to the elaboration of reporting tools. Once the investments have started under the guidance of a carefully crafted financial governance system, the monitoring of the various managers in terms of risk and investment guidelines, supervision and market reviews become the investment committees’ core activity. A fine-tuned financial governance system should manage a family‘s financial portfolio efficiently and in a transparent manner.
As the wealth cycle evolves, the importance of and the dependence on financial wealth increases. Creating an adequate financial governance early on is paramount to the success of both meeting financial objectives and insuring a smooth transition to the next generation. It prepares the young family members for their future and increasing responsibilities in the world of financial asset management. Additionally, it provides a truly, long term fiduciary relationship with external advisors.
Particularities of Financial Governance for Family Firms in the
Family firms must understand why financial governance is important and what its core functions are. However, at the same time the socio-economic and institutional context have to be taken into consideration for family firms who are defining their financial objectives. Therefore, when speaking of establishing such structures in Middle Eastern families, a closer look is warranted at their context-specific considerations and implications.
In family businesses corporate wealth and private wealth are strongly linked with each other. It can often be seen that successful families, have managed to separate corporate from private assets. To what extent a family firm has been able to undertake such a separation may be a function of the degree of professionalism within the organisation. Large families in the Middle East have started many years ago to become more sophisticated with regards to the structuring of their private and corporate assets, their risk management, and diversification. However, there are considerations when families formulate their financial governance that cannot be ignored; considerations that are on the one hand imposed by the socio-economic and institutional context from which family businesses operate, and on the other hand the individual characteristics of the family:
Family structures: In the Middle East, the family composition is rendered more complex because of the number of family members and the different age groups included in one family. Often by the time a family reaches its third generation (the cousins consortium), its numbers may have reached the three digits. It can be easily imagined how many different opinions and attitudes should be considered in financial objectives given these structures. To have a large next generation is an important consideration in the formulation of the family and has a direct impact on the financial governance.
Legal frameworks: In Middle Eastern countries financial governance must be compliant and take into account sharia law where it applies. In cases of inheritance, a country’s legal system might suggest a different distribution of wealth within the family than is perceived as just and fair by family members. While the question of inheritance is regulated by the family governance, good financial governance represents a tool that can provide the family with a balanced distribution of the family‘s wealth.
Mix of assets: Middle Eastern families are known to diversify their private and corporate investments regionally as well as globally. Such financial decisions bring with them certain additional challenges: Many families have to take into account the rules and regulations attached to buying, for instance, fixed assets abroad (e.g. real estate in different countries). The challenge here lies in different legal and fiscal regulations. Often this is well-coordinated when it comes to corporate investment, however, families should not forget that the same care should apply to their private wealth.
Liabilities: When speaking of corporate wealth, liabilities cannot be ignored. Private investments can be a liability when families buy fixed assets that come attached with financial responsibilities (e.g. mortgages). Families do not only need to consider how to diversify and structure their assets but also how much of a liability they represent and to some extend how much they wish to “invest” in it.
Economic and political crises: Certainly, factors, which are beyond the family‘s control such as political instability and economic crises, have to be acknowledged when formulating financial governance. The late banking crisis, for instance, has caused a great crisis of confidence and businesses that were not prepared for such a dramatic shift in their surrounding institutions greatly suffered in terms of financial losses on both the private and the corporate wealth side.
Institutional environment: Depending on the level of economic and social development of their home countries, Middle Eastern families may be confronted with limited institutional support for financing. When business is tough and when bank financing becomes a real issue, families often have to be prepared to tap into their private funds to finance their businesses. Again the strong link between the corporate and private wealth of family businesses becomes apparent and, with that, the importance of structuring both through a clear financial governance system.
Risk management: A family’s attitude to risk is often the same in private and corporate wealth management. Over the last few years there have been many disappointments in terms of returns on investment on the corporate and on the private side. A conservative attitude to private wealth combined with a careful planning of corporate wealth can be but beneficial for the business and, more importantly, for the family welfare.
Many family businesses in the Middle East are thinking about these issues and seriously study opportunities and consequences. There is an awareness and sense of urgency to act. Some have taken sophisticated planning measures and by setting up financial governance structures they can tackle challenges that arise from their context or their own structures. They set up investment boards and policies. Others become so large that they set up separate family offices for their wealth management. There are also those that decide to work with a select number of banks and their advisors. The choice of the right advisors is something that a family should invest considerable time in, as their roles are crucial for the success of financial objectives. Unfortunately, there are still many family businesses that have not addressed the issue of financial governance at all.
In the current financial turmoil many families would love to get a helping hand to explore financial opportunities. Financial assets can be very complicated but are sometimes made to look more complex than they really are. A golden rule is to keep it as simple as possible. The benefits of financial governance are manifold but first and foremost it provides the family business with peace of mind. Most importantly, the result of a balancing act between private and corporate considerations should always make sense to the whole family. It should be recognised as a crucial ingredient for family business sustainability and continuity over the coming generations.