Having explained the strong recovery of HNWIs in terms of their population size and investment wealth from 2012, it may be tempting to imagine a rapid surge in the size of the family office market in the following years. The reality is, however, much more complicated. Given the globalization of investment, advanced technology achievement, rapid speed of the market, and a series of events, such as the financial crisis in 2008, the euro crisis in 2011, and various investment scandals, family offices are cautious. All the while as business and regulators tighten industry regulations and compliance rules, around the environment of the family office.
Regulatory issues – the Dodd-Frank Act
Before the financial turmoil in 2008, family offices were not required to register with the SEC under the Investment Advisers Act of 1940 if they had fewer than 15 clients. Such exemption provided wealthy families substantial privacy and at the same time avoided the oversight by SEC and relevant regulatory costs. However, the crisis called for a dramatic change to not just Wall Street but also to the whole private wealth industry. The new legislation was the Dodd-Frank Act in July 2010.
After the financial crisis, the US Federal Government introduced the Dodd-Frank Act, which contained two major amendments to the Investment Advisers Act of 1940 that changed the lives of many of the family offices operating in the U.S. Prior to the implementation of the Dodd-Frank Act, a ‘family office’ was generally exempted to register with the SEC as an investment advisor. The Private Advisor Exemption in the Investment Advisers Act of 1940 exempted advisors with fewer than 15 clients the need to register with the SEC; and in practice, family offices that exceeded this number were generally excluded as well.
Obviously, the Dodd-Frank Act is a game changer to many family offices. The new rule provides a whole new definition to what a ‘family office’ is. It repealed the 15-client exemption and now defines a qualifying ‘single-family office’ as one that only serve ‘family clients’, which are then defined as family members and certain key employees of a family office.
For those family offices that fall in the category of ‘family office’ (vs ‘family clients’, and, all multi-family offices), and choose to register with the SEC, what is the downside of registration? (The same question can be posed to small family offices in Hong Kong).
As new regulation is designed primarily to demand more transparency, the immediate downside is the loss of privacy for those families that are involved. They are now obliged to disclose all their details like assets under custody, their office structure and other key data, such as key personnel, fees, investment strategies just to name a few. Ongoing compliance costs are certainly an issue, the need to set up financial books, records and all other administrative documents in a way that the SEC requires. In addition, it is reported that the legal fees and other expenses cost multi-family offices from between $300 to $450,000, with an average of $64,000.
The perception of increased costs and heavy administrative work, and most importantly the loss of privacy and confidentiality have caused family offices to take all possible steps to avoid registration. As stated by Osterland, A. (2012), there are four options to do so:
– reduce the size of family clients they provide investment management services to,
– ask for an exemption letter from the SEC,
– outsource the investment management function, including any investment manager search functions and performance – reporting activities, and
– form a private trust company, which is an even more expensive option.
Having stated the downside of SEC registration, is there an upside benefit?
Registering with the SEC will result in arguably greater scrutiny, a higher level of compliance, and its fiduciary status will require a new level of care from the family office. It benefits the family office clients in a way such that the possibility of family office managers breaching fiduciary duties will be further reduced. A stricter due diligence will be expected from mangers when they outsource their investment management. In addition, by registering, firms can expand the size of their business and take on new clients, taking us back to the point of economies of scale of multi-family offices and their wide range of (costly) services split among several families.