It might not seem like a big deal, but it is: Family business owners, of which there are an estimated 5.5 million in the U.S., have to think holistically about their capital -- their family business, their human capital, and their investment portfolio.
They can't think of those assets as separate pies, but as slices of one big pie.
So says Stephen Horan, the managing director of credentialing for CFA Institute. Horan, who spoke recently at the American Institute of Certified Public Accountants' (AICPA) Engage 2018 conference, also spoke to us about his presentation.
The gist of his presentation and his discussion with us is this:
The Family Balance Sheet
A family business owner, as part of their investment planning process, ought to create a balance sheet. But not a typical corporate or personal balance sheet or net worth statement.
Instead, the family business owner's balance sheet should look a bit like that of a corporate pension fund -- one that captures the present value of assets and the present value of liabilities.
The difference: The assets on the pension fund's balance sheet include traditional assets, alternative assets, expected employer contributions, expected employee contributions.
By contrast, the assets on a family's balance sheet would include financial assets, tangible personal assets (e.g., real estate), human capital, family business/stock options, deferred compensation, and expected inheritances. Read Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance.
Listen to Bob Powell's interview with Stephen Horan:
The liabilities on the pension's fund's balance sheet include accrued pension obligation (APO), projected pension obligation (PBO), and a surplus.
The liabilities on the family business owner's balance sheet would include mortgages, lifestyle maintenance, dynastic goals, other high-priority goals (e.g., philanthropy) and discretionary wealth (surplus).
And what family business owners need to understand is that this that human capital -- the present value of future earnings -- represents really the largest proportion of assets on almost any investor's balance sheet. That's going to look very different for the family business owner than it will for the tenured college professor, says Horan. "But it doesn't take away from the fact that that tends to actually outpace, or in some cases dwarf, the financial assets that we tend to focus more of our attention on," he says.
Asset Allocation Is Not Just About Financial Assets
For family business owners, their business -- which tends to be concentrated and illiquid -- is their single largest asset. In fact, Horan says, it could represent upwards of two-thirds of a family business owner's wealth.
And that asset, which is more like a stock than a bond, can dramatically affect the optimal asset allocation of one's investment portfolio. (Of note, human capital for wage earners, by contrast, looks more like fixed-income than equity, and "so that has significant implications for how the rest of the financial portfolio is managed," says Horan.)
For instance, let's say you own a family business worth $5 million and you have an investment portfolio worth $1 million with a traditional asset allocation of 60% stocks ($600,000) and 40% bonds ($400,000).
The total value of your assets, not including your human capital and the like, would be $6 million and your overall asset allocation would be $5.6 million stocks and $400,000 bonds or 93% stocks and just 7% bonds.
Given that sort of asset allocation, the family business owner should reduce how much is invested in stocks, an asset class that is just as risky if not more so than the family business. Read Optimal asset allocation in the presence of nonfinancial assets.
To be sure, many investment/financial advisers don't currently incorporate the family business and human capital into their management of client portfolios.
In essence, they have training and experience in managing investment portfolios, or financial capital. But they have less training and experience integrating human capital and a family business into an investment plan.
"To develop a financial plan and an investment strategy for a client that might ignore two-thirds of what they own, borders on malpractice; but perhaps stating that in a more positive way, it's really the very stuff that allows us to create the most value for our clients in a world that's characterized by automation and that might be sort of narrowing the scope of opportunities for us to add value," says Horan. "Well, this is one area we can really shake thinking and develop an asset allocation strategy and an investment strategy that reflects the most important aspects of that balance sheet."
The good news, according to Horan, is that advisers can easily incorporate a family business into an investment plan; they just have to treat it as they would a stock. "In fact, if the adviser wants, they can basically use the same tools they're currently using to create that efficient frontier," he says. "(They need) to modify the inputs into that optimizer to reflect the unique risks that the assets have on the company. So, what is the family's leverage ratio? That's going to change how they feel, if you will, the risk from the financial markets in each individual asset class that might go into the optimizer. And secondly, how they interpret the outputs."
The harder part is to get family business owners to incorporate their business into their portfolio. "It requires some time and a series of conversations to level set a client to buy into the framework," says Horan. "They (the family business owner) need(s) to believe that... 'I see what I'm seeing on paper and it sort of make intuitive sense, but I need to understand more about what this might look like for me and explain to me how that would really make sense in my situation.' That takes time. So, it is not the standard of practice."
And advisers who don't address this are missing out. "I think this is worthy of consideration to really be at the forefront of adding value to clients, because they're looking to us for holistic wealth management, not just specific financial wealth management and if our investment solutions aren't calibrated to their unique circumstance, then we're really missing an opportunity to do our best," says Horan.
Family business owners also need to factor their values and goals into their asset allocation, according to Horan. And the prioritization of those goals is what determines your risk tolerance, says Horan. What's more, the risk-free asset for family business owners is not the three-month U.S. Treasury bill or Treasury-Inflation Protected Securities, but it's an asset that's specific to the family business owner. Read Goals-Based Wealth Management in Practice.
Here's how it works: The basic framework is to outline all that you want to accomplish and prioritize it. The author of Goals-Based Wealth Management in Practice starts with the foundation of a pyramid: What's the most foundational important thing we hope to accomplish? For many people, says Horan, it's meeting their current and even some unanticipated spending needs so that their lifestyle can be maintained, whatever that lifestyle is. "It might be modest or it might be extravagant, but some maintenance with an allowance for future flexibility," he says.
Then the next layer on that triangle or that pyramid might be something important but maybe a little more aspirational, to pass money onto the next generation, and it might be for multiple generations beyond that, and then the apex of that pyramid is something even more aspirational yet and that may be philanthropy.
"The process basically is bucketing into those prioritizations and valuing, basically capitalizing in today's dollars how much I need to satisfy those goals, comparing them to the assets, and the ratio provides -- what I've called in the presentation delivered to the AICPA audience -- the leverage ratio," says Horan.
The leverage ratio shows how much larger are the assets than the liabilities. And that's going to determine how risk tolerant the investor is. "So, the more aspirations the investor has in proportion to their assets, the less risk they can accept in their investment portfolio and the fewer priorities, the really important priorities they have, the more risk they're going to be able to accept in their investment portfolio," says Horan.
Horan's bottom line: "When we think of asset allocation," he says, "we really should broaden our frame of reference to not focus exclusively on the financial portfolio, but rather the larger extended portfolio and that we should recognize that our rebalancing efforts are constrained to only that financial part and we need to be conscious of that and so that may inspire us to think about risk management in a different way and even thinking about hedging some of the preexisting exposures the family has in their business.
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