A REAPPRAISAL OF INVESTMENT RISK FOR BUSINESS OWNING FAMILIES
by Michael Maslinski
After 20 years of promoting sophisticated risk management as a core offering for wealthy private clients, the asset management industry is still coming to terms with many flaws in its methodologies, exposed by the financial crisis. It is acknowledged that these methodologies relied too heavily on volatility as a measure of risk, while seriously underestimating counter-party risk and the inherent risk of excessive complexity.
Very little, however, has been written about the particular risks for individuals and families who directly own businesses and how these risks should impact on the management of the investment portfolios . Most wealth managers lack the business experience to address this issue intuitively and it could be argued that risk management methodologies applied in isolation to the investment portfolio create a partial model, which gives an illusion of sophistication, causing decisions to be made on the basis of a partial and misleading analysis.
The risks faced by business owners in the financial crisis became very real:
Sharp and sudden reductions in business revenues creating unexpected cash flow problems
Sudden and substantial reductions in the value of business and property assets some of which became temporarily unsalable
Banks unable or unwilling to provide additional financial support, even to very sound businesses with excellent track records
Withdrawal or reduction of existing bank facilities sometimes for half completed projects
Clients forced to liquidate investments at the worst possible time, to support the needs of their businesses
Liquid investments ceasing to be liquid, in that they were gated into hedge funds or practically unsalable at any sensible price.
The first lesson is not to rely too heavily on mathematical models whose complexity creates a false impression of accuracy. Any risk analysis will depend as much on mature judgements gained from business experience as on the false certainty of spurious mathematics
A wealth manager claims to adopt a broader perspective and there is a massive difference between an approach based on asking the client how much they could bear to lose, versus a professional appraisal of liquidity risk, based on detailed scenario analysis of the needs of the family’s business interests in a variety of different circumstances.
The process must start with a detailed strategy which defines the purpose of the wealth and the objectives. The wealth manager will assess the risks, business by business, and will use his experience to pinpoint the type of problems which can arise, not only in the businesses themselves, but in the families which own them (potential for divorces, disputes etc).
Only after such an analysis has been completed can it be decided how much is available for long term investment portfolios, rather than a family treasury function. Equally important is the ongoing monitoring of risk, which can be dramatically affected not only by changes in the market, or the performance of business enterprises, but by business decisions made by the family. It is the job of a wealth manager to maintain a close watch for such developments, for which effective reporting is essential.
The wealth manager must also decide to what extent to incorporate the views and insights of the client into his portfolio judgements. Most entrepreneurs lack the formal risk management tools of investment managers, but nevertheless have a well developed understanding of business risk, which they approach from a quite different perspective. They often have strong belief in their own judgements, especially in their areas of expertise.
A wealth manager thus often has access to the real views of industry leaders in the private context of their own financial affairs, (rather than through the normal channels of investor public relations) and he must decide how much weight to attach to these insights.
While the day to day management of portfolios can be delegated to conventional investment managers, the global financial crisis has highlighted the need for the whole wealth management process to be overseen by a wealth manager who is genuinely able to look across all the assets of the family, combining the experience of mature business people with competent investment managers. The problem faced by the wealth management sector is a serious shortage of people with the experience and training to deliver such a service. The temptation for an under-skilled sector is to rely too heavily on formulaic processes for the management of risk, but the perspective of many clients is that these processes have not stood up to the tests of an economic crisis and those who cannot demonstrate an understanding of the businessman’s perspective will find it hard to gain the trust and respect of prospective clients .