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In a recent survey conducted by one of the top three global Alternative Asset Managers, overseeing assets exceeding $500 billion under management, findings suggest that family offices are currently experiencing a strong growth phase of their capital base. This phase involves a broadening of allocations, bolstering of risk management strategies, and enhancing product expertise.
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A notable observation from the survey is the significant divergence between older, established family offices heavily invested in real estate and alternative investments like Private Equity and their younger counterparts, who are in an exploratory phase of global asset allocation. Many of these younger family offices lack experience in managing investments amidst a high-interest-rate environment and significant economic risk. Hence, there’s a widespread recognition among family offices that further enhancements in portfolio construction are necessary not only to generate returns in different economic environments, but to optimize returns per unit of risk taken.
This recognition is reflected in the increasing number of family offices surveyed, who are seeking to increase exposure to asset classes not only offering favourable absolute returns, but “favourable risk-adjusted returns”. Currently, many family office are therefore reallocating their portfolios, reducing their exposure to Public Equity in favour of Private Credit and Infrastructure investments.
Our family office, Tropea Capital, embarked on this transition approximately four years ago, gradually shifting our allocations from a heavily overweight position in Public Equities to a predominant focus on Diversified Credit, encompassing Corporate Loans, Direct Lending, CLOs, and Asset-Backed Lending. This strategic realignment was driven by our given mandate to preserve capital, particularly in anticipation of a market corrections in global equity markets. While unforeseen events such as the COVID-19 pandemic and the war in Ukraine posed additional challenges, our proactive approach enabled us to mitigate risks effectively.
Nevertheless, even prior to China crisis, Ukraine war and epidemics, the risk levels in equity markets had become too high for us and we had to find ways to reduce our exposure to risk. As a multi-generational family office, we face the dual mandate of risk management and growth in capital. Mid-teen returns and continuous cash distributions are core features of our mandate, prompting us to embark on a journey to enhance risk-adjusted returns across our portfolio.
Our 24-month journey focused on refining asset allocation by improving risk metrics while maintaining or improving performance. Through deep dive due diligence on various asset classes, we identified favourable risk-return profiles and distinct return characteristics, especially compared to investments in Public Equity. Our conversations with numerous other family offices reinforced our findings, revealing widespread over-allocation in equity markets and a tendency to overlook and ignore inherent risks.
Our findings speaking to other Family Offices
We recently attended the London Business School Annual Family Office Conference 2024. What we found in our conversations with other family offices was that many family offices are:
- over-allocated in Public Equities, and
- mainly focus on historical returns and do not assess the current risks they are taking.
This came as a surprise and is completely counter-intuitive as the investment decision process at family offices is still predominantly driven by family members and not by external advisors. 77% of Family Offices have at least one family member on their Investment Committees.
And exactly those family members have historically generated their wealth in family businesses in a particular industry, be it in manufacturing, service businesses or consumer products. These family members will have exercised extreme caution when taking risky decisions.
When it comes to investment decisions in the family office, many ICs do not monitor the full extent of risks associated with their investments, in particular in Public Equity. Only limited due diligence and risk assessment is conducted on individual stocks or broader market indices.
As Nassim Taleb, NYU Professor and bestselling author of six books on uncertainty and risk management puts it:
“If you are not a baker, don’t open a bakery, if you are not a dynamite expert, don’t produce dynamite, if you are not an equity trader don’t buy stocks.”
Family offices often invest in stocks, wrongly seeking solace in a perceived “diversification” and they often do not consider the inherently risky features of Public Equity as an “investment for promised future unknown returns”.
Those features can lead to significant and permanent losses for the investor, features like:
- “first loss” quality of an equity investment,
- the “unlimited loss” quality,
- the “optional dividend”, or
- the “unknown recovery path” of an equity investment.
Many of these qualities are entirely mitigated in other asset classes such as Private Credit investing, where risks are significantly lower. Consequently, equity investors may very often (if not always) be significantly underpaid for the risk they are taking in relation to the returns they may or may not receive.
We have found other asset classes such as Diversified Credit to have by far more favourable investor qualities such as:
- “last loss” features,
- “contractual returns”,
- “a defined recovery path“, and
- “collateral security” inherent in many credit investments.
In view of these differences across the risk stack, we have changed our main assessment metric from return track records to risk adjusted return track records in our investment decision process.
Returns per unit of risk (RPUR)
We have designed an investment framework that manages our portfolio in relation to return achieved per unit of risk (RPUR) as a key metric. Consequently our focus is on both dimensions, return and risk, when taking investment decisions. For example an investment with an expected return of 10% per annum, taking 2 units of risk is in our view by far a better investment, than one offering an expected return of 18% per annum and taking 6 units of risk. We think RPUR is especially important for family offices because of their multi-generational mandate to preserve capital. Their mandate is different to other investor types such as private investors including high net worth individuals (HNWI) who often use a more “betting style” investment approach, seeking excitement in winning on the upside, even if those wins are only temporary and losses are forgotten quickly. This of course is called the “Casino effect” of investing which so many individuals take as a core driver for investment decisions.
Also very large institutional investors are often driven by different investment guidance as they must match their capital growth in accordance with liability streams and therefore take decisions in line with balance sheet stability, liquidity planning and regulatory capital rules. They often become forced sellers whereby Family Offices with well positioned investment setups can easily take advantage of such underpriced asset sales.
In our 12 month due diligence period, we have assessed over 25 asset classes and 300 asset managers, from super large global managers with multiple hundred billion in assets under management to smaller asset managers with specialised regional knowledge, who are particular well positioned to assess and mitigate the risk aspect of the RPUR equation.
Our current portfolio of Diversified Credit has surpassed our return targets and at the same time reduced risk substantially. When making investment decisions, we are guided by our risk/return framework RPUR.
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