A Case for Investment Outsourcing

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Over the last months, I was happy to see that my Case for Small Family Offices has been subject to lots of positive feedback. The many small family offices in our network were happy to see someone finally speaking highly of them. Affluent individuals thinking about setting up their own family office felt supported in their notion despite traditional market participants telling them that they’re ‘too small’. I even got featured in private banking magazin, the leading German wealth management publication. 

(Another positive result: Lots of introductions to individuals looking to make the step from wealth management, PE/VC, or even large family offices into this world of small family offices. We have helped a number of entrepreneurial families conceptualize, staff and train their small family offices - if you are looking to make a career change, or are looking to set up a small family office of your own, please don’t hesitate to reach out.)

Remember that my Small Family Office Blueprint relied on two key aspects: One, that they are constrained by capital, meaning that while they are still large enough to access all asset classes, it is likely uneconomical (or simply irrational) to insource all of them. Two, that they benefit from their limited complexity, meaning that some investments that don’t make up enough of the overall asset allocation are also clear contenders to be outsourced, or might not be part of the asset allocation at all.

When I started working in the family office space, the trend clearly went in the other direction - towards insourcing. After all, that’s intended role of a family office, small or large. But in the last two years or so, I’ve been observing an interesting trend: That family offices are making the choice to outsource - or at least partially outsource - the management of substantial parts of their investment portfolios.

It’s not a question of size, or driven by a smart marketing push by banks or consultants. Based on our observation, it’s an active decision being made by some the smartest family office CIOs that I know. What is driving them to outsource? What are examples of this reemergence of outsourcing in liquid and illiquid asset classes? That will be our topic for this week’s newsletter.

Why family offices outsource (again)

Whether it’s the aforementioned Small Family Office Blueprint or last year’s newsletter What’s Your Alpha, I’ve long been a supporter to think hard about which investments a family office, regardless of size, should really insource, and which are better off being ‘outsourced’. That thinking is in our view further supported by the Aspirational Investor Framework: Don’t try to reinvent the wheel in investments such as stocks and bonds, or even diversified illiquid investments. Instead, spend your time in ‘Aspirational’ assets where you can really move the needle, like starting a new company or making direct investments in your area of expertise.

The strictest interpretation of this philosophical view might mean that you don’t need a family office at all. If you are affluent enough to set up a family office, but don’t have the complexities required to keep a family office(r) busy, there really is no need to have one - and you might be better off, cost-wise, to either take care of investments yourself, or to outsource them. In practice, we see a majority of individuals and families with sufficient assets decide to set up a (small) family office, with the remainder either outsourcing their investing work, or taking care of the work themselves.

So with that in mind - why do we see institutional, large family offices outsource again? Let’s use our Blueprint again:

They are typically not constrained by capital - but even for a large family office, it might not be economical to insource all investment activities. Take VC: The asset class offers a lot of Alpha, but typically only receives a small allocation (<5%). Even if that 5% is 50M€, which is essentially a venture capital fund (of funds) in its own, a family might be hesitant to hire a team if those resources might generate a lower percentage but higher absolute return if instead put to work in the larger allocations of the overall portfolio.

They have higher complexity - but building the required capacities inhouse is easier said than done. Imagine that the family office really wants to invest <100M€ in high-alpha direct investments. But how can they entice them a team of the required institutional quality to leave a high-paying job in what might likely be a fund to switch to a family office, especially if that family might not want to raise external capital (yet)? And how do you find a rockstar that is still a good fit for a family office job? Unless the family is willing to spend time and effort to solve those questions, the better answer might also be outsourcing.

Lastly, there’s also the question of where the family office is in its life cycle.

If the family office is just being set up, outsourcing might be a great way to ‘get the ball rolling’. Rather than waiting to build up the perfect internal team for fund investments, or have the the core investment team to cover all asset classes, outsourcing might be worth its money. We see this frequently in alternative assets (more on that shortly).

If the family office is later in its life cycle, it might have more clarity on where the team can best spend its time. Going back to what I said in ‘What’s Your Alpha’, the family office might have clarity on which asset classes they might discontinue at some point - or which might make sense, but are better outsourced.

With that in mind, let’s move on to some practical examples.

Outsourcing in Public Markets: Better service at the same price

One of the most frequent services that we provide to family office clients is a ‘third-party opinion’ of their liquid assets. After their liquidity event, the family (office) gave their liquid assets to a number of banks to be managed, and a few years later, they wonder if the realized performance was worth the fees and effort. 

In our unfortunate experience, that is mostly not the case. Banks and wealth managers invested their funds in 60/40 portfolios that are at best ETF-based and at worst full of overpriced, active strategies, on top of substantial fees to the bank or wealth manager. Besides the value-add of a good wealth manager and/or a bank’s wider investing platform, there are some managed strategies that are worth their money, but they are rare (we hope to be one of them). 

Given that experience, our ‘third-party opinion’ often ends with a suggestion to instead go (mostly) passive. That brings its own risks and challenges, as it still relies on an adequate asset allocation. But interestingly enough, that shift to passive is actually what drives a reemergence of outsourced (i.e. managed) liquid mandates: While many banks still cling to selling their underperforming 60/40 mandates, there’s a few banks that have understood that a low-cost, efficient managed account (rather than a brokerage solution) can be very attractive to family offices - especially if it is further enhanced by the bank’s wider platform.

An example of how this can look like: A family office client that we worked with was looking to consolidate various equity-oriented managed accounts into one, index-oriented portfolio. They asked the banks they were working with for offers, and two of them - despite explicitly asking for an index-oriented, i.e. passive solution - came back with yet another actively managed account. Not the third bank, however: They pitched a MSCI ACWI-oriented, passive mandate, making use of individual country building blocks to capitalize on Structural Alpha, i.e. in the US or China. Finally, rather than offer this as a brokerage solution, they pitched it as a managed account, in which the bank takes care of ongoing (admittedly minor) rebalancing and monitoring - and in which they can also onboard clients onto bank-internal index funds, which in certain regions were even cheaper than comparable ETFs. 

The overall result? A fully managed, globally indexed equity mandate at a lower total expense ratio (including management fees to the bank) than if the family office client would’ve managed it themselves on a brokerage basis. A great outcome, and unsurprisingly, more than one client in our network ended up working with that bank as well. (Don’t hesitate to reach out if you’d like to know more.)

I think this trend for outsourcing in public markets might be further enhanced once so-called ‘direct indexing’ comes to Germany - but more on that in a future article.

Outsourcing in Private Markets: Is Manager Selection … overrated?

Talking to family offices about private market fund selection is an interesting experience. While most family officers tend to be somewhat diplomatic in most of their actions, not so in private equity or venture capital: The fund they picked? Absolute best in their category. Mind-blowing returns. The fund that that other family officer talked about? Would never invest there. Bad GP, look at that one big deal, not enough DPI.

Which makes the current trend of outsourcing in private markets even more interesting: Some of the largest, smartest family offices in our network don’t try to go the other way and outsource the manager selection process entirely to consultants.

What are the reasons for this decision?

For one family office, it was a question of true value-add from the manager selection process. As we outlined in Quantitative Approach to Private Equity, great private equity managers (i.e. first and second quartile) are clearly worth their money, generating risk-adjusted returns in excess of that of a levered public benchmark. But at the same time, all but the fourth quartile have no predictive factor on future funds - in other words, you have no way of knowing whether a first-quartile manager will be a first-quartile manager again.

This family office took this to heart, and decided to outsource their manager selection process entirely. They are still involved in the final decision, but all other parts, such as sourcing, due diligence, or monitoring, are taken care of by the consultant. And there is one crucial piece that they retain inhouse: How they combine funds of different strategies and (alternative) asset classes with one another, especially in regards to the resulting impact on the liquidity profile, where they see a larger incremental return on their time and efforts.

For another family office, it was a question of access. While large, institutional family offices can typically build access to high-quality managers over time, they might not be able to do so on day one. There’s a number of high-performing GPs that easily raise billion-dollar funds only from their LPs - and if you’re not a part of this roster, you might not even know when their ‘one and done’ fundraising process begins. 

While this family office didn’t outsource their manager selection process entirely, they did decide to work with a consultant to help kickstart their investments in private equity. Rather than having to hire someone to go to conferences and knock on the door of top-tier GPs, they decided on working with a consultant for their network, effectively helping them skip the challenges around sourcing and access. Furthermore, he also highlighted the benefits of the quality level of a consultant’s due diligence at a truly institutional level, far beyond what their team could reasonably provide.

While not always the case in private markets, there can also be some cost benefits. Consultants might be able to pool all of their advised LPs as one ticket, which might result in slightly lower fees. For more niche opportunities, i.e. anchoring new strategies or co-investments, there might not be fees at all, further helping cover the fees of the consultant.

Takeaways

If you asked me three years ago if I would’ve expected to see more or less outsourcing in the family office world, I would’ve clearly expected less outsourcing. While the overall trend of insourcing (through the setup of more, smaller family offices) remains, it’s still interesting that my intuition was wrong, especially when it comes to larger family offices.

How should we see this trend - from the side of family office, and ‘outsourcing provider’?

Family offices should be open-minded to outsourcing. A common view of family officers might be that outsourcing is not preferable, but my personal experience has shown that a right partner can add value through a number of ways, ranging from lower fees to more efficiency to incremental performance.

‘Outsourcing providers’ - meaning consultants, wealth managers, and banks - should be mindful of their offering. The wind has been shifting for a long time, with new family offices no longer willing to pay overpriced fees for low-quality service. In the question of being right or making money, banks in our experience mostly pick being right - like pushing for an overpriced managed account because that’s what they’ve always done, even if that’s not what the client wants. 

There is a big opportunity for both sides to come together in value-creating ways, as we’ve outlined below. I’m curious to see how this trend will develop.

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