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One of our most-read, but perhaps also most-discussed articles, is our Case for Small Family Offices. ‘Small’ family offices in our network were happy to see someone 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’. (It also got featured in private banking magazin, in case you’d rather read our thesis in German.)

Our 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 the intended role of a family office, small or large. But in the years, I’ve been observing an interesting trend: that family offices are making the active choice to outsource - or at least partially outsource - the management of substantial parts of their investment portfolios.

It’s not a question of size, nor driven by a smart marketing push by banks or consultants. Rather, it’s an active decision being made by some of the smartest family office CIOs that we 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.

I’ve long encouraged our clients 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. (For continued reading, check out What’s your Alpha?).

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 complexity required to keep a family office(r) busy, there really is no need to have one. You might be better off, cost-wise, to either take care of investments yourself, or to outsource them. However, practically, most individuals with the relevant levels of wealth do choose to set up some sort of (small) family office structure. But with that in mind - why do we see institutional, large family offices, that typically aren’t capital-constrained, outsource again? Let’s go back to our Blueprint:

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%) in a wider portfolio. 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 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 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 asset classes do have a place in their asset allocation, but are better implemented in an outsourced fashion.

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

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 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). (For continued reading, check out Managing Your Managed Account.)

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 lower costs of country ETFs over global ETFs, as well as opportunity to capitalize Structural Alpha, i.e. in the US or China. Finally, rather than offering 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. And, of course, fully outsourced, freeing up time that the family officer could use elsewhere in the portfolio in a more value-generating manner than a purely passive portfolio would. 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.)

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. And in PE, even an average fund has historically generated some outperformance over public equities (although you can argue a lot if that is actual Alpha, some sort of factor bias, and/or simply levered Beta.) However, 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 raise billion-dollar funds from existing 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, using a consultant also provided them with access to their due diligence reports, which were prepared at an institutional level that their team likely wouldn’t be able to provide, or would cost them a fortune with Big 4 consultancies. In the family officer’s view, they’d likely break even on the consultant fees from not having to commission their own due diligence reports after only one or two funds every year.

And that was even before taking into account potential cost benefits of using a consultant. In some cases, the consultant was able to pool all of their advised LPs as one ticket, resulting 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 their fees.

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.

The family offices that tend to get outsourcing right are the ones who are clear on what they are looking for. They know what problem or challenge they have, what solution they think is right, and how much they are willing to pay for that solution. And if you are a service provider ready and able to provide that solution at a fair price, nothing more, nothing less, you are well positioned to benefit from this shift.

Are you a ‘small’ family office contemplating what asset classes and topics to cover inhouse, and which might be better implemented in an outsourced fashion? We’ve helped many families tackle that question - ranging from strategic considerations, to where insourcing makes sense, to helping them choose the right banks and asset managers. We’d be happy to help you as well.