Financial planning during periods of relatively higher interest rates is certainly not elementary. In a low interest rate environment, the opportunities for wealth transfer seem boundless; one can seemingly draw from a myriad of strategies and have a high likelihood of success. A high interest rate environment, however, all but eliminates the effectiveness of such. In particular, strategies that involve intra-family loans or installment sales are negatively impacted by high interest rates. A Grantor Retained Annuity Trust (GRAT) is one of the few exceptions.

A GRAT does not seek to transfer the trust assets to the beneficiaries, but only the appreciation on those assets. Transferring only the appreciation, unlike other gifting techniques, can^[1] allow for a transfer that is entirely gift and estate tax-free. For this reason, GRATs are particularly attractive for those who have already transferred assets equal to (or more than) their lifetime gift tax exemption of $12.92 million per person. GRATs may also be a good fit for those who are undecided on how they would like to use their lifetime gift tax exemption.

A GRAT is an irrevocable trust, yet it contains characteristics that are contrary to the very essence of an irrevocable trust. For example, by definition, in an irrevocable trust, the grantor relinquishes his or her ability to change it. However, for a trust to be considered a grantor trust for income tax purposes (i.e. the grantor pays the taxes incurred by the trust), certain features must exist. This includes, but is not limited to, grantor powers such as adding and changing the trust beneficiaries, or the power to substitute the trust assets with other assets of equal value. The ability to substitute trust assets in a GRAT should not be overlooked.

Functionally, the interest rate at GRAT inception is meaningful. You may be familiar with the Applicable Federal Rate (AFR), which is the minimum interest rate that the Internal Revenue Service allows for private loans and is published monthly based on current interest rates. GRATs utilize another monthly interest rate known as the Section 7520 rate. By definition, this is the AFR rate for determining the present value of an annuity. It is also known as the hurdle rate and can be perceived as the IRS projection for appreciation on the assets contributed to the GRAT.

For a GRAT to be successful, the trust assets must appreciate more than the annuity stream. This is why GRATs are particularly successful in a low interest rate environment when the Section 7520 rate is low. However, GRATs can still be fruitful in a high interest rate environment. The current market conditions could be viewed as favorable for GRAT creation due to the repressed prices of assets—most publicly-traded securities are trading at significant discounts due to lower valuations. As of this writing, the Section 7520 rate is 4.40%. A GRAT created today can successfully transfer wealth to the beneficiaries if the assets contributed appreciate more than 4.40% over the GRAT term.

So how do you go about actually creating a GRAT? First, identify the assets you wish to fund the GRAT with—generally either marketable securities, private company shares or real estate. Then you must engage an estate planning attorney to draft the GRAT agreement. This document will contain key provisions such as the funding amount, the annuity term, the annuity payments back to the grantor and the trust beneficiaries. It would be prudent to consider utilizing a “zeroed-out” ^[1] GRAT strategy, for which the annuity payments bake in the hurdle rate. These annuity payments will be considered in good standing with the IRS as long as they do not increase by more than 120% of the prior year’s payment. There’s an alternative Section 7520 interest rate applicable for these purposes (this rate is 4.45% as of this writing versus the 4.40% standard Section 7520 interest rate).

It’s important to note that success can be contingent on selecting the best assets to fund the GRAT, but an unsuccessful GRAT shouldn’t necessarily be considered a loss. If the contributed assets do not appreciate more than the hurdle rate, those assets are simply transferred back to the grantor. Keep in mind, however, that you will incur administrative expenses to implement the strategy, including, but not limited to, fees paid to the attorney who drafted the trust agreement and valuation expenses should you choose to contribute private company shares to your GRAT. While it may be tempting to fund a GRAT with family business stock, some experts opine that GRATs funded with marketable securities are more likely to succeed than their counterparts, as valuation expenses can be quite costly. A pre-initial public offering stock would be a notable exception.

Even in a high interest rate environment, there is one GRAT strategy that is highly likely to succeed. This strategy is known as “rolling GRATs”, which can be defined as a series of short-term (read: 2-year) GRATs, for which each subsequent GRAT is funded by the annuity payments from the preceding GRAT. This strategy reduces mortality risk versus implementing one longer-term GRAT, which is one of the key considerations for any GRAT. The grantor of a GRAT must survive the annuity term. Otherwise, the contributed assets and their appreciation are clawed back into the grantor’s estate. Rolling GRATs also spread out interest rate risk, as each subsequent GRAT would have a new hurdle rate.

Functionally, a rolling GRAT strategy would operate as follows:

• Execute the trust agreement with a 2-year annuity term and a zeroed-out^[1] annuity payment schedule. Assume an agreement date of March 15, 2023, a contribution of assets with a fair market value (FMV) of $2,000,000 and the current 120% Section 7520 hurdle rate of 4.45%. For your GRAT to be successful, the GRAT assets therefore must appreciate to $2,089,000 by March 15, 2025.
   
• The first-year annuity payment, made on March 15, 2024, should be 47.47729% of the initial FMV of the contributed assets. This allows for a second-year annuity payment percentage to be 120% of the first-year annuity payment percentage and for both annuity payments to total the FMV which beats the hurdle rate ($2,089,000). Therefore, the March 15, 2024 payment is calculated to be $949,546.
   
• If you funded your GRAT with marketable securities, you would calculate the FMV of the GRAT on March 15, 2024, and transfer shares with an FMV of $949,546 to a new GRAT with an agreement date of March 15, 2024, which also has a 2-year annuity term. The hurdle rate would be the Section 7520 interest rate on March 15, 2024. Should you have chosen to fund your GRAT with, for example, real estate family business stock, you would engage an expert to perform a valuation as of March 15, 2024, and transfer an interest with an FMV of $949,546 from the initial GRAT to the new GRAT.
   
• Given that the first-year annuity payment percentage is 47.47729%, the second-year annuity payment should be 56.97271% of the initial FMV, which is 120% of the first-year annuity payment percentage and calculated to be $1,139,454. When you add both annuity payments together, they total $2,089,000, meeting the hurdle rate.
   
• Should the FMV of your initial GRAT be greater than $1,139,454 on March 15, 2025, this would make it a successful GRAT. You would then apply the same exercise that was performed at the end of year 1, calculating the FMV of the initial GRAT on March 15, 2025 and transferring shares with a FMV of $1,139,454 to another new GRAT with an agreement date of March 15, 2025. The shares remaining in the initial GRAT after the second-year annuity payment can now be transferred to the GRAT beneficiaries free of gift and estate tax. Again, do keep in mind, should you have chosen to fund your GRAT with harder-to-value assets, you would need to obtain yet another appraisal as of the end of the initial GRAT term.  Avoiding the expense of obtaining three valuations for your initial GRAT (and then annually thereafter for each of the new GRATS) makes for a compelling argument to consider funding your GRAT with marketable securities rather than illiquid assets.

[1]: Only a “zeroed-out” GRAT eliminates all possibility of a taxable gift. A Zeroed-out GRAT is one where the present value of the annuity of the grantor’s retained interest is equal to the full value of the property initially transferred to the GRAT. Essentially, the hurdle rate is baked into the annuity payments.

Many years ago, I was asked to finance a start-up company that wanted to create a cigar vending machine business for sports arenas.  I quickly passed.  Didn’t get it.  Couldn’t see why the world needed it. 

I’ve yet to see one at a ball game, so maybe I called that one right.  I wish I did every time.

Getting It Should Be Easy

When an entrepreneur says to me, “You get it,” it always strikes me as odd — as though the basic economic driver for their business — its why — is some secret that only a select few can grasp.  Really it should be as plain as day to anybody! 

If you’re considering a private investment, whether venture capital or lending money to a business, you should easily get it – to understand why its customers are (or will) buy its products.  If you can’t, you ought to move on to the next opportunity.  

Why the “Why” Matters

Why is a powerful question.  Much more so than what because it leads to much greater insight, to the essence of things.  It creates context and relevance for all the whats and then, for investors, guides further due diligence for a given potential investment.  

A business needs a compelling Why and to communicate it effectively, both internally and externally.

Among the most popular TED Talk presentations on YouTube is Simeon Sinek’s “How great leaders inspire action” where he highlights the power of communicating the underlying why within any enterprise to drive achievement.  He explains that sharing the vision with employees inspires them to do their best work.  Prospective investors … take note.

His message is so powerful because each of us instinctively wants to understand things, at least we did when we were very young.  By age 3 or 4, children naturally begin to ask why.  The challenge for investors is to apply this innate form of curiosity to deals.      

An investor presentation dominated by whats will leave you trying to piece together the disparate elements of a business plan.  This contrasts with one guided by whys which leads to a fundamental grasp of the business supporting the investment. 

Following Bell Cows

In farming, the “bell cow” is the one that naturally leads the herd, so a farmer puts a bell around its neck to know where the herd is.  With investments, there is a similar phenomenon ... the “lead investor.”

Often, like a herd of cattle, we follow another investor’s lead when deciding whether to participate in an investment.  If that investor has sector experience and a solid investing track record, this approach certainly has its merits and saves us a lot of effort.  Nevertheless, I’ve found that the best questions are generally the most basic, and someone who isn’t already familiar with a given industry is less inclined to make inaccurate assumptions.

However, based on my 30 years of venture experience, I’d argue that investors should still at least understand an investment’s whys or they’ll be relegating themselves to blind faith in their bell cow. 

Not All Whys Are the Same

There are many reasons for starting a business. 

Consider the power of the passionate why: where some very personal reasons underpin the creation of the company.

For example, putting a stop to injuries and deaths of children resulting from the hanging cords of window coverings was the impetus ten years ago for one of our North Carolina clients.  They now develop patented products which eliminate this risk, and their sales are growing rapidly.  Further, the U.S. Consumer Product Safety Commission recently issued an industry-wide ruling eliminating hanging cords.  An altruistic, meaningful why doesn’t always ensure financial success, but it’s a good place to start your analysis when probing for an entrepreneur’s conviction.

For-profit businesses, and the investment opportunities they generate, however, won’t make it unless they can consistently deliver products which satisfy customers. 

So, focus early on the why involving target customers – the business opportunity it represents, and underlying customer motivations.  Is it an urgent “need” – like a medical device which offers a diagnostic tool for early detection of a deadly disease – or a “want,” such as the latest fashion fad being promoted on TikTok?

Getting to the Why … Quickly

Pitches by company founders usually start with a review of their backgrounds and the size of the business opportunity.  Entrepreneurs naturally want to tell you their story in their own way.  You can ride along with their presentation, but you’ll probably waste time doing so and not sufficiently vet the company’s key business driver – sales.  I did for years. 

These days after pleasantries, I redirect presenters to start with their why, particularly their customer-related why.  If I’m still interested, we can move to their prepared material.  Then, even if they can’t convincingly connect the dots between their why and their whats (how to make sales), I’ve at least gotten to those whats that are critical to the investment’s success.  At that point, I’m in a position to make the decision whether to spend more time on it.

If this approach seems basic … it is.  But none of the whats matters if there isn’t a fundamentally sound why.  

You have unlimited investment choices.  If you’re going to put your money to work in a private transaction, you need to get the opportunity’s why efficiently and then drill deeper into those which are, fundamentally, best positioned to succeed.  

This approach still won’t guarantee you “smoke one” out of the park, but I believe it will greatly improve your batting average.

Originally published in Forbes.com, Jan 18, 2023

Bruce V. Roberts, CEO of Carofin, arranges direct private investments in growth companies by family offices and high-net-worth individuals.

Whether you’re a newly minted tech billionaire in Silicon Valley or the owner of a family business in Asia experiencing exponential growth, you’re likely to face challenges in coming to terms with financial success. First-generation wealth owners are often ill prepared for the changes that come with new levels of wealth and their corresponding responsibilities, including how they might spend and invest their newly earned fortunes.

Many business owners come to realize that their interests are best served when management of the family’s wealth is handled separately from the business. Management of family wealth is often eclipsed by the needs of the company, or improperly delegated to business executives who are not equipped to manage personal assets (a comical yet important lesson learned in the CBC Television series Schitt’s Creek). Many families establish a family office to address their unique wealth and investment needs. This article will discuss investment management through the lens of a family office, but the information can also be applied more generally to individuals or families who choose not to establish a formal structure.

As new wealth owners explore how to best manage their assets, they often face three key questions about effective investment planning: how best to invest to sustain future generations; how best to engage the next generation; and how best to ensure family unity endures. A good governance structure and the power of impact investing can help address these concerns.

At a recent European family office conference, a member of the audience asked me what would be the best investment for a family of wealth. I responded that if she meant a truly long-term investment with a 50- to 100-year horizon, I would rely on the advice of a wise old American friend of mine. The best investment, he said, would be farm real estate in a common-law jurisdiction with a good recording system, such as the U.S., Canada or Australia.

One year after that conference, I met with an adviser to three wealthy Beijing families. I asked him what his clients were buying as investments, and he replied that their attention was focused on finding good farmland or timberland in the Southeastern U.S. “We believe that is the best long-term investment,” he said.

Throughout the world, many families of substantial private wealth have owned farms or timber real estate for generations. Other wealthy families are now buying farms. In fact, the family farm can have more than purely financial benefits. It can help build and preserve family legacy (as identity) in a number of ways. But making the family farm serve its purposes is getting more complicated than ever for the modern global family.

A long time horizon

Well-selected and well-run farmland can be an excellent investment for the long term. A multi-generational family can look beyond the quarterly performance and even beyond the five-year, long-term perspective of corporate finance.

As a financial investment, though, farmland rarely provides substantial current income. For this reason, its owners should be without debt and should recognize that its value will come with capital appreciation. There will be little current economic income for living, and there can be years when earnings are minimal on account of climatic events or commodity prices. However, there have been many landed families over the generations, and those families have held great value in their land.

As many wealthy individuals have come to understand, the family farm is much more than a purely financial investment. If managed strategically, farm ownership can help a family build legacy and maintain harmony, two challenges every family faces.

A family farm can come to represent a family’s place geographically, historically and in a community. The farm itself can generate comfort and represent sentimental value for many generations, while also being the geographic marker of the family. Consider the medieval estate, with the noble family surrounded by serfs and tenants. It is geographically fixed, it has a history within its boundaries and it represents status and role in a community. The family members gathering at the farm are respecting history, rooted in a particular place and having a presence in the community.

Building family legacy

The family farm can be seen as a refuge from the grime and dangers of the city. It is a retreat in times of trouble. It is a place of wholesome living and minimal distractions. On the farm, family members and their children can spend summers and weekends together, being outdoors and close to nature.

A farm represents production of food, and much of a family’s identity is involved in food. The family grows up around a dining room table and dinner is often a family ritual. Holidays, reunions and other celebrations include an abundance of food and rich interaction that creates the fabric of a family. The family farm can highlight the family’s relationship to its world.

The farm is also a place to reinforce old-fashioned values reflecting the importance of family, concern for community and engagement in productive activity. A farm is still a place of hard work and strong relationships with neighbors and the community. The family farm is a place where a child can learn the life lessons that parents and grandparents hope to instill in the next generation.

The notion of stewardship, that we have responsibilities to future generations, is inherent in the family farm. Cicero observes in De Senectute that old farmers plant trees as well as annual crops. Although they may sow the seeds of the annual crops, they will never live to see the full growth of the trees. When asked why, the old farmer replies: “For the immortal gods, who have willed not only that I should receive these blessings from my ancestors, but also that I should hand them on to posterity.”

The well-run farm embodies legacy that can be passed on to future generations, whether planted in trees or managed so as to stay fertile and productive over many years. It can be a legacy to be preserved and enhanced.

The challenge for the modern global family

The capacity of the family farm to embody legacy and to sustain harmony is challenged for the modern global family. Climate change can threaten the long-term investment quality of a farm if areas once lush and fertile become arid. The transition from farm to dustbowl threatens many areas of the world, even in common-law countries with good recording systems. Economic pressures to produce crops can result in denigration of the land, so that the old farmer is not planting for future generations.

Even as climate and economic developments threaten the economics of farming, the modern global family has difficulty owning and using a family farm. The family itself may be based in Beijing or Singapore, where there are no “backyard” family farms with common law and recording stability and the family faces the many difficulties of managing remotely located property. The modern family is likely to be scattered around the world, so that there is no opportunity to gather on the farm. Multi-jurisdictional families have difficulty finding a place to gather for any purpose and instead build a kind of “virtual” place rather than geographic space. Multi-culturalism can make the family farm that breeds hogs anathema to the in-law who is an Orthodox Jew or a Muslim.

It may be difficult for the family farm to serve as a refuge for all family members when they are scattered throughout the globe. Equally challenging for the modern family are the plague of pollution and the consequences of poverty and political upheaval. These scourges can touch even the most remote farms. Parts of the rural U.S. have all the turmoil of cities as the rural population loses the advantages of wealth and education. The farm’s “healthy environment” may be inaccessible or gone for the modern family.

Technology and the farm

For the modern global family farm, agricultural technology can play an important role. Technology is being developed to allow sustainable farming to increase productivity without denigrating the environment. Indeed, one of the goals of new agricultural technology is feeding a global community without destroying the environment. Drought- and disease-resistant crops are being developed so that food itself can feed a hungry world. Agricultural-based fuels may ultimately replace fossil fuel, and timber may be harvested to ensure a replenishing inventory of mature trees in a forest.

It’s important for a family farm to utilize the technology not only to ensure sustainability and productivity, but also to ensure the farm itself can be a good long-term investment. Investing in the development of that technology, which can be implemented globally, can expand the family’s sense of place into a world community both geographically and historically. Consider how a family-owned company like Cargill can establish a family in the global -community.

Developing good technology can feed the world. Investing in agricultural technology that promotes sustainable farming can help eliminate hunger and improve the planet. This type of “impact” investing allows the family to make a difference in the world. A family’s legacy can truly be improved by applying modern technology to the farm and by investing in ways that improve farms everywhere.

Given the turmoil in the world today, it is time to redefine the family farm for the modern global family. If it is to be a physical place, it must be a model farm that operates with the latest available technology. If it is to be a vision, it must be as an investment in technology that helps feed the world and keep it clean. In fact, a wise family will realize that the farm is an opportunity to set the standard for sustainable and efficient farm management and encourage others to follow.

Charles Lowenhaupt is chairman and CEO of Lowenhaupt Global Advisors, a firm that helps families of substantial wealth build, preserve and control their assets (lowenhauptglobaladvisors.com). He is also managing member of Lowenhaupt Global Advisors’ affiliated firm, Lowenhaupt & Chasnoff LLC, established by Lowenhaupt’s grandfather in 1908.

Copyright 2013 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permssion from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.

A family in control of a successful, large and growing business will eventually find itself running not just a business but also a family enterprise. The vitality and longevity of a mature family enterprise depend on three equally important key value drivers: the family economic engine, including both business and financial assets; the family itself, its culture and members; and “leakages” that include both cash flow management and estate planning. To thrive for the long run, you must manage your family enterprise as a comprehensive, integrated whole.

Otherwise, over time, diffuse and fracturing ownership, estate taxes, poorly designed or executed investment strategies, and fraying and fragile personal ties will overwhelm the family’s economic engine and the family itself. Achieving the goal of a thriving, multi-generational family enterprise requires a deep understanding of each of the key value drivers and the interplay among them.

The graphic below highlights the key value drivers for successful family enterprise governance.

Flourishing family enterprises require a clear and shared family purpose, a strong economic engine and effective management of leakages. Sometimes these key value drivers work in harmony, but conflicts among them regularly arise and must be resolved.

Are your family’s long-term objectives defined, communicated to and absorbed by family members? Are your governance and operating structures stable? Does your family take a fully integrated approach to risk management? If your family is executing well in all three areas, you can make business decisions for the success of the business, invest more financial assets prudently for long-term appreciation, support family members to realize their individual potential and strengthen family ties. In well-managed families, success and stability in any one sphere influences and strengthens the other spheres and the whole system, creating a virtuous circle.

I’ve also seen families’ assets destroyed by poor understanding of the math of maintaining wealth, flip-flopping priorities, undisciplined investing and personal animosity. Problems rarely arise in isolation:

• A common family purpose is not identified, adequately communicated or cultivated. In this vacuum, family members may feel obligation or guilt, value autonomy or feel a strong sense of entitlement. They may have lost a sense of positive commitment to the family. Divisive and competing self-interest and short-termism may come to dominate family decision making.

• Family members with poorly managed financial assets become dependent on dividend cash flow to support their lifestyles, putting increasing pressure on the family business to distribute cash.

• Estate planning structures work at cross-purposes with optimal investment strategies, thus creating havoc in the business and the family at generational transitions.

Non-family predators often seek to divide and to undermine the economic engines of underperforming, unsuspecting or factionalized families. It is too late to try to shore up the family’s defenses when your prized asset is under threat.

For the virtuous circle to prevail, effective leadership and governance are necessary, within and among each of the three key value drivers. Governance structures must be aligned, values and rules of engagement must be shared and understood, and leaders must be credible and empowered.

Within each of these value drivers are levers of control that must be managed effectively.

Family purpose
The family’s leadership, operating within the governance structure, is responsible for shaping, communicating and advancing the family’s purpose. Family purpose is supported by three commitments:

• Maximize the human potential of each family member. When each individual is encouraged to flourish and be productive, your family benefits, regardless of the way in which each individual meets his or her potential.

• Adapt and evolve the family’s culture and values over time. A stagnant family culture and value set will likely become irrelevant and be ignored.

• Identify and invest in shared affinities. What brings family members together with purpose or fun? What builds a sense of shared identity and purpose?

In catalyzing connections and common identity beyond your family’s economic ties, a shared purpose provides the platform for stronger interpersonal relationships and more effective decision making. The strength and value of shared family purpose become particularly evident during times of transition: of leadership, of generational ownership, and during the complex transition from business-owning family to financial family.

Economic engine
Your lifestyle is fundamentally tied to the strength of your economic engine. In the wealthiest families, this link may seem tenuous—but even in these families, eventually reality bites.

The math is clear, though not widely understood. Your family’s economic engine—businesses and/or financial assets—must generate annual returns of at least 10% just to cover the combined weight of taxes, fees, inflation, (modest) distributions and the “law of compounding children”: the growth in the number of family members from one generation to the next. Over a generation or two, only exceptional businesses and investment portfolios generate returns at this level. The strength of your family’s overall economic engine depends on the robustness of each of the following: your business, your family members’ careers and the performance of your financial assets.

• Your family business. Businesses are typically the primary engine of wealth creation. Most family businesses start out undiversified, illiquid and subject to powerful operational, economic and competitive factors that can lead to wealth creation and, just as rapidly, wealth destruction. Mature family enterprises, in contrast, control businesses that generate stable excess cash flow—although they still entail considerable risk. Families in this situation face additional challenges. How do you maintain a family culture of entrepreneurship as the wealth grows? What should be your family’s continuing operational involvement in the business? How should your operational involvement affect your governance structure? How do you diversify if you don’t want to sell your business? How do the cash flow requirements of the business, financial assets and family members relate to each other?

Some families eventually choose to sell the core family business. For any number of reasons—perceived risk in the business, lack of family business leadership, animosity within the family, inadequate returns—a family may determine that the benefits of continuing to own the business are insufficient relative to the value achievable from selling. You want to maximize the probability that your family controls the disposition of your core asset, rather than having a decision forced upon you by externalities. For the optimal outcome, you want to be able to evaluate the decision to hold or sell within the context of your family enterprise as a whole. What would be your net-net result, after the sale causes you to realize what may be decades or generations of deferred capital gain on your company shares? What will you do with the cash? Where will you reinvest the proceeds not earmarked for spending? Are you prepared—organizationally, culturally and in terms of financial infrastructure—to be a financial family? The transition from a business-owning to a financial family is a radical and risky transformation of the family enterprise.

• Careers. Careers generate additional income and reduce your family’s overall economic risk profile because they diversify family members’ sources of cash flow. Careers carry a cultural benefit to your family, too. Over generations, wealthy families risk creating a culture in which family members are always valued customers but do not benefit from the discipline of having customers themselves. A culture of setting stretch goals, of prudent risk taking, of service to customers and community, and of having to make reasonable sacrifices in the pursuit of those goals is healthy. We see the potential for a virtuous circle: The less each family member depends on the family’s wealth for his or her lifestyle, the more risk you can collectively afford to take, and the more likely the family enterprise will flourish for generations to come.

• Financial assets. Excess cash flow generated by the business can be redirected back to the core business. It also can be used to diversify in either related or unrelated businesses or into financial assets. Alternatively, it can be distributed to family members to spend or invest. Seeking to improve liquidity and to diversify their wealth, many mature family enterprises redeploy cash flow from their businesses into financial assets. If too much distributed cash flow is spent by family shareholders rather than invested, the opportunity for this important diversification disappears.

Effective management of your financial assets is crucial to the functioning of your family enterprise, especially as they become substantial asset pools in their own right. Financial assets bring your family greater economic security and relieve distribution pressure on the core business. But poorly managed financial assets do not just intensify pressure on dividends; far more dangerously, they can bring unanticipated liabilities to bear on your whole economic engine (for example, when a cousin uses shares in the family business to collateralize a risky loan).

Some families distribute excess cash flow to each family member, leaving it up to individual family members to manage their capital as they see fit. Other families make a concerted effort to commingle financial assets, develop a common investment strategy and retain highly experienced investment professionals.

Considerable benefits come from managing financial assets with scale and focus, especially if your collective assets exceed $100 million or more. First and most important, you can attract better investment talent, specifically a chief investment officer (CIO), with a single large asset pool than with a series of much smaller, independently managed pools. A CIO is a professional investor—not a client service representative or product salesperson—responsible for delivering investment performance and integrating that effort with the strategy for the entire family enterprise. Second, your single, larger pool of capital will have access to more desirable investment opportunities, which often come with higher minimum investment requirements and lower management fees. Third, commingling assets allows your family to share the administration of estate planning and investment management, simplifying tasks and lowering administrative costs. Finally, with a commingled investment strategy, family members are mutually accountable. To make the strategy work, each family member must control his or her financial affairs within guidelines that are agreed upon through the family governance process. While to some this all may feel constraining, the structure and discipline of pooled investing can significantly increase your family’s economic security, including the long-term security of your core business.

Leakage management
Think of the economic engine as having leaks—dividend payments, expenses, taxes and inflation, to name a few. Leakages are an inevitable part of any family enterprise, and they are much more within the family’s control than the value of a business or an investment portfolio. Year over year, leakages profoundly affect your family’s wealth, but their importance to the long-term vitality of your family is often poorly understood. The larger and less well-managed your leakages are, the greater the risk to the family enterprise and the more likely it won’t stand the test of time.

You can divide family leakage management into two buckets. The first is cash flow management. How much is distributed to family members and spent each year? What are family operating expenses above and beyond those of the business? How much does your family pay in taxes annually? The second area is estate planning, including governance, control, succession planning and tax minimization. How much of your family wealth will be transferred to government coffers upon the death of family members? Are estate plans structured to help protect the family’s assets from unwanted outside interference?

Good leakage management can mean the difference between maintaining control of your family business and leaving the fate of your family enterprise to chance.

Building a virtuous circle
People wonder why family enterprises don’t last. The math describes the challenge clearly: It is very difficult to grow and spend your wealth simultaneously. A healthy economic engine is necessary, but also insufficient, if you want to maintain your family enterprise over time.

For long-term vitality, you must manage your entire family enterprise as an integrated whole. Mature, well-managed family enterprises are stable and strong with good governance, clear family purpose, diversified assets and controlled leakages. Operating in this context, you can make prudent long-term investment decisions for your core family business, determine the most productive level of family involvement in the business, and control its destiny. Your family’s financial assets, professionally managed to realize the benefits of scale and focus, are key contributors to your family’s continuing economic vitality. Family members feel strong positive connection to your family enterprise and are encouraged to thrive and contribute to an evolving and relevant family culture. When you build this virtuous circle, you are stewarding your good fortune and cultivating your family’s valuable business, human and financial resources. In doing so, you serve the family enterprise as a whole as well as each family member.

Stuart Lucas is chairman of Wealth Strategist Partners LLC, based in Chicago (www.wealthstrategistpartners.com). The firm acts as chief investment officer for its clients, investing their financial assets in the context of their family enterprise. He is the author of Wealth: Grow It, Protect It, Spend It and Share It (Wharton School Publishing, 2006), which provides useful general background and specifics about “the math” alluded to in this article. A new edition of Wealth is to be released in early 2013.

Copyright 2012 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permssion from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.

Back in the 1990s, a seller of a closely held business generally expected that investing the proceeds in public markets would provide enough income to support his family’s lifestyle and enough growth to keep up with inflation and to supply a nice legacy for younger generations. A seller’s major considerations were how much to reserve to invest in a new business and how to diversify low basis stock received in the sale without paying taxes.

Then came 2008 and the Great Recession. Business owners who sold their companies in 2008 had very different concerns than their counterparts of the ’90s. Global markets continue to be volatile today, with dramatic fluctuations this past August. Sellers whose transactions closed on favorable terms have been grateful, but since the proceeds are current or deferred cash, they worry about how to invest those assets safely.

Despite the uncertainties since the Great Recession, people are still selling businesses and receiving liquid assets in exchange. Those assets must be invested somewhere; hiding cash under the mattress is not safe, and storing gold is cumbersome. What do you need to consider if you are about to sell your business?

How will you structure the deal?

During the technology boom, stock was the currency of choice for both sellers and acquirers. Stock prices were soaring, and interest rates were high enough to make acquirers think hard about borrowing capital. Taxes were also high (28% capital gains rates), and tax-free stock-for-stock mergers were attractive to sellers. The downside for the seller was a concentrated position in stock of the acquiring company, often accompanied by restrictions on sales. In order to diversify without a high tax burden, the seller needed to institute complicated structures and hedges against price fluctuations.

The environment today is different. Cash and highly structured earn-outs are usually the currency of choice. Seemingly depressed stock prices are not attractive currency for acquirers, and cost of capital is low; interest rates are at historic lows and many corporations have a lot of cash on hand. Fortunately, capital gains rates are also low (15% federal rate), making cash a more attractive currency for sellers.

Cash deals offer immediate benefits, such as instant liquidity and known valuations. Cash deals also present questions. Occasionally such deals, particularly those involving private equity purchasers, require reinvestment by the seller into the new entity. Cash deals often involve deferred payouts that depend on continued performance by the purchased entity, and they usually involve tax liabilities that must be funded at least by April 15 of the year following the sale. Sellers should set aside enough cash for taxes in a safe and very liquid investment, even though those investments today pay almost no interest.

How will you replace your paycheck?

Low interest rates make it difficult to replace a paycheck with interest alone. The specter of future inflation also means that some part of the proceeds should be invested for growth.

If cash flow is a concern, think about investments in two tranches, one to fund necessary expenditures and one to fund discretionary spending. The tranche that funds necessary expenditures should be invested in “safe” liquid securities and, if possible, should produce constant yield. However, in some cases, it might be necessary to spend principal in this tranche, with the idea that the other tranche will grow enough to replenish the first fund. The tranche that funds discretionary spending should be invested in assets that are expected to grow over a full market cycle. Many people are comfortable with volatility in this tranche because lifestyle funding has been taken care of in the other tranche.

Many business sellers are anxious to build another business. If you want to reserve a portion of the proceeds to buy a new business that you will operate or oversee, timing is important. Ensure that the economic climate is favorable for the new venture and that you have the necessary energy so soon after selling your previous business. It’s also important to estimate how much you will need to fund the new venture.

What should you think about in formulating an investment strategy?

Being an investor is different from being a business owner. As an owner, you knew and understood the risks inside your business and learned to hedge them and use them to your advantage. Investing presents different risks and involves different management tools. Here are some points to consider:

• Take your time. You will be bombarded with investment opportunities. Remember that you don’t have to invest in everything; it’s better to miss a good opportunity than to invest in a bad one.

• Don’t commit to anything until you have developed a strategy for the future. In addition to writing down your investment goals and strategies (an investment policy statement), think about creating a strategic plan for three to five years that includes broader financial and lifestyle goals, timelines and measurements.

• Learn about investing. Serving on the investment committee of a well-run institutional endowment (such as a university, hospital or foundation) is one of the best ways to learn both the practical and theoretical aspects of investing. Reading is also important; David Swenson’s Pioneering Portfolio Management is a favorite, but there are many more.

• Manage your expectations. Most investment professionals will counsel you to diversify your portfolio as a way to manage risk. A diversified portfolio should produce returns over a full market cycle equal to inflation (in order to protect purchasing power) plus enough growth to replace reasonable spending. A diversified portfolio typically will not “beat the market,” or be interesting enough to make you the star of the cocktail party circuit. As an investor in public markets, you are subject to the whims of other investors whose interests are not necessarily aligned with yours. Accordingly, values will fluctuate, and you should be comfortable with volatility and the asset allocation that you have chosen.

b>• Manage risk. Risk means different things to different people. You must define risk for yourself and determine how comfortable you are with the level of risk you are taking. In today’s environment, the investments that have historically been considered “risk-free” may entail more risk than before; consider the current conversations about default risk in municipal bonds. Investments that were considered risky in the past may be less risky than other more conventional choices. For instance, stock in well-capitalized companies that pay dividends may be less risky today than some government bonds. You must still take risk in order to get returns, but taking risk does not guarantee returns. Therefore, it is important to understand where the risks lie, the magnitude of the risk, how the environment might affect the risk and what the upside is for taking that risk.

How much are you willing to delegate?

How much assistance do you want with managing investments? Unless you are an investment professional, you will probably want to delegate at some level. How do you choose the people you work with? Although integrity and aligned interests are key ingredients, successful relationships are generally based on shared values and mutually respected behaviors.

Think about who will handle the day-to-day items. When you owned an operating company, you had a staff that managed the affairs of the business. When the proceeds of the sale become your “business,” your staff may no longer be available to help, or they may not have the appropriate skills to manage the new issues.

Perhaps you plan to create your own family office, or maybe you want to be a part of a larger multi-family office structure. Alternatively, you might prefer to handle everything by yourself. There are benefits and problems associated with each structure.

Anne B. Shumadine, Esq., is chairman of Signature, a multi-family office and high-net-worth wealth management firm advising families, foundations and endowments. Signature is located in Norfolk, Va., and serves more than 150 clients from across the country (http://signatureus.com).

On the list of roles and responsibilities of the family office, none is more important than the preservation and proper investment of the family’s wealth. But what does this endeavor actually entail?

In general, the investing role within a family office encompasses the following:

• Development of an investment policy. A comprehensive, thoroughly researched document should be created. The policy should catalog the family’s investment constraints, objectives, strategies and implementation tactics. An effective policy follows from a deep understanding of the family’s risk tolerances and lifestyle requirements, as well as other structural factors.

• Implementation of the investment strategy. This involves (1) decision making related to the allocation of assets to various broad investment categories; and (2) selection and monitoring of individual investment managers and other vehicles (such as funds of funds, hedge funds, managed accounts and exchange-traded funds) to satisfy allocations within these categories.

• Monitoring and reporting of investment performance. Information from numerous investments with various levels of aggregation (e.g., family-wide or by entity) must be consolidated and presented. Proper reporting enables the family office to accurately assess and attrib-ute its risk-adjusted performance.

Although considerable time and effort are expended on investment manager selection (and rightly so, given its importance), results are often lackluster, if not downright frustrating. While our experience has shown the selection process to be equal parts art and science, it is complex enough to confound even the most skilled and experienced practitioners. Few family investment offices have the internal resources, networks and training to appropriately investigate the managers they hire.

What is a hedge fund?

Among investment options, hedge funds still receive considerable media attention and are prominent in most families’ investment strategies—and this focus is warranted, given the promise of exceptional returns at potentially lower risk. Yet the due diligence burden on family investment offices has never been higher, in light of well publicized recent scandals and outright frauds on top of the general requirement to get your money’s worth in a dynamic and sometimes arcane field of investing.

The term “hedge fund” was coined in 1949 by A.W. Jones, whose investing partnership was among the first to buy securities viewed as undervalued while also “hedging,” or short-selling, securities believed to be overvalued—in effect positioning the fund to make money in rising and falling markets. Over time, the concept has morphed into a fairly broad and eclectic universe of strategies well beyond this original mandate. Hedge funds today are organized as partnerships of qualified investors and have compensation schemes that include a management fee (e.g., 1% to 2%) and a performance incentive (typically 20% of profits). Some observers would say that hedge funds have become not a unique asset class, but a unique fee structure.

Navigating the many choices

One of the main challenges in seeking quality hedge fund managers centers on the realities of the industry’s business model: The barriers to running a hedge fund are quite low, and consequently there are many funds to choose from. The availability of prime brokerage services makes it easy for a new entity to open its doors. There are few skill-based or operational barriers for fledgling managers; the only real barrier is marketing the fund to raise start-up capital. And even in this area, the prime brokers are willing to offer some guidance in the preparation of marketing materials, facilitate mock due diligence interviews and introduce firms to potential investors. Consider that in an industry of about 7,000 managers, the top 100 made more than three-quarters of all returns for investors since they were founded.

Higher compensation and the pure intellectual sport attached to the hedge fund industry clearly have had the effect of attracting top talent. Alongside top talent, however, are a high number of candidates who may not have the appropriate background or staying power for a highly competitive world. Some newer managers entering the field, for example, have never shorted a stock. How can an earnest family office navigate the potential minefield in search of high-quality hedge fund managers?

Here are the most common pitfalls:

• “Brands”: Certain buyers feel more comfortable selecting larger, “brand-name” managers to fulfill their hedge fund mandates. Firm size, however, provides no assurance of delivering outsized returns. In reality, the opposite can be argued with considerable data to support it. Brand-name firms are likely to have strong distribution platforms focused on gathering assets. But as assets grow, excess returns typically shrink. In this scenario, a brand name could be considered a liability for those who seek excess returns.

• Size: In most hedge fund styles, increasing the size and age of a portfolio tends to produce a drag on excess returns. There are notable areas, such as distressed securities and certain arbitrage strategies, that seem to be less affected by these factors. By and large, however, size and age can become considerable liabilities. In some multibillion-dollar funds, the management fees alone represent several million dollars in compensation per front- and back-office employee.

Hedge fund managers as star athletes

Establishing the right objective is an important first step. We believe the focus should be on selecting managers who can maximize excess portfolio returns for the longest period possible. In some ways, this is analogous to evaluating private equity managers based on not only internal rate of return (which takes timing of cash flows into account), but also multiples returned on dollars invested (which takes quantity of profits into account).

Selecting hedge managers can be compared with drafting athletes into the professional ranks. Decisions on potential are typically made before the individual has fully matured. The period of compelling excess returns delivered by an investment manager is analogous to the length of an athlete’s career. Top athletes, like top investment managers, are able to sustain peak performance for extended periods. Henry Aaron hit 44 home runs in 1957, but he also clubbed 40 of them in 1973—a span of 17 years. By contrast, the average major-league career lasts only a handful of years.

Investors in hedge funds should follow a manager selection methodology that emphasizes structural and qualitative factors to maximize the probability of success.

Newer funds with experienced managers

One of the most important structural factors in determining future performance is the age of the fund at the time of investment. Given the risk of diminishing returns over time, investors should select funds as early in their life cycle as possible—even when the fund is still in the formulation phase. However, this does not mean inexperienced managers should be hired. Preference should be given to managers who have earned their pedigree—developed research methods, honed stock-picking skills and amassed track records—at larger, brand-name firms.

Many future stars have left larger firms because they ended up managing people, not analyzing securities. Managers at newly independent firms have a lot to prove, and this motivation is reflected in their level of effort. Hiring these “boutique” firms carries other benefits. For example, helping to put a firm in business (a “seed investment”) virtually ensures the daily attention of the top talent and the potential to secure more favorable investment terms (liquidity, transparency, risk controls and fees).

One temptation may be to select hedge fund managers based on the criteria used to evaluate traditional, long-only managers. This process tends to be highly quantitative with some augmentation from qualitative factors. We believe quantitative measures are important, but they have limits when evaluating hedge fund managers. It’s also advisable to consider simple questions: What is the right benchmark? Is it even mathematically appropriate to consider certain metrics (e.g., standard deviation, value at risk)? Conclusions based on peer group comparisons can be perilous when the degree of leverage or the long/short exposure varies from manager to manager.

The ‘three Ps’

We regard philosophy, process and people as paramount in evaluating hedge managers. A manager’s stated philosophy is helpful in forming an opinion as to whether that manager can achieve excess returns and how long those returns might last. Hedge managers should be able to demonstrate a sustainable competitive advantage in how they gather, consider or use information. This advantage may come from a dogged approach to investment research, a focus on an overlooked area of the markets or a unique position in the flow of information.

Process is crucial, especially as it relates to sell discipline and risk control. The best firms seem to be those that can clearly articulate their investment process and point to examples of this process in action within the portfolio. Historical returns have little predictive effect on future performance, but a robust and differentiated research process is repeatable (akin to manufacturing) and can be highly determinative. Understanding “how” returns are generated should therefore be a key focus.

People is the last P, but certainly not least. Here the crux of any investigation is threefold: (1) verifying a manager’s integrity through extensive reference and background checking; (2) assessing the cohesiveness of the manager’s team as defined by how long and how successfully they have worked together; and (3) determining whether the manager’s interests are in alignment with those of the outside investors. Has the manager placed a substantial portion of his or her net worth in the investment strategy?

A qualitative approach

Hedge funds have earned well-deserved attention from a wide variety of investors, including family offices. Now that they are under the glare of the spotlight, it is incumbent upon investors to fully understand which managers, if any, deserve consideration for their portfolio. In our opinion, the most appropriate approach is to emphasize a comprehensive, qualitative investigation of newly independent and smaller firms. This is in sharp contrast to a highly quantitative approach generally used to select traditional, long-only asset managers, and to the tendency of many investors to gravitate to larger brand names.

How does a family investment office turn this thesis into a reality? This type of hedge fund due diligence requires a major commitment to identifying and researching the managers with the same degree of rigor that they perform when analyzing securities for their portfolios. Needless to say, it is a full-time endeavor.

Gordon Stone is a portfolio manager and partner at Veritable, L.P, an independently owned, multi-family office and SEC registered investment adviser in Newtown Square, Pa. Founded in 1986, the firm has 178 relationships and approximately $9 billion under management (www.veritablelp.com).

The lessons to be learned from famous family feuds 

Family Wars, By Grant Gordon and Nigel Nicholson; Kogan Page, 290 pp., $37.50; www.koganpage.com

How could a committed family business owner possibly benefit from a recounting of the world's most sensational business family feuds-the scandalous lawsuits, firings, divorces, splitoffs, buyouts and other misfortunes that over the years have been reported by not only the business press but also, in many cases, the gossip columns? Why would a serious steward of, say, a $25 million family enterprise want to read, yet again, about the woes that have befallen the Redstones, the Pritzkers and other squabbling billionaires?

Family business stakeholders should revisit these scandals, Family Wars authors Grant Gordon and Nigel Nicholson argue, because they serve as extreme examples of what can go wrong in a family enterprise. Exploring the factors contributing to the epic conflicts-which in some cases had their genesis in events that occurred a generation or more earlier-will inspire readers to institute processes for governance and communication that can prevent a feud from festering.Gordon is director general of the Institute for Family Business in London, U.K., and a fifth-generation member and non-executive director of William Grant & Sons, a Scottish family business. Nicholson is a professor of organizational behavior at London Business School.

"[W]e believe strongly in the positive magic of family firms, but recognize that this comes at a price of increased vulnerability," they write. "Family firms have to be smarter and more alert than other kinds of firm to regulate the flow of positive emotional energy and avoid the dark side.

"Two dozen "family wars" are discussed in the book. They include clashes that took place generations ago (Henry vs. Edsel Ford, IBM's Tom Watson Sr. vs. Tom Jr.) as well as those recently in the news (involving, for example, the Ambanis of India's Reliance empire and the Hoiles family of Freedom Communications). Along with many familiar names (the Binghams of the Louisville Times), there are some that may not be as recognizable (the Lur-Saluces family of France, producers of Chateau d'Yquem wine). Each tale of family conflict is accompanied by a family tree to help readers keep track of the key players.The feuds that Gordon and Nicholson chronicle are grouped into categories: "brothers at arms" (conflict among siblings), "fighting for the crown" (parents and children tangling over succession), "the house that hubris built" (leaders with dangerously inflated egos), "heads in the sand-the insularity trap" (a family too out of touch with reality to make sensible business decisions), "schism-the house divided" (family splits) and "uncivil war" (described as "tribes with diverse and divergent interests").

"Many of the family wars we shall review," the authors write, "could have been prevented by a little self-control, a little external discipline and some counsel from outsiders."The protagonists' great wealth and its attendant power give them the means to wage their wars on a grand scale. "Rather than being a support and a buffer enabling parents and children to make optimal choices, which it would be in an ideal world," the authors state, "in the real world it seems often just to raise the stakes."

Of course, these family stories are page-turners, even though the gory details printed on the pages might make us wince. But the authors' analysis of what went wrong in these cases is just as riveting as the dirt they dish on the families. For example, in their discussion of McCain Foods, a giant Canadian frozen-food firm that was plagued by sibling rivalry, Gordon and Nicholson note that the McCain brothers had hired family business adviser and scholar John Ward to help them work through their differences. Ward suggested that the McCains institute a board with a majority of outside directors, but "trust between the brothers was at such a low ebb that they were unable to agree on the board structure, let alone on candidates," they write. "When the patient is in no mood to take the medicine, the physician's wisdom is for naught." (Wallace McCain, estranged from his brother Harrison, ultimately exited the business.)In their concluding chapter, the authors provide lists of warning signs, risk factors and remedies. Unlike the tabloids' smirking accounts of the fall of the mighty, Gordon and Nicholson's text abounds with praise for family enterprise and explains how family conflict can be a force for positive change. The generous helpings of sound advice served with the spicy scandals will alleviate any misgivings you might have about picking up a book entitled Family Wars.

Free advice on ‘greening' your business

The National Resources Defense Council (NRDC), a non-profit organization of scientists, lawyers and environmental specialists, is offering a free online resource to help companies establish environmental policies and carry them out.

The resource, called the "Greening Advisor," offers a sample environmental policy statement and a range of steps companies can take to promote energy efficiency, conserve water, reduce waste, minimize paper use-and provide cost savings in the process. The NRDC created custom "Green-ing Advisors" for each Major League Baseball team and has worked with a range of corporations and cultural institutions, including Warner Music Group and the Oscar and Grammy awards. It is now offering online information for companies of all sizes at no cost.The "Greening Advisor" is available at www.nrdc.org/greeningadvisor. (Click on the "Get Advice" column at the right.)

A global investment vehicle with a patronage element

Music lovers seeking alternative investment opportunities might want to consider a hedge fund investing in 17th- and 18th-century Italian violins. The Fine Violins Fund, founded by London-based violin restorer and dealer Florian Leonhard, has attracted investments from four family offices that as of early May represented 75% of the investor group, according to François Mann Quirici, a former Lazard investment banker who is the fund's director of business development. The fund had raised $30 million as of May 1 and planned to begin acquiring the instruments in the summer. A rare violin can command a price as high as several million dollars.

The Viscount St. Davids, a former deputy speaker of the House of Lords who holds a certificate in advanced music studies from King's College London, is the fund's chairman; advisory board members include cellist Julian Lloyd Webber and Sir Curtis Price, principal of the Royal Academy of Music in London. The fund will be 90% invested in fine violins and 10% in fine cellos. "These string instruments represent a unique investment," Mann Quirici writes in an e-mail to Family Business, "because there is a finite, non-renewable supply of these instruments and there is ever increasing demand," from musicians as well as collectors and museums.The fund plans to lend its violins to promising musicians rather than remove them from the marketplace, according to fund literature. Artists sponsored by the fund will be asked to perform in private concerts for each investor and his or her guests. "It is the investment and patronage rolled into one which attracts families to this investment," Mann Quirici's e-mail says. The fund will target promising young violinists; their use of the violins will enhance the value of the instruments, he asserts. "We have relationships with a number of violin competitions."Less than 1% of the fund will go toward insurance; premiums are low because there is little risk of theft in this specialized market and there tend to be few accidents, according to Mann Quirici. For information, contact Mann Quirici at francois@nexusassociates.co.uk.

H&R Block's former CEO explains how and why he reinvented his life

In 1995, Thomas M. Bloch, the second-generation CEO of H&R Block, walked away from his executive post to become a seventh-grade math teacher at an urban school in Kansas City, Mo. After less than three years of working in the trenches (and donating his salary back to the school that employed him), Bloch teamed up with his mother's first cousin Barnett Helzberg Jr., who had sold his Helzberg Diamonds chain to Warren Buffett, to establish an inner-city charter school.In Stand for the Best: What I Learned After Leaving My Job as CEO of H&R Block to Become a Teacher and Founder of an Inner City Charter School (Jossey-Bass, 223 pp., $24.95), Bloch, now 54, explains why he made the dramatic career shift and the psychic rewards that resulted-even as he confronted pupils who blurted out, "This is boring" or fought with historical preservationists who objected to plans for a new school building. Why would he give up a nearly $1 million-a-year position at the firm his father and uncle had founded (the family had changed the spelling of the company name so it wouldn't be mispronounced as "blotch") to police a classroom, contend with apathetic parents and, ultimately, endure the administrative headaches involved in building a school from scratch? As the CEO of the publicly traded, family-controlled firm, "I couldn't shake the feeling that something-something big and fundamental-was missing," Bloch writes. "What was missing was a life outside H&R Block."In the first chapter, Bloch tells his family business story. (Full disclosure: Bloch is related by marriage to Caro Rock, the publisher of Family Business.)

"Dad went out of his way to avoid -pre-s-suring me to succeed him," Bloch recalls. "Nevertheless, even before I was thirteen, when he assigned me to sweep tax office floors, H&R Block somehow seemed bound up with my self-image and my expectations of the future."The CEO's job "certainly had its satisfactions," Bloch writes. "Probably the biggest one was the feeling I got when I would make an executive decision and then feel the company respond beneath me, changing course like some great ocean liner. And it was especially satisfying when changing course proved to be a good decision. But I simply couldn't leave my office problems at the office door."

Bloch's announcement of his decision was met with skepticism. A friend suggested, "Go travel and enjoy life. Teaching in the inner city will only bring aggravation and disappointment." And his father warned, "If you leave, you realize that you probably never will have an opportunity to come back."But years later, at a 2004 mayoral prayer breakfast, Henry Bloch lauded his son's career change in a speech that's reprinted in full as an appendix to the book (and is the source of the title): "I believe Tom made an ethical decision," Henry Bloch said. "He chose to be the best person he could imagine himself being.... Let us stand in the places we are most afraid we will fail. Let us stand for the best, no matter what the cost...."In the classroom, Bloch's pupils persisted in asking him the kinds of questions that family business owners may find familiar: "Are you rich?" "Do you own H&R Block?" "How many cars do you have, Mr. Bloch?""It was tough enough to discuss my personal wealth with my own wife for the first time," Bloch writes. "Besides, their world and mine were so far apart.... I grew up in an environment where one didn't talk about personal wealth, let alone flaunt it." He ultimately decided to use such questions as a teaching tool, leading "a series of conversations ... about happiness and the material world."Bloch's engaging descriptions of the teaching profession's challenges -cheating, disrespect, unruliness, parental belligerence-draw the reader in. He also writes compellingly of the joys of "what I consider my second semester in life." A ceramic apple inscribed with the words "Greatest Teacher," he recalls, "meant more to me than any year-end bonus I had received at H&R Block."As Bloch gained teaching experience, he and his wife, Mary, developed an interest in philanthropic initiatives to aid inner-city youth. In 1999, they established the Youth Service Alliance of Greater Kansas City, which fosters community service through school-based recognition and support programs. Bloch's discussion of this effort and of the establishment of the charter school, called University Academy, gives readers a feel for the extensive preparation and research that must take place to bring a philanthropist's vision to fruition.As a reader with a special interest in family enterprise, I would have liked to know more about Bloch's relationship to H&R Block after he left the company. (He notes in the epilogue that his son Jason now works there.) Were there days when he wished he were back at the CEO's desk-and, if so, how did he conquer the feelings of regret? To what degree did he keep up with the company's activities, and did he ever feel the urge to meddle? That being said, anyone concerned about educational opportunities for inner-city kids can learn a great deal by reading Stand for the Best. "I had wanted a challenge," Bloch writes. "Well, I got one, and it was at least as taxing (pardon the pun) as running H&R Block." From Our Articles Library1990:

Bloch takes the helm as H&R Block president

“Tom Bloch never considered doing anything but working for his father’s company,” stated an article in Family Business in 1990, shortly after Bloch had assumed the role of president at H&R Bloch.

“It was almost a nondecision,” Bloch told Family Business (“Chip off the old Bloch,” by Stephan Wilkinson, FB, March 1990). “I remember growing up hearing my dad talk about his day, at the dinner table. During the summers, I used to come in with him and do small jobs. Sitting on the sidelines watching this company evolve and succeed, wanting to be part of a wonderful success story. I think I was drawn to it because it was so family oriented. When I graduated from college, I didn’t seriously consider going to business school, I was ready.”

To read the whole article, see our Articles Library at www.familybusinessmagazine.com.

Planning for life in retirement

Far too many business owners put off succession planning until it’s too late because they view retirement as tantamount to a loss of identity and lack of meaningful activity. Business consultants advise executives to develop a plan for life after work that addresses this key non-financial issue—finding a fulfilling way to spend their time—in addition to the plans they need for ensuring their personal financial security and for transitioning leadership of their business. CEOs who are excited about the prospect of moving on, advisers note, are more likely to hand over the reins at a time that makes sense for the business.

Under the name Next Dance, a team of practitioners offers a set of tools designed to help people prepare for the non-financial aspects of retirement. The tools were developed by Aphelion LLC, a partnership of psychotherapists and specialists in organization and business development, business strategy and executive training.

The Next Dance Retirement Exploration Survey helps participants to assess 15 dimensions of life that have been found to be important in planning for life in retirement: self-awareness, work identity, life stage expectations, attitude toward aging, physical well-being, financial security, residence issues, relationship with spouse/partner, relationship with others, commitment to society, spiritual connectedness, emotional well-being, coping ability, adaptability and responsibility for self. Participants determine their level of agreement with statements such as “I view change as a challenge versus a problem,” “I am comfortable with my accomplishments in life” and “My moving would cause little disruption for others I care about.” Survey participants receive a personalized analysis; the scores help identify an individual’s strengths, current limitations and concerns. The Next Dance Review covers a participant’s current state as well as what should happen in the future to ensure a fruitful retirement.

Another tool, the “Learning New Steps Workbook,” offers advice on achieving retirement satisfaction. Next Dance also can match individuals with retirement coaches.

For more information on Next Dance tools, see www.mynextdance.com.

A new opportunity on Wall Street

Baby Boomers are inheriting trillions. That's good news for family firms hungry for capital. 

When your family business needs capital, according to conventional wisdom, you can't eat your cake and have it too. You

1. operate on a limited budget; or
2. go into debt; or
3. take on unwanted partners; or
4. sell your company's soul to Wall Street, whose heartless bean counters care only about your latest quarterly results.

But suppose Wall Street wasn't such a brutal place after all? Suppose it was run not by folks like Gordon Gekko but by erstwhile hippies and tree huggers who care more about saving the world and rewarding good corporate citizenship than about maximizing their return on equity?

No, this is not a dream. It could happen. In fact, it's happening already. Those hippies from the '60s have now reached their 60s, and they've inherited trillions from their parents, some of which they're already passing on to their kids. Over the next three decades, Federal Reserve senior economist Robert Avery estimates, the Baby Boom generation will bequeath some $35 trillion in assets—the biggest potential intergenerational wealth transfer in the world's history. But when it comes to investing those assets, many of these new inheritors still cling to their old warm-and-fuzzy values. In the process, they're changing the whole character of Wall Street in ways that could benefit warm-and-fuzzy family companies.

Welcome to a brave new phenomenon called “socially responsive investing,&148; now the investment industry's fastest-growing sector. SRI, as it's called, was once the province of dowdy church endowments or peace-and-love activists in isolated college towns, but today it caters to a potential audience of 50 million “New Age” Americans (plus another 80 million to 90 million in Europe) who've emerged as a major market force in the past generation.

As defined by sociologist Paul G. Ray, these “cultural creatives” are folks who “care deeply about ecology and saving the planet, about relationships, peace, social justice, and about self-actualization, spirituality and self-expression.” And they've put their money where their hearts are—specifically, more than $2 trillion in SRI portfolios, or one of every nine investment dollars currently under professional management in the U.S.

“These SRI investors are people who read a lot, listen to National Public Radio and shop at Whole Foods,” says Stephen Schueth, past president of the Social Investment Forum and also president of First Affirmative Financial Network, a nationwide network of some 100 financial advisers whose clients want SRI. “They fueled the green movement, alternative health care and organic foods, and now they're doing the same for SRI.”

This burgeoning market has channeled about $151 billion into more than 200 SRI mutual funds, each with its own social agenda (the Sierra Club Stock Fund, for example, avoids companies with poor environmental records) and many with sophisticated research departments devoted to evaluating every imaginable corporate sin, from growing tobacco and fomenting gambling to overpaying executives and underpaying workers. The SRI movement has also spawned a mushrooming subculture of “shareholder advocates” (like the Millennium Fund) that seek, with increasing success, to use proxy resolutions to reform corporate behavior from within.

Although some SRI boosters trace the movement's roots to the Bible and the Koran, its modern seeds were planted by the political protesters who took to America's streets in the 1960s and '70s. Their successes in mobilizing for civil rights, peace in Vietnam and women's liberation eventually emboldened them to expand their focus from the halls of government to corporate executive suites. This newfound interest in the private sector occurred at just the time that some of these Boomers were beginning to inherit sizable stock portfolios from their parents.

Meanwhile, the advent of computers made it feasible for the first time to attempt to track and quantify the social behavior of hundreds of publicly traded companies. And as women—the more nurturing and thus more socially conscious gender—entered the workforce in large numbers, assets invested in SRI grew dramatically. (Women account for 60% of SRI fund holders, according to the Social Investment Forum.)

But SRI strategies aren't limited to the save-the-whales-and-recycle-your-empties crowd. The field runs the gamut from politically liberal investors, eager to reward companies that support family planning and gay/lesbian rights, to investors on the religious right who are equally determined to punish such companies. Either way, it's an industry that appears to be attracting many of America's best and brightest young minds with its astonishing message: Idealism can be just as lucrative as greed.

“Were it not for SRI, I wouldn't be in financial services, because it's too boring,” says Steve Schueth, who at age 51 has spent 16 years in SRI.

Against seemingly insurmountable obstacles—like the higher cost of all that social research, plus the smaller universe of stocks to choose from—today's alternative world of SRI stock indexes, research programs, websites and specialized services often outperforms the market as a whole. Which makes sense when you think about it: SRI screens against polluters and labor exploiters often serve as a de facto early-warning system against wasteful and shortsighted managements.

Even corporate executives, who once regarded the SRI crowd as a pain in the neck, have grudgingly come to perceive SRI as a valuable ally against all those myopic money managers preoccupied with quarterly earnings results.

Who ever thought we'd see the day when the forces of capitalism would be mobilized to make the world gentler and corporations friendlier?

A lesson from Terrell Owens

If the problem is Freudian, who ya gonna call?

The wide receiver Terrell Owens, late of the Philadelphia Eagles, was (is?) a spectacular individual performer playing in a team game: professional football. When he joined the Eagles in 2004, Owens signed a seven-year contract for $49 million. After one sensational season he tried to renegotiate. When the Eagles insisted on holding Owens to his original contract, he rebelled last fall by skipping the first week of pre-season training camp, refusing to speak to teammates and coaches at practice sessions and games, and verbally attacking his coach and teammates in media interviews.

In an age when professional athletes switch teams every few years, the Philadelphia Eagles aren't really a family. But family companies often encounter a very similar scenario: the prodigal son (or daughter) who's a star performer but who harbors Freudian resentments against his siblings or parents. No one can work with him, but you can't fire him without wrecking your family. What to do?

Or consider a problem that arose recently in a private Philadelphia lunch club to which I belong. A longtime devoted member, now in her 70s, began displaying signs of dementia. At lunch she would drink too much and talk too loudly. When guest speakers addressed the club, she would interrupt them with pointless questions and then repeat the questions. As a result, lunch at the club—the club's primary function—became a less pleasant experience, and members and guest speakers alike began avoiding the place. Like a drop of ink in an otherwise pure glass of water, a single rogue member might ruin the club.

Again, family companies often face a similar challenge: How do you handle a beloved old relative or employee who's been around seemingly forever and who's now losing it to such an extent that he's more of a liability than an asset?

There's no easy solution, but both of the institutions above, in my opinion, could have handled their situations better than they did.

• The Eagles, concluding that no team can function with a fifth-columnist in its midst, suspended Owens without pay for the maximum permissible period (four games) and then deactivated him altogether while continuing to pay his extravagant salary. For whatever reason—perhaps because of Owens's disruptiveness, perhaps because of his absence, perhaps because of other players' injuries—the Eagles suffered through their worst won-lost record in a decade.

• My club's board designated a “minder” to sit with the errant member at lunch and try to limit her wine intake. That didn't work. Then they gave her a session or two with a psychiatrist who belonged to the club. That didn't work either. Then, with much reluctance, the board placed the poor woman on probation for three months in the hope that this sanction would shape her up. It didn't, of course, because she was no longer capable of functioning rationally. So when she returned from her probation and resumed her old dotty ways, she was expelled.

These days, lunches at the club are indeed more pleasant. But a cloud hangs over the place, and several members have resigned to protest the harsh handling of a loyal member who was no longer responsible for her actions.

What would I have done? I'm no psychologist—which is precisely my point. The science of psychology is barely a century old, which means we humans have just begun to unlock the secrets of the human psyche. Nevertheless, good organizations have learned to use business psychologists to deal with institutional challenges. For family businesses, that can mean quarrels between parents and children or between siblings and cousins. Or it can mean parents who are afraid to sell their company for fear that their kids won't be able to survive elsewhere. More than a thousand business psychologists practice in the U.S., by most estimates. (See “This is no job for an ordinary mortal,” by Alan Horowitz, FB, Winter 2003.)

Maybe it's too much to expect a not-for-profit social club with a voluntary board to keep a psychologist on retainer. But it astonishes me that most professional sports teams, with their centomillion-dollar payrolls, haven't thought to spend six figures or so for a full-time team psychologist. Some NFL teams, like the Arizona Cardinals, use a team counselor to detect potential leaders and potential troublemakers. And in 2001 several NFL teams brought in sports psychologists to address players after the traumatic events of 9/11. But most teams see the use of sports psychologists as the prerogative of individual players—as reflected in Baltimore Ravens coach Brian Billick's suggestion last fall that his flaky quarterback, Kyle Boller, “may need to see a sports psychologist.”

On teams as in families, lawyers and arbitrators should be the last resort, not the first one. I can't help thinking that a psychologist could have found a way to make Terrell Owens click with the Eagles. Well, do the Eagles have a team psychologist? “That's information we would not disclose,” a team spokesman replies.

Next question: Since when is use of a psychologist something to be ashamed of?

Contrarian follow-up

Catching up on a couple of items from my previous columns:

1. The “New Nepotism” at Dow Jones. The Wall Street Journal's parent company used to prohibit spouses from working there simultaneously. That has changed with a vengeance, I observed in Summer 2003: Several married couples were sprinkled throughout the company, most notably CEO Peter Kann and his wife, Karen Eliot House, who was appointed the Journal's publisher in 2002. This situation raised an interesting question: If Kann were to be fired, would House quit out of loyalty to her husband, or would she stay out of loyalty to the company?

Update: Under pressure due to Dow Jones's sluggish stock performance, Kann announced his retirement (at age 63) as CEO this past January. His wife was one of three finalists to succeed him. But Kann bent over backward to avoid lobbying for her, awkwardly describing House as “a longtime colleague” and “a very good publisher of the Journal,” who “also happens to be my wife.” When House was passed over for the CEO job, she too announced her retirement. Wall Street seemed relieved: That day, Dow Jones's stock rose by 10%.

2. Secretary as wife as boss at Bertelsmann. During the American Revolution, John Adams explained to his wife, Abigail: “I must study war and politics that my sons may have liberty to study mathematics and philosophy, geography, natural history, naval architecture, navigation, commerce and agriculture, in order to give their children a right to study painting, poetry, music, architecture, statuary, tapestry and porcelain.” In Summer 2004 I caustically suggested that Bertelsmann AG founder Carl Bertelsmann might have reasoned this way: “I must study business, Protestant morality and social betterment so my great-grandson can produce illegitimate children with his secretary and subsequently marry her and turn control of the family company over to her.”

Update: The founder's great-grandson, Reinhard Mohn, died in July 2004 and passed control of Europe's largest media company to his wife, Liz, now 65, who was previously his secretary and lover and mother of his three illegitimate children before he divorced his first wife to marry her. Bertelsmann is private and the Mohn family owns 75% of the vote, but Liz Mohn is now battling to prevent Belgian investor Albert Frère from selling the other 25% to the public, lest the company be exposed to public scrutiny.

“Liz Mohn is a street fighter,” one Bertelsmann insider told the Financial Times. “Her origins are humble…. She doesn't want outsiders peering in because she fears for her children's careers.”

For almost a decade, the federal government has been offering tax credits for investments in affordable rental housing for working Americans of modest means. To some, the little-publicized program may seem like just another do-gooding government welfare scheme, but many companies have recognized that it is also a good deal for them. Warren Buffett alone has reportedly invested close to $100 million in it through Berkshire Hathaway's World Book subsidiary.

The chief attraction of the program is that it allows companies (as well as individuals) a dollar tax credit for every dollar invested in housing that is sorely needed around the country. That's not a deduction against income — it's a straight dollar-for-dollar reduction off their tax bill. The investors become limited partners in the ventures. Depending on the project, they get significantly more credits than the dollars they put up — because they pay a large amount up front. They can also write off any losses from them against passive income over a 15-year period. Altogether, if the apartment complexes are sold or refinanced at the end of the 15-year period, the partners stand a good chance of recouping their investment plus a double-digit return.

The Federal Housing Tax Credit Program traces its origins to the landmark Tax Reform Act of 1986. In that legislation, Congress did away with virtually every other tax shelter but included the tax credits in order to provide incentives for the private sector to support new construction and rehabilitation of rental housing. The program has received bipartisan support in Congress ever since.

The properties financed under the program should not be confused with public housing sponsored by the Department of Housing and Urban Development. The tax credit program is administered by the U.S. Treasury Department and finances private housing through partnerships put together by over a dozen syndicators across the country.

One leading syndicator, Boston Capital, requires a minimum investment of $5,000 and channels funds mostly to for-profit developers for construction and rehabilitation of high-quality, garden-style apartments in suburban and rural locations. Another, the Chicago-based National Equity Fund, requires a minimum investment of $500,000 million and raises capital through private offerings for housing in disadvantaged urban neighborhoods. This housing is operated by nonprofit groups such as church organizations, which expect to buy the properties at the end of the 15-year tax credit period.

Each year Congress budgets a new batch of credits, which are then allocated to agencies in each state that oversee the private developers who build the housing. The number of credits that companies can purchase in each state thus depends upon the total available in the state. The credits are taken over a 10-year period, while depreciation and other losses can be written off over a period of 15 years.

Most of the projects are for profit, financed in part through equity from the tax credit funds and in part by mortgage loans. Boston Capital has already funneled more than $1.5 billion into construction of over 70,000 apartment units in 48 states. According to Richard DeAgazio, president, companies in every major industry have invested in the credits, among them General Electric, United Airlines, BankAmerica, and H&R Block. The National Equity Fund has channeled tax credit investments to a total of 700 projects, from 117 corporate investors such as World Book, Hallmark Cards, the Weyerhaeuser Co., and Levi Strauss and Co. Large corporate investors usually prefer to distribute their credits among several ventures rather than taking a major stake in any one. Unlike investors in other syndicates, partners in the National Equity Fund ventures do not profit from eventual sale of the housing that they help finance. Their benefit comes strictly from the tax credits.

Although individuals investing in the program are limited to an annual credit of $9,900 for the life of the tax credit period, widely held C corporations can purchase virtually any amount of available credits. Investors can use the credits to reduce their federal income tax liabilities from all income sources, subject only to the limitations on general business credits and the alternative minimum tax (AMT). Larger public companies usually prefer to distribute investments among several projects to avoid a major interest in any one.

The tax credit rules are complicated, and there are pitfalls:

• If an apartment complex is mismanaged and ceases to qualify as low-income housing, all or a portion of tax credits may be subject to "recapture" — that is, those credits again become tax liabilities for the investor.

   

• The credits are worthwhile for companies only if their profits are growing steadily. If profits turn down, a company may be stuck holding credits it has purchased but cannot use until some future time (which is what happened to some banks and savings and loans that bought them up in the 1980s).

   

• Because the apartment complexes usually have some mortgage indebtedness, they may be subject to foreclosure by lenders if mortgage payments are not met. In the event of foreclosure, the investors may lose all or a portion of the tax credits they have already taken, along with future credits.

   

• Corporations cannot use the tax credits against portfolio income such as dividends, interest, and capital gains.

   

• Though the limited partnership interests are transferable, sales are restricted and there is no assurance that they will find a market.

Firms such as Boston Capital that handle tax credit investments are required to disclose the history of any "recaptures" in public offerings for projects. Mark Brenner, a low-income housing tax credit specialist in the Baltimore office of Grant Thornton Inc., advises companies to pay close attention to this risk before investing in the credits.

Large public companies find accounting benefits in the tax credit program because it strengthens bottom-line results that are so important to keeping up their stock prices. Clearly, however, one of the main reasons many of them invest is that they want to be good corporate citizens. Hallmark Cards, for example, invests in rebuilding neighborhoods in its hometown of Kansas City. Almost all of the new construction of affordable housing in the past several years has been financed by the tax credit program, according to the National Council of State Housing Agencies.