“Shirt-sleeves to shirt-sleeves in three generations.” This well-known proverb claims that a family will not preserve its wealth for more than three generations. Of course, few families in business believe it will happen to them. Yet more often than not, families in business fail to preserve wealth over a long period of time.
As I have traveled the world at the invitation of families seeking help with wealth preservation, I have discovered the same proverb in each culture. I also have discovered the same reason family wealth tends to dissipate over time: Many families define their wealth financially, failing to realize that their greatest assets are their individual members. The real wealth of a family is its human and intellectual capital. If this is successfully reenergized in each successive generation, the family can not only maintain its financial prosperity but see it grow.
I had the good fortune to practice law with my father for 18 years. In that time he taught me that family businesses rarely fail due to their financial practices. He taught me that they most often fail because of poor long-term planning for the family’s human capital. If a family thinks it is in business to enhance the lives of its family members, it taps the most powerful form of preservation-thinking it can practice. Without preserving its human and intellectual capital, a family cannot preserve its financial capital.
This is the philosophy that will lead to long-term financial stability. Achieving it, however, requires work. It requires the creation and maintenance of a system of joint decision-making, which will result in the making of more positive decisions than negative ones. It requires practices that help a family define its mission, measure its success, learn to invest together, enhance its members’ financial skills, and finally, make the best use of the skills of their closest advisers.
It is the older generation’s responsibility to teach these practices to the younger generation. Two tools are particularly helpful in this cause: an investor allocation program and a family bank. Together, these can form a core strategy to turn young family members into wealth creators.
Investor allocation
Most family business leaders adhere to one of two inheritance strategies: give the next generation a great deal of money, or deprive them of it. However, neither prompts young family members to become wealth creators. A new generation of wealth creators can only be born through the active enhancement by older-generation family members of the individual pursuits of happiness chosen by each younger family member.
Families who are successful investors have elaborate asset-investment strategies. They often include equities, bonds, real estate, collectibles, venture capital, oil and gas, and alternative investments such as so-called “hedge” funds. All too often, however, the family members making these investments are not chosen on the basis of how far they are removed from estate or gift taxation, but rather by “who has cash” when the investment opportunity arises.
Unfortunately for long-term tax avoidance, it is often the oldest family member who is wealthiest and “has the cash,” so it is she or he who buys the asset. The result, over time, is that the elder family members hold many of the fastest growing assets on the family financial balance sheet. What’s more, they are often encouraged by their investment advisers to grow their portfolios to assure more funds for later generations. At the same time, the elder members are often the most risk–averse and would emotionally prefer to hold assets they can count on to provide steady income.
These arrangements bring a huge smile to the face of the Internal Revenue Service. The IRS knows that if it waits patiently, the estate tax it will collect will actually be the largest proportion of the growth being achieved. Assuming grandmother’s estate exceeds $4 million, which puts her estate in the highest estate tax bracket of 55 percent, the IRS will get 55 cents of each $1 of the growth.
A program of “investor allocation” can reduce the size of the IRS’s share year after year. How do we do it? By reinvesting each new $1 of family wealth in the following way: Each time the family’s adviser suggests a new investment, the family member or family office professional charged with allocating this investment opportunity determines its projected long-term growth rate. The “investor allocator” then chooses the family member or members to actually make the investment based on their proximity to the payment of estate taxes. Normally, the oldest family member will buy the investment offering the lowest growth and the youngest family member will buy the investment offering the highest growth.
Suppose the investment is to be made in bonds worth $100, which the family expects to hold to maturity and from which it expects to receive current payments of interest. This investment offers no growth of principal since the investor expects to receive, upon maturity, what she or he originally invested. Now suppose the investment to be made is in venture capital. Let’s assume the goal is to double the value of the $100 invested over five years; the family expects to make $200. Clearly the IRS would be delighted if grandmother bought the venture capital investment since the IRS will get $55 of that $100 profit upon her death.
However, the IRS would be unhappy if grandmother bought the bonds and a younger family member bought the venture capital investment. The IRS would be particularly unhappy if grandmother bought the bonds and used them as collateral for borrowing by her grandchild who, without the loan, couldn’t afford to make the venture capital investment. Grandmother is doubly happy since she will receive current income from the bonds while in the venture capital investment she will not normally receive any distribution for five years. The family is delighted with the result because grandmother’s estate didn’t grow but the overall family financial balance sheet grew by $100.
This is an example of investor allocation, and although quite simple, it makes the point. Obviously, there is a continuum of risks between the two categories I chose. Every asset allocation program, properly made, will have investment classes throughout the risk universe.
The point of investor allocation is to manage this risk universe within all family member portfolios, by maximizing growth of the overall family financial balance sheet while minimizing the growth of the portfolios most likely to be subject next to estate taxes. Families I work with that employ this strategy have become very excited by how quickly they see results. Happily, the IRS has no authority to decide which investments each member of a family makes.
To obtain maximum benefit from investor allocation, the family has to agree on several issues:
• It should have a family mission statement that commits the members to a strategy of long-term wealth preservation. Successful investor allocation requires that each family member elect to participate.
• The directors of family philanthropies, managers of family investment vehicles, and trustees of family trusts should all agree to participate in the investor allocation program.
• Trustees have special legal responsibilities that govern their behavior as investors. A trustee cannot give up ultimate discretion over the investment policy of the trust. The investor allocator will need to be mindful of these special responsibilities. Hopefully, the family trust instruments will grant the trustees the broadest possible investment discretion.
• The youngest family members—those furthest from estate and generation-skipping transfer taxes—should acquire the assets with the greatest growth potential, in a way that matches the family’s 100-year investment horizon. The oldest family members should acquire the lowest growth assets, to meet the family’s 20-year horizon. Intermediate generations should take positions in accordance with the family’s 50-year horizon. Indeed, the plan works best when the youngest family members and the long-term family trusts have the most money and the oldest family members have the least. Obviously, this is not the normal situation. It is highly unusual.
The challenge is to get assets to the youngest family members and the exempt long-term trusts so they can make the desired long-term investments. One answer is through gifts. Unfortunately, the U.S. gift tax law places low limits on the amount that can be given before taxes begin to accrue. The most successful strategy is for the oldest generation to make loans to the youngest generation and, in certain cases, after careful legal advice, to the tax-exempt long-term trusts, to permit acquisition of the appropriate assets. Inter-family loans carry with them certain IRS responsibilities to ensure that they are arm’s-length loans and not disguised gifts. A lending strategy should not be developed without proper legal and accounting advice.
An added benefit of this strategy is that the oldest-generation family members receive cash from interest on their loans, while capping the growth of a portion of their assets. The additional cash flow will meet their desire for cash, while providing them with additional liquidity to make gifts to family and philanthropy, or to make additional loans. As with any investment decision, careful analysis of the role of such loans in the family’s overall investment program, and the individual investment program of each possible borrower, must be made to determine what portion of an individual’s portfolio might be devoted to this program.
The family bank
The investor allocation strategy can be enhanced, and given a larger purpose, with a family bank. A family bank leverages a family’s wealth by making loans available to family members on terms not available commercially. These loans would be considered by commercial bankers to be high risk, but in the family’s eyes they are low risk because of their contribution to the family’s long-term wealth preservation plan. Loans from a family bank are usually granted for two purposes: investment to increase the family’s financial capital, or enhancement of the family’s intellectual and human capital.
In loans for investment, the family’s purpose is to take advantage of opportunities available to individual family members. The loans lead to growing financial wealth, while enhancing the person’s intellectual growth. They frequently take the form of investments in businesses founded by family members.
The considerations for the family bank in making this type of loan are:
• The individual family borrowers should be required to develop a business plan and submit a loan application like those required by commercial lenders;
• The borrowers should participate in dialogue with the bank’s board and advisers over the feasibility of the project;
• If a loan is granted, the borrowers should provide proper business reports on the results of the loan;
• Ultimately, the borrowers should repay the loans.
This process gives the borrowers excellent training and the highest possible chance for a successful financial outcome.
Loans from older-generation family members to younger-generation family members, or to the family’s long-term trusts, can be a key component in an investor allocation program. They can enable individuals and trusts to make investments in asset classes they otherwise would not have sufficient capital to make. Frequently, these are investments in venture capital, hedge funds, high-yield bonds, and other vehicles that investors in general perceive as high-risk but high-reward.
In the case of loans for enhancement, the family’s purpose is to increase the family’s intellectual and human capital by increasing the independence of individual family members. Many families, and particularly many family trustees, cannot make the intellectual leap between the words “subsidy” and “enhancement.” Too often, requests for help by individual family members are treated as requests for subsidization, and deemed to show dependence on the part of the individual. Dependence on subsidy, or as I call it “dependence on remittance,” is an addiction that is as serious as dependence on alcohol or drugs. It saps the human and intellectual capital of a family faster than almost any other liability on the family balance sheet.
As with investment loans, proper lending procedures for enhancement loans are critical to the growth of each borrower’s human and intellectual capital. The borrower should state how such a loan will increase his or her independence, and how the loan will add to the family’s intellectual capital. When a family’s leadership begins to view distributions to family members as loans for enhancement, and family members agree to go through the process of loan application, a family makes real progress in combatting remittance addiction. In this atmosphere, family members must be certain that their human and intellectual capital will really be enhanced.
The family bank has a long and fruitful history. Perhaps the most notable example was created by the Rothschilds. My understanding is that their history began in the 18th century in Frankfurt, Germany. The progenitor was Meyer Amschel Rothschild, who provided private banking services to an aristocratic German family and helped them successfully overcome dislocation in their part of Germany caused by war. His success provided him with significant financial capital.
Rothschild was also extremely fortunate to have an abundance of human capital: five sons. (I apologize that 18th-century history doesn’t tell us about his daughters.) As the story goes, the father gathered his sons together and advised them that he had decided to create five new banks, one in each of the then financial capitals of Europe: Frankfurt, Paris, London, Naples, and Vienna. He asked each of his sons to move to one of these centers and head up a new branch bank there. As an incentive, he offered each son a loan to serve as the initial capital. As a further incentive, he offered a rate of interest that was lower than might have been required by a lender outside the family, and he asked for no percentage of the new banks’ profits. It was his intention that each of his sons become successful through his own bank. Finally, the loans had to be repaid so that future family borrowers would have the means to pursue new opportunities.
Rothschild required each son to advise him regularly of what he was doing in his business and what was happening in the financial center where it was located. The patriarch agreed to communicate this information to the other branches of the family as part of the family’s overall long-term wealth preservation plan. This sharing of information gave the Rothschilds a bank of knowledge to help each other that quickly distanced them from competitors.
When we speak of families who have preserved wealth for more than three generations and, even more importantly, are still growing, the Rothschild family is always one to emulate. What can we learn from their experience? The sharing of intellectual capital was most critical to the Rothschilds’ success. Families striving to preserve wealth quickly grasp this idea; while having a friendly lender gives an enormous competitive boost and is reason enough to create a family bank, it is the sharing of intellectual capital through the operation of such a bank that is the true wealth-preservation reason for forming it.
Unfortunately, in America there is no normal school curriculum that teaches people how to obtain a mortgage, car loan, personal loan, or business loan. This deficiency deters most individuals in their financial growth. It also leads most of us to learn by necessity. While this works well for a few people who are gifted in this field, the system leaves most family members financially undereducated and ultimately financially unsuccessful. If a family’s goal is to enhance the lives of each of its family members, ensuring each person a full financial education will go a long way toward accomplishing that goal. A family bank fosters such an education.
The creation of a family bank has been a fruitful exercise for each of the families I have counseled on wealth preservation. They have found in it ways to achieve financial education, community, character-building, and a safe environment for financial mistake-making. At the same time, operating the bank has increased the power of the family’s financial, intellectual, and human balance sheets through the individual successes of the borrowers. The bank, and a program of investor allocation, enable families that have shed their shirt-sleeves to continue living in fine clothes for generations.
James E. Hughes Jr. is a principal in the law firm Hughes & Whitaker in Manhattan. He has advised families on wealth preservation for 30 years. This article is excerpted with permission from his book, “Family Wealth: Keeping It in the Family” ($25). Copies can be ordered from the Madison Avenue Bookshop, 212-535-6130; for larger orders call 212-751-3838.
Setting up a family bankA family bank will succeed only if it is established with clear policies that are communicated and agreed upon. These should include the following:
• The family bank should not be a corporate institution. It is important that it be informal, so its activities remain private and so it can evolve a system of governance that meets the unique circumstances of the family.
• The family bank must have formal rules for meetings. It should have officers, directors, and if needed, advisory boards. It should have procedures for receiving and processing loan applications. The rules and procedures may vary considerably, depending on who will fund the loans.
• The family bank must have a mission statement explaining its philosophy and reason for being. It is important that lenders and borrowers clearly understand that the primary purpose of the bank is to be a high-risk, low-interest lender, and they should be prepared to live with the consequences of this policy. The statement should also contain a values section incorporating the overall family mission statement and how a bank will assist in carrying out that mission.
• The family bank should identify family members (and trustees if the family has trusts) who might be lenders and borrowers. It is particularly important that trustees of family trusts participate in the family bank.
• All family members who participate should be given copies of all loan applications. While it may be appropriate for confidentiality to omit personal financial data, it is important that all members receive the intellectual capital portions of the applications.
—J.E.H. Jr.