Family offices, and the investment professionals serving them, have long been participants in traditional M&A transactions. Of late, however, middle market and lower-middle market family offices are experiencing an increased migration of private equity professionals from traditional private equity funds. This migration has prompted an increased need for investment professionals (and their advisors) to consider the often-perceived sleepy legal field of trusts and estates when structuring both a family office itself and its transactions.
At their core, trust and estate arrangements address the questions of control over and beneficial interests in family wealth. These foundational principles guide how family offices and their transactions are best designed.
Structuring Considerations
The organizational structure of an established family office and its investment arm(s) are often indistinguishable from a traditional private equity counterpart, with numerous investment vehicles supported by a standalone management company or general partner.
Unlike the traditional market-driven economic terms between a traditional private equity fund and its investors, however, family offices are not subject to the same market-based conventions to inform their equity-based capital allocations. Instead, capital allocations within a family office may be a product of varying investment preferences or perceptions among family members combined with the corresponding level of control those family members exert over various portions of family wealth.
Indeed, just as no two families are alike, a family office structure should be designed to balance the various interests and attitudes of the family member constituents it serves with a focus on the beneficial interests supported by the office’s capital. Among a litany of other factors, family members, as well as their investment professionals and advisors, should take heed of a couple of key structuring considerations:
• The need for capital among family members — both an actual need, to maintain standards of living, and a perceived need for access to capital, to provide comfort in that regard.
• Psychological factors and family dynamics play an important role, and in different manners. Older generations, for example, may or may not be satisfied with a fixed rate of return on capital and may have differing attitudes about a younger generation seeing greater upside benefits from an investment’s growth trajectory.
The legal form in which wealth is owned will be one of the primary driving factors in this analysis. In recent years, many states have provided greater flexibility with — or repealed altogether — laws governing restrictions on assets being perpetually held in trust. That allows wealth to be housed in dynastic trusts on a perpetual basis or for extended terms such as 1,000 or 360 years, in many cases without being subject to estate or generation-skipping transfer (GST) taxes as it passes for the benefit of members of succeeding generations. The structural benefits associated with this type of wealth allow family offices to experience much less concern over committed capital and even to use easy access to capital as a marketing device when courting a potential target.
Other wealth, however, may be the product of legacy planning before the expanded flexibility for trust arrangements or may otherwise be owned directly by family members, exposed to their creditors and subject to transfer taxes during their lifetimes and at their deaths as a result. To the extent otherwise consistent with the family’s interests, this wealth should be exhausted through the family office infrastructure in a manner that shifts value to dynastic wealth free from transfer taxes and benefitting from at least some degree of creditor protection. Additionally, older generations can also offer intangible benefits to younger generations, such as leveraging a family’s reputational goodwill to direct business opportunities to family wealth that has the lowest cost of capital from a transfer tax standpoint.