Real Estate SFOs vs Public Assets SFOs vs Private Asset SFOs

The reasons that SFOs do not always manage to build a genuinely diverse portfolio range from fiscal reasons (tax — especially historic unrealised gains on which the family are not prepared to pay tax) to family pressures (if one or more family members insist upon a particular investment category). Often, they inherit a legacy portfolio that, for all sorts of legal, tax and family reasons, they cannot restructure.

Wealth creators, whilst still alive and well, often dictate the investment programme. Wealth creators often have very specific investment objectives, with decisions driven more by sentiment than cold analysis. They will often have a strong attachment to a specific asset class. This can be advantageous, insofar as conviction to a particular asset class can encourage bold decisions and avoid following the market. Taking a long-term view with a portfolio of assets (especially when it comes to real estate) enables SFOs to consider projects to enhance the capital value, or to pursue a higher risk endowment style strategy in public and private financial assets. But it can also lead to inflexibility, with certain assets effectively locked up until after the wealth creator’s lifetime. This can frustrate SFO officers who have a keen interest in the discipline of asset allocation. 

Wealth creators can sometimes have a particular attachment to a specific asset, such as a trophy asset. This can be more inhibitive and may create a laggard within a portfolio. SFO officers can find this frustrating, and it is unfair to carry out an assessment of an SFO’s performance where they hold stagnant assets that they are prohibited from selling.

Many SFO chief investment officers choose to join a family because they are attracted by the idea of building a portfolio, freed from the constraints (whether financial, geographical, regulatory, or risk-based) of banks and other investment houses. In an ideal world, many SFO officers seek complete freedom to construct a portfolio which might include high risk assets such as tokenised interests or significant hedge fund exposure. However, the reality is often quite different — in practice the powers of an SFO are far more limited than they would like. And it is not always the wealth creator who can impose limitations — they can come from second or third generations too. Even more difficult to manage is the situation where a CIO is given multiple instructions from different family members, sometimes conflicting instructions. This can result in a poorly balanced portfolio, far from the original vision.

This is where family charters become helpful, establishing a clear investment vision and chain of command on decision making. Consideration should also be given to the legal structures. If the assets are held in a trust, should there be an investment committee at trust level, to have oversight of the investment performance of underlying companies? Many trustees prefer not to have investment committees at trust level, if that means they have a duty to monitor underlying investment performance. Most trustees instruct their trust lawyers to minimise their investment responsibilities as far as possible using ‘anti-Bartlett’ clauses.

Illiquidity Challenges 

Public asset focused SFOs have the privileged position of holding liquidity. Thus, in the event of a family rupture, such that one family branch exits the investment programme, the assets are easily divisible. Liquidity is also very valuable if a ‘trigger event’ arises within the trust, and major capital distributions are due to family members. 

The same cannot be said for private asset and real estate focused SFOs, who have to grapple with the challenges of illiquidity. SFO officers (especially when from an investments background) do not always focus on these issues, or may take a short-term investment-focused view as opposed to a long-term succession-focused one. But the right approach is to strike a balance when constructing a portfolio - to have close regard to the family’s succession plan as well as their core investment objectives. Families should ensure that the job description of SFO officers is to focus on both elements (as often the succession element is ignored), or ensure someone is hired specifically with a succession remit.

Another risk for illiquid portfolios, especially real estate SFOs, is that when decision-making powers transfer from one family generation to the next, they may fundamentally change the investment programme. SFOs focused on real estate and private assets need to manage expectations that this could be a five to ten year process.  

Resourcing SFOs And Tax Issues

It is sometimes said that a public assets focused SFO can be a smaller office. This type of SFO may allocate full discretionary management to banks and investment managers and find that only one or two people are required to oversee and allocate to such portfolios. This may change if the SFO gives the bank an execution-only mandate, at which point the SFO may need greater resources for research and proposals.

Private asset SFOs are a different story — more resources are often needed if they are to take responsibility for asset allocation to a range of fund managers, or to make direct equity investment.

The risk that all financial asset SFOs run is that they may create an onshore taxable ‘Permanent Establishment’ if they can be said to habitually exercise authority on behalf of an offshore entity. This risk exists in many of the onshore family office hubs, whether it be London, Dubai or New York, but can often be managed with good tax advice, well-drafted Investment Management Agreements, and good corporate service providers.

Subject to Permanent Establishment risks, financial assets SFOs often have an easier journey in terms of tax. Real estate SFOs, on the other hand, spend their lives dealing with tax lawyers and accountants, which may not be as thrilling as it sounds. Real estate focused SFOs are usually less likely to create a Permanent Establishment issue than financial assets SFOs, but otherwise real estate investment creates many more tax complications.

Thus the challenges between different SFOs vary greatly, but whatever the investment programme may be, the life of an SFO officer is never a quiet one.

James Brockhurst
James is a Partner with the firm, specialising in trusts, estate planning, UK tax and cryptoassets.