Private family funds: a global phenomenon

  • Author : Janine A Racanelli
  • Author : Gavin Leckie
  • Date : December 2011
ABOUT THE AUTHORS: Janine A Racanelli is Head of the Advice Lab and Gavin Leckie is Head of the Cross-Border Advisory Team at J.P. Morgan Private Bank in New York

Investments in family portfolios have become far more sophisticated in the past few decades, with such innovations as hedge funds and private equity becoming mainstream. Asset classes have proliferated and investment opportunities are more global than ever. As a result, wealthy families are increasingly interested in finding a single vehicle that can handle the complexity of managing and supporting today’s portfolios. Many are asking whether an umbrella legal structure known generally as a private family fund (PFF) is the answer.

The PFF is attracting attention because it seems to provide a one-stop solution to a wide range of family needs, including consolidation of an individual’s complex investment portfolio and net asset value (NAV) reporting, as well as the pooling and administration of family members’ assets. As large, single-owned fortunes transfer to multiple members of subsequent generations, PFFs enable the less wealthy family members to pool funds, achieve economies of scale and have access to more exclusive investment opportunities.

For example, two brothers based in the Middle East founded and ran a successful family business for decades, gradually broadening the ownership to their respective families. As they continued to distribute and amass dividends, they decided that one of their sons would oversee the management of the entire family’s liquidity, selecting investment managers, hiring service providers and setting up family meetings to discuss performance.

A year later, at a family meeting, the ten family members realised they had no uniform investment-performance reporting. They were unclear about exactly how much they were worth. They had no guidelines as to how they could exit the family investments. It also was difficult for them to communicate, because the family members were scattered across four different countries and three time zones.

The family’s advisors recommended a private fund as a solution to these concerns. A fund would enable them to provide regular reports on the family’s, as well as each individual shareholder’s, net asset value. It would also keep the family wealth working together with clearly defined guidelines about subscriptions and redemptions. The individuals’ holdings would be reflected by the number of shares they held.

PFFs also potentially provide tax benefits to families, depending on the laws of their home countries.

One concept, many forms

PFFs are the latest example of structures that originated in the institutional arena and have been adapted for use by wealthy families and small groups of investors on a bespoke basis.

Like other widely used financial vehicles, such as trusts and partnerships, a PFF can take on many different forms, depending on where it is established and the wishes and intentions of the individuals creating it. In other words, PFFs are not all created equal – they vary dramatically – making it dangerous to assume that any one PFF will work in every circumstance.

The universe of private fund types available is vast, ranging from the most straightforward options (such as Bahamas specific mandate alternative regulatory test (SMART) funds) to heavily regulated mutual funds in the European Union and the Delaware statutory trust in the US. The range of nomenclature hints at the variety of the vehicle’s manifestations. Also referred to as ‘private structured funds’, ‘bespoke funds’ or ‘bespoke regulated funds’, PFFs are perhaps best described as ‘customisable’ funds that, in form, look similar to mutual funds.

‘Private family funds enable less wealthy family members access to more exclusive investment opportunities’

The benefit of a PFF to a particular family hinges on at least as many factors as a trust might, including the family’s domicile, the law of the fund’s situs, the fund provider’s administrative capabilities and the success of managers employed for investments. Families should also consider such factors as cost of set-up and maintenance, appropriateness of a single entity across multiple jurisdictions and investments, and other restrictions that may be inconsistent with family goals.

Ultimately, each family and its advisors must decide whether the family’s home country laws, the fund fees, the provider attributes and any applicable restrictions warrant creating their own fund.

Main Benefits

Interest in PFFs is sparked by the fact that providers are offering, in readily available packages, key services that some families may prefer not to handle directly themselves. These are:

  • the ability for an individual to aggregate assets held across multiple providers under one fund umbrella that uses a master custodian
  • the ability for multiple family members, and even friends, to pool their assets, creating economies of scale, a potentially broader universe of investments for members with smaller asset bases, and the spreading of risk within a defined group; and
  • NAV reporting derived from independent valuations.

Portfolio consolidation and daily NAV reporting have become more challenging, desirable and sometimes essential. Today’s family offices often oversee portfolios of institutional size and complexity with holding vehicles – trusts, limited liability companies (LLCs) and personal holding companies – that reflect a family’s diverse membership and multigenerational planning. See Chart 1, below.

Chart 1: Evolution of investment portfolios

These diagrams show J.P. Morgan’s allocations for a balanced portfolio 15 years ago and today. They are specific to the firm, but reflect the trend toward increased diversification of asset classes

Source: J.P. Morgan

Family investment specialists require a market-based consolidated view of holdings. Family investors (individuals or entities) want timely information regarding their precise share of commingled portfolios.

Consolidation can also become critical as international tax-reporting requirements grow more demanding. In addition, the PFF’s consolidation and accountability can aid in the transfer of wealth from one generation to the next.

For example, a widowed patriarch in Latin America had two sons and three daughters. He created a PFF to aggregate his investments (held with multiple providers), obtain a clearer accounting of his holdings and rebalance some of his accounts.

When he reached 70, the patriarch transferred 25 per cent of his shares in the PFF – 5 per cent to each of five separate trusts – for the benefit of his children. In this way, he was able to efficiently provide them, through a trust structure, with an ownership stake in the PFF’s nearly 125 underlying investments.

On his death, he transferred his remaining shares to the same trusts for his children.

More benefits

Other benefits of PFFs typically include:

  • oversight by the regulators of the country where the fund is sited
  • independent monitoring and administrative services from the fund provider
  • liquidity (the ability to borrow against the fund’s holdings)
  • uniform policies governing participants’ ability to redeem out; and
  • generally enhanced privacy for fund participants vis-à-vis third-party providers, while complying with relevant regulatory and tax regimes.
In-country PFFs

A wealthy family’s home-country laws significantly influence which PFFs are most appropriate. Developed nations tend to have comprehensive fund and tax regimes that make using non-local fund vehicles less tax-efficient.

For example, US taxpayers rarely go offshore to form a PFF, as they can too easily run into difficulty with rules such as the ‘controlled foreign corporation’ or ‘passive foreign investment company’ regimes, which impose punitive tax consequences on investment earnings. In addition, reporting obligations imposed on US taxpayers with interests in foreign vehicles and accounts have become increasingly onerous in recent years, with significant penalties for failure to follow the reporting rules to the letter. For these reasons, US taxpayers are usually better advised to establish a tax pass-through vehicle such as the Delaware statutory trust, or an LLC.

For similar reasons, many western European families seeking tax-deferral benefits tend to stay in-country, particularly those domiciled in France, Germany, Spain and the UK. The downside of such local funds is that they are often more cumbersome, with capital and disclosure requirements as well as independent oversight procedures. These funds also tend to have stringent restrictions on the types of investments that can be included or impose local registration requirements on the investment advisor of the PFF.

‘Consolidation can become critical as international tax reporting requirements grow more demanding’

For example, funds that comply with the European Union’s series of directives on mutual funds, Undertakings for Collective Investment in Transferable Securities (UCITS), are limited in investments to ‘transferable securities’, which have had an evolving definition and generally now include derivatives as well as equities, listed bonds and other kinds of debt securities1. Short sales are prohibited and biweekly liquidity must be available to investors, to name just two of several investment or fund restrictions that result from UCITS’ initial focus on retail investing.

Offshore funds

Demand for offshore funds is heaviest among families who live in countries that have neither local fund providers with sophisticated global investment offerings nor tax regimes that make it disadvantageous to hold assets in foreign funds.

Four structures are popular among these offshore users:

  • Bahamas SMART fund
  • Cayman regulated mutual fund
  • Irish qualified investor fund (QIF); and
  • Luxembourg specialised investment fund (SIF)

These are explored in more detail in Chart 2, below.

Chart 2: fund regimes that are popular with families

Each has a unique set of characteristics

  Minimum investment per investor Investor criteria Risk diversification Investment restrictions
Bahamas SMART fund No minimum Any natural person with a net worth, individual or joint, in excess of USD1 million No No
Cayman regulated mutual fund USD100,000 per investor No No No
Irish qualified investor fund EUR100,000 per investor A qualified investor standard applies No No
Luxembourg specialised investment fund Minimum capital requirement of EUR1.25 million to be reached within 12 months A qualified investor standard applies A diversification standard applies No

Source: J.P. Morgan

Many investors have gravitated to the Bahamas SMART fund and Cayman regulated mutual fund, both regulated mutual funds that permit considerable investment flexibility and have limited restrictions regarding both fund managers and fund participants.

The Bahamas SMART fund, for example, was designed in 2003 specifically to enable private family use. It is innovative in that it lets families employ hedge-fund-type investment strategies. A potential PFF owner needs no professional investment credentials to open a SMART fund. As a result, the use of SMART funds has doubled in the past three years, with the greatest number of funds in 2010 dedicated to the use of ten investors or fewer2. See Chart 3, below, for further information.

Chart 3: Bahamas SMART Funds

These graphs reflect the universe of specific mandate alternative regulatory test(SMART) funds as at 31 December 2010. Available information does not state whether a fund has been set up for private family use, but a small number of investors suggests a fund might be a private family fund

Source: Bahamas Financial Services Board

* Fund #002: An investment fund with a maximum of ten investors who hold equity interests in the investment fund and who meet the criteria of an ‘eligible investor’ in a professional fund, and the majority of whom have the power to appoint and remove the operators of the investment fund. The fund may be licensed and launched either on the same day through an unrestricted fund administrator or through a 72-hour response by the Securities Commission of the Bahamas.

** Fund #004: An investment fund with a maximum of five investors operating as a private investment company. May be used as a credible, licensed holding vehicle.

In contrast, a Luxembourg SIF requires that a PFF owner be declared an informed investor and be willing to invest a minimum of EUR125,000 to start, with the fund asset size required to grow to EUR1.25 million within 12 months of a fund’s creation. Without a declaration, the wealth owner can provide an appraisal from an investment or credit institution that attests to their ability to open a fund.

Some cautions

PFFs can provide great benefits when properly selected, formulated and administered by reputable providers. As with any structure, details are critical:

  • What are the mechanics and components of client reporting?
  • Who is the auditor?
  • What would happen if there were a mistake in valuation?
  • How much detail does the family want in performance reporting? Net or gross of fees?
  • Who is liable for any manager’s mistakes, and is there sufficient capital to cover potential liabilities?
  • How much will it cost to unwind?
  • How can the family effect change (the corporate governance)?
  • What happens if the tax law changes (how easily can the vehicle be restructured, if necessary)?

In addition, technology platforms matter a great deal to ensure the fund administrator can link properly (agnostically) with managers of funds held outside the fund’s investment platform. Even in this internet age, not all technology platforms and data systems can share information easily. Before a family creates a fund, their advisors would be well advised to conduct a technology review, enlisting input from personnel from the family office, if there is one, as well as from outside experts.

Families also should think carefully about redemption, particularly when there are multiple holders. Individual family member redemption may be difficult, as there is no market for the shares.

For example, an Asian couple had a PFF in which both of their children participated. When the daughter married, she and her husband decided to immigrate to the US. Concerned that the family fund would be characterised in the US as a passive foreign investment company and attract unfavourable tax treatment, the daughter carefully considered her options before emigrating.

Before the move, the young woman followed the fund’s established procedures regarding notice and liquidation to redeem her shares. Liquidity reserves provided redemption without disruption to the fund’s overall asset allocation.

Key details

PFF owners need to know:

  • How much does it cost to unwind?
  • What tax liabilities may be triggered?
  • What is the liquidation reserve?
  • How will redemption of illiquid assets be handled?
How to proceed

These complex issues require counsel by professional advisors knowledgeable in the laws of the family’s home jurisdiction and, if the family is going offshore, by those who are expert in the laws of the fund’s situs.

UCITS-compliance is a kind of passport that allows the fund provider to market the fund in any European Union (EU) country. However, users setting up even a UCITS-compliant fund must still adhere to their individual country’s set of regulations, which are not coordinated across the EU
Because of confidentiality, the regulators of offshore funds do not provide a breakdown between private family versus professionally marketed funds

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