Outsourcing vs. insourcing: More family offices are choosing hybrid solutions
Over two decades of working with highly sophisticated family offices, I’ve observed that most successful family offices have a few things in common: a clearly codified purpose, an overall strategy, governance and investment strategies. And they have ultimately aligned their resource level, structure and internal setup with these factors.
But reaching that position is no simple feat. To do so, families must make the key decision of settling on a team resource plan that will best implement their chosen investment strategy. It often comes down to the difficult “make vs. buy” debate, which is tied to economic break-evens and the level of expertise that can be procured internally without compromising on quality.
But insourcing and outsourcing are not the only options. Family offices often find that hybrid solutions, combining internal and external expertise, are often the most effective in achieving the clearly codified structure that enables success.
INSOURCING VS. OUTSOURCING
The “make vs. buy” decision comes down to whether to build an in-house investment team with the requisite skill to deliver the chosen investment strategy or outsource the investment management to one or several outside providers (e.g., outsourced chief investment officer (OCIO), consultant, private bank).
There are obvious benefits to building an in-house investment team, including cost-effectiveness for the largest family offices and management control. However, building such an internal team can be challenging and, in some cases, impractical. If the investment strategy includes alternative investments, a fully internalized model would require a minimum of two or three people to cover each asset class — an enormous investment. In addition, even if you employ a lean team, the best investment talent is costly and can be difficult to attract.
From a financial perspective, a full multiasset-class in-house team would start being viable for an investment portfolio of $2 billion in assets and above.
THE HYBRID SOLUTION
So, where does a family turn?
A hybrid model of in- and outsourcing is becoming increasingly favored by family offices, with families managing a smaller investment team while outsourcing a portion of the investment process. This allows the family to limit the fixed cost of hiring a full internal team while allowing it to focus on areas of particular interest and/or expertise.
The decision to manage specific strategies or asset classes internally is often the logical result of the family having specific sector expertise, usually acquired through the ownership of operating businesses.
Two hybrid models that appear most often adhere to the following structures:
- Family office focus is on high-level execution of investment strategy.
- Family office manages one or several asset classes.
In the first option, the internal family office team focuses on high-level execution of the investment strategy (i.e., portfolio construction, asset allocation, overall risk management and reporting to the investment committee) and is supported by external investment managers/advisers for the investment management (largely manager selection and monitoring). In such cases, the family hires a small team of usually one to three people who set the overall asset allocation framework, target risk and illiquidity levels, and also tend to oversee financial activities. The family office then outsources the management of each asset class to a single OCIO firm or to several specialist advisers/providers.
In the second option, the internal family office team focuses on the high-level execution of the investment strategy and directly manages one or several investment areas, with other specific asset-class mandates being delegated to external advisers.
The most common way of partially outsourcing is to clearly divide the asset classes managed in-house from those managed externally. Family wealth has often been created via a family’s in-depth knowledge of a specific industry or sector, with individual family members maintaining expertise and a passion for that sector. Therefore, it seems natural for the family to keep a very hands-on-approach, hiring an internal team comprising investment people whom they have identified as particularly capable in this asset class and are already familiar to the family and managing such investments directly.
A typical example is that the family internally manages all direct private equity investments with strong involvement from the family itself, often focused on a single or narrow set of sectors. Such personal passion or internal expertise tends to rarely extend to other asset classes. Some family offices therefore opt to leave the management of these unfamiliar asset classes to outside firms rather than hire in-house staff.
The investment strategy and resulting internal setup are merely two important decisions that family offices face. The manner in which wealthy families manage their investment portfolios will remain as varied and diverse as the families themselves. There is no single template that will ensure that family wealth will continue to grow. However, it is important to regularly revisit a set of key questions in order to arrive at the most effective long-term family office strategy.
Read the full paper: Best Practices in Institutional Family Office Investment Management