Practical Capital 2021

Welcome to Practical Capital, our guide for family office executives.

An entrepreneur once said to me, that real money is made in doing the kind of work that other people don’t have the time or energy to do. That may well be true, but in our industry, I would amend that statement in just one way; real money is saved in doing that kind of work. Investing captures people’s attention because it is exciting, but the structural work that goes into looking after intergenerational family capital can be highly financially rewarding when done right. What’s more, the regulatory, legal and investment landscape is always changing. There are the major structural shifts that dominate the headlines, like how the investment industry is going to navigate the post UK-EU deal landscape, and there are also subtle changes; shifts in regulatory attitudes that can have deep ramifications for structuring family capital. Luckily for family investors, Brexit will have very little impact on how you work with the investment industry; your paperwork might look different, or you might hear different accent but there are no obligations that you, as buyers, need to meet.

But there are other changes afoot that do warrant careful thought and analysis, and these are the kind of trends that we explore here. Because our clients are intergenerational families, we have to be as active in our approach to monitoring these kinds of changes, as we are in our approach to investment.

To that end, we thought that we would share some of our on-the-ground insights into the shifts and dynamics that we are seeing in the structural side of managing capital. As well as a few tips and guides to the areas of structuring that – while labour intensive – can save you precious basis points in the long run.

Richard Adams, Partner, COO

Hiroko Atherton, Partner, General Council

Structures: striking the balance between tax efficiency and privacy

Trusts were once the gold standard of intergenerational wealth planning; they were the ideal structure for both privacy and tax efficiency. Today, the landscape has changed; thanks to shifting attitudes from various regulatory bodies and a complex web of differing international tax regimes, there is now no one-size-fits all structuring solution for wealthy families to pass on their legacy.

KYC is at the heart of this. Counterparties undertaking KYC analysis are becoming more wary of both the opacity of the trust structure, and the use of offshore jurisdictions. While the UK and some European countries are well acquainted with trust structures, they are a less familiar concept in much of the rest of world. What this means in practice is that in order to onboard a trust client with a custodian or bank, you are often required to disclose even more private information than you would with a corporate structure. Full disclosure requirements now catch not only beneficiaries and trustees, but also settlors and protectors. Further complicating the picture, is the fact that there is no single, consistent approach. Some banks are happy to rely on structure diagrams and reliance letters, others want to go far further than the letter of the law requires.

What is the best approach today?

There is a tension now between tax efficiency, and privacy when it comes to choosing a family structure. Families starting from scratch today are often more tempted to opt for a corporate structure than a trust, even though the tax ramifications can be more punitive. The important thing is to know the pros and cons of each structure and what you might be expected to disclose with either.

We generally find that families with existing trust structures fall into two camps; some have a ready-made KYC pack with every detail a counterparty could ask for, accepting that they may end up disclosing more than they need to. Others have different levels of disclosure that they work through case-by-case in the onboarding process. For many families, giving away information about their children’s inheritance, or even sensitive information on minors, is simply too large a price to pay for greater tax efficiency. Ultimately, it is up to families to decide what matters most to them, while accepting that one single structure is unlikely to work across multiple regimes.

Top Tip

Choose between keeping a full pack of KYC information, and a tiered approach to disclosure. Then have as much documentation as you can, pre-prepared and ready to sign. Another option is two operate with two separate structures, one which is more confidential and one which enables full disclosure.

Fund Terms: beware the small print

One of the lesser-known effects of the 2008 Great Financial Crisis, was a widespread tightening of the terms under which investors were willing to commit to funds – particularly those with broad investment remits. It wasn’t until after the GFC that many investors realised how loose those terms had been, and how little protection they had as unit holders. Perhaps the most obvious example of this lay in the hedge fund world, where investors were surprised to learn that in many cases, managers operated with no binding limits on investment objectives, leverage or concentration. If they wanted to, they could place the entire value of a fund on a single trade and lever it twenty times over (without breaching the terms of the PPM or management agreement).

While we’re not quite back to that point, we have started to see a reversal of that post crisis tightening, and a shift back towards a world in which asset managers largely dictate their own terms. Why is that the case? Arguably this shift has its roots in the extraordinary asset price expansion we’ve seen in the last decade. Put simply, the buy side is extremely well-funded, less concerned about risk, and the low yield environment has left investors open to a broader set of strategies and styles than they may have otherwise considered. What’s more, there are now fewer managers in the market, so assets are concentrated in the hands of a smaller number of large players, making allocations more sought after. Combined, these dynamics have created a sellers’ market for the fund industry. What’s more, there are now fewer managers in the market,

What are the practical implications for investors?

Were you to ask a fund manager why they need a fairly loose set of trading terms, they might understandably say that that’s the framework they need in order to generate the kinds of returns that clients want. In some cases that may well be true, and there’s no denying that there are great managers out there with the ability to truly deliver alpha for our clients. That being the case, the onus is on the investor to undertake two major pieces of work; due diligence, and monitoring ongoing risk. While the former is standard practise, the latter is often woefully overlooked.

We would suggest that anyone investing in funds now – particularly ones with a broad remit – operate with active risk management. That means monitoring structural risk in exactly the same, dynamic manner that you do investment and market risk. We work with a risk grid on an ongoing basis throughout the life of the investment that covers everything from bottom line legal terms to firm culture, manager personality & behaviour, departures and concentration risk. By keeping on top of these less obvious factors, and deeply understanding the terms under which those funds can trade, we maintain the ability to tap into great funds, without taking on unnecessary (and often hidden) risks.

Top Tip

Once you have fully understood a manager’s investment terms, grill them on any aspect of the terms that you either haven’t had any disclosures on, or simply don’t agree with. It may be that certain terms will not move, but you can gain soft comfort as well as an invaluable overview of the full spectrum of investment risks, which helps to map out the risks that need to be monitored on an ongoing basis.

Liquidity terms are particularly important, you need to know how quickly you can get all your money back in the event of a crisis or other unforeseen event. It’s also good to know who is liable to pay administration costs in the event of a fund liquidation and closure.

Choosing a custodian: a step-by-step guide

Despite the risks, choosing managers is often considered one of the more exciting elements of managing family capital. The same cannot be said for choosing a custodian, but those who do put the work in might be surprised at what they find. Costs, risks and structures vary a great deal, and as the regulatory landscape has changed, so too have the risks for clients.

Here, we’ve boiled down the lengthy process of finding the right home for your assets into a simple, step by step guide.

  1. Jurisdictions and oversight

    Behind custody sits tax structure. Each custodian will operate with different jurisdictions, and these dictates where the register of assets is held. A critical first step is to understand which jurisdiction customer services are provided, managed and controlled from, where the default nominee entity lies, and where the default contracting entity lies. Where you contract is important because those jurisdictions do vary great deal in their regulatory environments. Understand the ownership structure.

  2. How do custodians differ?

    While all custodians have a handle on mainstream securities, they vary in their approaches to funds. Some are specialists with funds, others struggle – particularly with private equity, where the lack of upfront capital creates difficulties that some are more willing to overcome than others. Most custodians won’t hold funds with ‘contingent liabilities’ via their nominee, but that doesn’t mean you can’t lean on them to take some of the administrative burden of record keeping and capital calls/distributions.

    Most operate with a list of approved funds - which they are not required to disclose – and investing in non-approved funds can incur charges of up to 2%. So it’s important to match your investment needs with your custodian. As well as costs, lead times for investment into non-approved funds will vary, as most custodians will conduct a review of the prospectus and get internal sign off before agreeing to hold.

    Approaches to KYC and AML matter not just in the onboarding stages but also in the ongoing process; if you’re investing on a short time horizon you need to know that they will deal with their side of the KYC process in time. Some will own the AML process themselves; others might expect an introducer’s certificate.

  3. What are they charging?

    Fees vary far more widely than you would expect. Some will offer all-in fixed fees, but most will have a fixed fee and a variety of additional costs, for transactions, FX, sub custody and more. Some will look like good value by offering a very low fixed fee, but charge you through the nose on transactions and execution. What’s more, those extra charges are not usually disclosed; you have to ask for them.

    Once you have their full fees and are ready to compare them with other custodians, you’ll encounter another difficulty; you’re comparing apples with pears. Some will charge in basis points, others in flat fees, so you have to do your own accounting to work out the true differences.

  4. How are my assets protected?

    Positions regarding liability can vary from one provider to another. Some will have a cap, others will have a cap even with a “cause” event, and some will have no cap at all. When you’re looking at a provider that uses a sub-custodian, you’ll need to know who is ultimately liable.

    Operational protection is key; UK custodians are held under the CASS rules, which are the gold standard in asset protection. If you have a custodian in another jurisdiction it’s important to know that they are held to the same account. It’s also helpful to know how your cash is held; some custodians (where they have a banking licence) will hold it separately to invested assets (as ‘banker’), if so that offers you additional protection with FSCS cover, but increases your credit risk.

  5. Who is my risk actually with?

    There are lots of layers of risk with custody. Ultimately, you are relying on your provider to keep clean, accurate records of your accounts, but they in turn are doing the same thing with either sub-custodians, or directly with Central Depositories. One major custodian was fined millions of dollars for not ensuring that every client within their book was fully identifiable. While practices have since improved across the board, it is still important that you understand the level of due diligence that each layer of the custody structure has undertaken.

Custody: a case study

We compared the offering and fees of two custodians while onboarding a new client. They had an existing relationship with custodian A, but we wanted to explore whether custodian B would offer better value, having used them before. Both were global custodians from well-known institutions. What we found, was that despite the overall offering being near-identical, custodian B was charging a very reasonable all-in fee of 20 basis points, while custodian A offered a lower flat fee, but up to 1.5% on every transaction. To find a true comparison, we modelled the differences in fees, considering everything from the client’s AUM to our own annual portfolio turnover. After some detailed analysis, we discovered that the difference in fees between the two added up to just under £100,000 per year. Whilst requiring some upfront effort by CapGen and the client to onboard with a new custodian, had we not switched, that client could have been nearly half a million pounds poorer after five years, with nothing to show for it.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.