It goes without saying that Biznews has been abuzz this past week with breaking news of the Belvedere ponzi scheme. Ponzi schemes have been around for years and people looking to make a quick buck are more often than not left invariably disappointed. In the case of massive ponzi scandals such as the Belevedere one, investors and innocent shareholders stand to lose thousands upon thousands. Even more upsetting is when people – unwittingly – invest their life savings into such a scheme. In the following article by Greg Harris, emphasis is placed upon the idea that investing takes time, discipline and patience – it’s as simple as that. Interest rates will always fluctuate and this is why discipline and patience are important – investments WILL pay off in the long run when invested responsibly and discerningly. Harris also discusses the importance of family capital and investing for the family. Read up on his useful and insightful advice. – Tracey RuffÂ
By Greg Harris*Â
The world is abuzz with commentators speculating on when or whether the US Federal Reserve will begin raising the base rate, and so interrupt this period of quantitative easing and accommodative monetary policies characterised by the sentiment of “all risk assets must go up”. 
Yet history shows that such “pivot points” can be a fantastic catalyst for bad decisions, perhaps primarily because investors consider the world as they know it to be changing, and feel that a consequent wholesale change in their portfolio is required. Ultra high net worth families are no different, and because of the emotions involved, knee jerk reactions can be even more severe and value destructive than in institutional portfolios.
Discipline and Patience
When I attended the Berkshire Hathaway AGM in Omaha a couple of years ago, one of the things that struck me was how I had heard, or rather read, it all before. Buffett and Munger provide many with a master class in investing Discipline. If you have read their previous shareholder letters, it is unlikely that you will be surprised by anything said at the AGM. The problem with Discipline is that it goes hand-in-hand with Patience.
Buffett summed it up excellently when he said:
“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”
A study from Morningstar on US fund and investor returns suggests that (lack of) discipline is a persistent and pervasive value destroyer.
The chart below shows the average 10-year manager returns (dark grey) for a number of sectors relative to the average 10-year investor return (light grey) investing into these same funds. The orange bar is the difference between the two, or more directly, the percentage of underperformance attributable to lack of patience and discipline.
Investors, particularly emotional ones, tend to buy what goes up and sell what goes down. This means that invariably some or – in the worst case – most of the good returns have happened by the time investors allocate capital to a strategy, sector or asset class (and they often sell when in the pit of despair). This is borne out clearly by the graph which shows that the opportunity lost by investors averages in excess of -2% per annum across the fund sectors shown.
At Maitland, we encourage the use of investment policy statements for families of all sizes. An investment policy statement sets the “neutral gear” and is most often discussed and agreed during a period of low emotions. In this way it frequently benefits from the rational type of thinking that is often absent during a period of market panic or euphoric excess.
It is much easier to make large capital allocation decisions when there is a stake in the ground in terms of what represents the family’s normal positioning.
Incentivisation
Incentivisation is not a new problem. The question of incentivisation remains key to ensuring that those who are entrusted with capital are encouraged to achieve their target returns on capital invested and penalised, in some way, for failure – the most common being capital walking out the door.
There are, however, some intricacies when dealing with private investments. For example, incentivisation can be a problem in friends and family type equity raisings where the structure doesn’t exhibit the same levels of corporate governance as larger capital raisings would. While recognising the amount of capital involved can sometime make these deals very sensitive to fees, there are certain aspects of these transactions that cannot afford to be overlooked, the most basic being that management is invested into the same company as investors and share both the upside and the downside along with investors.
We often see a similar incentivisation conflict in private equity funds where general partners (GPs) charge a fee on committed capital and measure themselves on the internal rate of return or return on invested capital basis. We recognise the need to ensure that GPs are not incentivised to put capital to work more quickly in order to earn fees (potentially sacrificing the quality of investment opportunities) but at the same time clients struggle to find an optimum solution to incentivise them to reduce the cash drag and increase their return on committed capital.
Capital flow priority
Capital flow priority can also affect families participating in friends and family rounds or any type of venture capital investment. It is not a new challenge but it can be overlooked. We therefore encourage the use of drip-feeding capital, particularly in early stage ventures, to limit the downside risk for a family.
We would suggest that families should at least consider phasing in capital commitments to early stage companies. Management should be incentivised to hit certain technological or commercial milestones to qualify for further drawdowns of capital. The risk to be aware of is that the company is starved of capital which can create animosity between founders and investors.
This approach admittedly may come with the founders arguing for a higher valuation for the subsequent tranches but even so, the family can consider whether this is a fair price to pay for the benefit of being able to manage their downside risk as new information comes to light over time.
Family governance
Family governance is a bit of a buzzword at the moment. We do, however, think it is critical for families, particularly those facing a generational shift, to implement a Family Governance Charter, or similar. The document forms a recordal of the “founding principles” for family members to refer back to when making investment and other decisions.
This could mean, for example, that if a family value is to encourage entrepreneurism, then a portion of the investable assets may be allocated to private equity ventures in which family members are participating; however it could be that any venture considered must meet certain viability standards so as not to encourage recklessness.
Unfortunately, the presence of money often exposes insecurities on the part of family members, particularly in younger generations that may feel they have something to prove. The risk is that they frame the thought process regarding investment decisions around these insecurities and a potential outcome is an investment into trophy assets that threaten the long term wealth of the family.
Family governance plays a much broader role in a family’s intergenerational well-being and goes further than just the investment aspect, but it can play a vital role in preserving capital for future generations.
Consolidated reporting
As a family’s capital grows, generally so does their level of diversification – often unintentionally. The problem is that as the portfolio becomes more and more diversified, they begin not only to struggle to get a feel for their overall positioning – which can be conflicting at times – but also just administratively to keep track of which assets or positions are held with often multiple custodians across the globe.
Decision making is made even more difficult than it ordinarily is if you don’t know what your current exposure is. We think the answer is consolidated global asset reporting – a single view of a family’s assets held across the globe, with multiple custodians spanning both public and private assets.
To sum up, whatever the markets may be doing, we encourage our clients not to lose sight of their long term objectives, and to take into account such lesser discussed aspects of family investing as mentioned in this article. By doing so, they will stand a better chance of realising their longer term target returns.
