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Horizons: Family Office & Investor Magazine

Dominik v. Eynern: Managing Family Risks Systemically

Monday, September 19, 2022

Dominik v. Eynern is a founding member of Family Hippocampus and comes from a business family which is now in its 5th generation. He holds a BSc in Economics and a MSc in Finance, worked in the international investment banking industry, and co-founded a family office.

His research is inspired by insights from behavioural economics, cognitive neuroscience and dynamic complex system and chaos theory.

Family businesses and enterprises are the oldest form of business organisation, which to this day is of systemic relevance. Family dynamics exert significant influence on business performance and the socio-emotional wealth of a family (Family Effect), which has profound ripple effects. Family Hippocampus is a NPO aiming to contribute to the preservation of the business family culture by supporting family dynamics, helping families to use the advantages of the Family Effect while reducing the associated disadvantages.

Business Families

Business or enterprise families consist of individuals that are bound by bloodline or alternative (quasi) legal bonds like marriage/life partnerships that exert significant influence on- and make collective decisions about mutually owned assets respectively are exposed to the associated risks. Assets may be held in an operating family business or in a financial portfolio e.g., wrapped in trusts. When family members are working in the family business or enterprise it adds complexity. The main task at hand is to manage all associated risks in conjunction.

Family Risks

Family wealth can be depicted as a non-linear utility function of socio-emotional and financial wealth, which a family seeks to maximise. But where there is light, shadows can be expected. We call this ‘family risk’. A family office typically assists the family with risk identification, risk analyses and optimal risk responses to mitigate family risks across all risk domains.

Let’s adopt this functional view for the matter of this article:

‘Family Office ≝ Family-Risk Manager’

Typical family risks are a non-linear combination of Financial Risks, Operational Risks and Behavioural Risks – the three family risk domains I will briefly discuss in this article before I contemplate possible solutions to the problem.

Financial Risks:

In essence, this is an asset-liability problem. The family and individuals have short, mid, and long-term expenses that need to be financed by the current asset total base. To preserve financial wealth, the asset base must be invested to produce sufficient risk and inflation-adjusted returns with suitable liquidity profiles.

Financial risk-management includes the management of cash-flows of investments and the planning for contingent liabilities. Investment activities are to be coordinated to introduce true diversification based on risk-behaviours rather than on narratives.

A coordinated risk overview and the utilization of economies of scale leads to risk- and cost efficiency and thus, supports the family to meet their financial goals.

Operational Risks

The process of how assets are invested or divested, especially in the non-liquid / non-standardised domain such as real estate and private equity must be carefully managed. Where assets are held is important in terms of security, tax efficiency and legal compliance which usually is offered by custodians, tax advisors and law firms. Ex-ante planning and ex-post management is crucial, but so is monitoring, on the private as well as on the family-business side. Tax and legal provisions change, and people are globally mobile, moving and changing jurisdictions for educational, professional, or personal reasons. The implications are manyfold in terms of legal & tax compliance, respectively the operational efficiency of investments.

Operational risk management also includes the creation of transparency i.e., the overview of all assets, locations, jurisdictions, returns, risks, and costs etc. across all levels in a convenient manner, including the book-keeping and record keeping for further reference and generations (document management). Another aspect of operational risk management is the physical and cyber security from a technical standpoint. However, most issues regarding this matter belong to the behavioural risk domain.

Behavioural Risks

It is the greatest risk exposure of all and the hardest to manage. Studies show, that failed transgenerational wealth transitions are caused by behavioural risks in over 90% of the cases. 60% of the families call a break-down of trust and communication the reason for their demise, 25% claim it was the lack of preparedness (succession planning) and another 10% think it was a lack of common vision1. Thus, behavioural risks are the biggest risk any family has, and it is asymmetric in time: families build socio-emotional as well as financial wealth over centuries and decades, but they only need a short period of time to destroy family wealth!

Family Risk Management [FRM]

Families are different, but they all must deal with the three family-risk domains that are highly interrelated and interconnected. We can view ‘family risks’ as a portfolio of risks that in general a family is exposed to.

A family office needs to hedge the family risk portfolio by constructing a suitable portfolio of services that dynamically mitigates the family risk portfolio with error δ:

With δ > 0 under-hedged, i.e., services are not rendered but are required leaving the family with risk exposure, and δ < 0 over-hedged, i.e., services not required are rendered, leaving the family with unnecessary costs.

A perfect hedge is difficult to achieve, so a family office should work towards a satisficing condition i.e.,

δ should converge to zero:

1Preparing Heirs: Five Steps to a successful Transition of Family Wealth and Values; Roy Williams, Vic Preisser

A Non-Linear View

For δ ? 0 we first need to understand the dynamics of the family risk portfolio and adopt a holistic, non-reductionist view. It is a departure from what we have been indoctrinated with since the French philosopher and mathematician Rene Descartes separated mind and matter which was later expanded by Isaac Newton. This reductionism follows the belief that all aspects of complex phenomena can be only truly understood by reducing them to their smallest constituent parts. Systems are broken down to the smallest units to analyse and arrange these in their logical order.

However, this leads to system errors, which is associated with solving the wrong problem precisely, because the problem formulation occurs out of context and ignores that the whole is greater than the sum of its parts. We need to adopt this holistic view of which Aristotle was an early proponent.

Social systems such as families are dynamic, complex social systems that consist of many hierarchically organised, nested sub-systems (fractals and holons). The individual is the smallest sub-system that iteratively connects with other individuals and patterns of relationship emerge on a micro- level according to the self-organizing principal. The patterning morphs into a structure (macro-level) that recursively influences the pattern of relationship on the micro-level. This interplay fundamentally describes complex system dynamics.

All patterns of relationship are path-dependent, irreversible, reflexive, and self-referential with reinforcing (diminishing) feed-back-loops. Because of individually different mental models of the world and the associated, distinct realities, pattern-dynamics build up tensions, which is followed by tension-releases, followed by tensions etc. We tend to ignore incremental changes, so they often compound to symmetry breaking quantum changes, i.e., impulses come in bursts through oscillations with increasing (decreasing) amplitudes, which can reach breaking points that initiate qualitative system-changes. As a result, dynamics don’t seem to be continuous but come in fits-and- starts.

Social systems are prone to chaos because they are closed, as they feature very limited freedom degrees through social norms, which is more profound in business families than in other social systems. Cause and effect are not clear and when we think we understand the system, it has already changed. It is like going through a maze and the walls rearrange with every step you make. However, causal knowledge is central to our ability to analyse, make predictions and plan.

These patterns of relationship are not confined to the Behavioural Risk domain but extends to the other family-risk domains and extends to the service provider portfolio, which a family office must curate to mitigate family risk.

So, to converge δ ? 0 is a tall order since we humans are limited in our ability to grasp and process information that is needed to manage dynamic, complex systems consisting of human beings. It requires a tremendous amount of data and intelligibility along the time continuum to understand the dynamics of the system. This is important, because when we look at a system, we only can see a snapshot of it that seemingly looks static. The logical second after the observation point, the system has already changed. On top, observers are inevitably part of the system they observe and thus, influence system-dynamics.

Another challenge is, that we are dealing with ‘inert matter’, because it’s human nature to resist change, even though there is nothing more constant in life than change.

How can we overcome inertia and achieve δ ? 0?

Risk Identification, Measurement & Analysis

Behavioural Risk is the key system-leverage point: It is the dominant risk factor which propagates through all other risk domains that feed-back to the behavioural risk domain. Thus, the greatest risk to family wealth is the family itself!

Like in any corporate risk management approach, we need to identify and analyse risks. But family heads often resist dealing with behavioural risks in detail because it is not tangible.

Risk identification, measurement and analysis is well established in traditional risk domains which we can model, but not so much on the behavioural risk side in the context presented here. To quantify and benchmark behavioural risks on a social-system level we could calculate a Value at Behavioural Risk [V@BR] that gives a dollarized indication about the potential loss related to materializing behavioural risks. The measurement of current antagonistic respectively synergistic forces in the family system could be performed with a model we develop and call ‘Behavioural Risk – Applicable Monitoring System’ [BRAMS]. The inputs are derived from questionnaires and a multiplayer ‘Serious Game’ family members play on their home computer.

Once family heads understand what’s at stake, they can choose to accept or mitigate the behavioural risk inherent in the family system. But the V@BR should convince the staunchest m/patriarch to hire a ‘behavioural risk manager’ to mitigate the behavioural risk exposure, since losing money feels twice as bad as it feels good to make it, as Daniel Kahneman et. al established with their Prospect Theory2.

BRAMS can help to overcome the inertia to act, as I illustrate with the Miller family in the example box below:

2 https://en.wikipedia.org/wiki/Prospect_theory

EXAMPLE BOX: The Millers

The Millers have been in the shoe business for 2 generations. Arthur Miller started the business as a cobbler in Nottingham. His trademark was to be very friendly, reliable, and service orientated. His speciality was that he always made sure customers paid the best price available. They expanded from a one-shop trader and opened several other stores. After the war, cheap shoes were in high demand, and he started to mass-produce shoes.

When the second generation took over, they started to produce shoes in cheap labour counties and massively scaled up the business, but sadly, the 2nd generation was forced to sell the business to a strategic investor.

The 3rd generation was distanced from the original business ever since and couldn’t convey much of the business story to their children. Since then, the family has pooled the financial wealth in a family office.

They meet once a year for the AGM, but not everyone shows up, especially the next generation. Some even block decisions, just for the sake of it. They don’t have a family constitution, but a family head called Antony ‘Ant’ Miller who is calling the shots and holds most of the capital and he derives some entitlement from this fact.

Ant met Jane Parker in May 2015, a family advisor who was introduced by their family officer who met her at a conference.

Ant would listen to her stories, where business families similar in size and wealth disintegrated and lost a great deal of money to lawyers and courts. The socio-emotional wellbeing was eroded. All because there was a lack of cultural cohesion. Family members did not care to work with one another, were free-riders and harmed each other e.g., by blocking agreements against their own interest.

An economic crisis struck and tipped the family system into a transition phase which ended in chaos. The family couldn’t handle the transition phase, and everyone was playing the blame-game. After many painful and expensive years, a considerable amount of assets had to be sold at low prices, split up and individually invested after the courts gave green light. The several financial institutions and advisors re- invested the assets at higher prices, i.e., in fact, the family paid high bid-offer spreads, and on top, had to pay higher service costs (loss of economies of scale). In addition, most family members suddenly couldn’t get access to the good deals, because they lost the ‘AUM fire power’ they had previously (opportunity costs).

Ant thanked Jane for her illustrations and replied: ‘trust me my dear, we are very different as a family, and I have everything under control’.

Jane asked if Ant would be happy to put it to the test. Convinced that he would win this argument, Ant consented and the whole family went through the BRAMS process within the comfort of their homes. After the family played a multiplayer – ‘serious game’, they answered a questionnaire and immediately saw the result in £ simultaneously: They had reported a financial wealth of £1bln which was weighted with the outcome of BRAMS – a pseudo probability Φ of losing wealth linked to materialised behavioural risks.

According to the result from BRAMS, the family had a 65% probability to lose their wealth, which amounts to and expectation value of -£650mln! The behavioural risk adjusted wealth of the family was only £350mln. Even though the result was hypothetical, it starkly remined them on the family Jane has spoken about.

Ant hates losing money, more than he likes to make it. Other family members also didn’t like the prospect of losing that much wealth to behavioural risks and found their behavioural risk adjusted wealth discomforting.

Ant has now a choice which he did not have before. Knowing what he knows now, he can choose to either accept or to mitigate the behavioural risk, however, he can neither avoid it, nor can he hedge it in the insurance market.

This is important because family heads are used to having choice and make strategic decisions. But if Ant wants to preserve the family and himself from losing a significant part of it, he needs to act and mandate Jane to help him.

He called Jane after the summer and mandated her with the required behavioural-risk mitigation. Jane’s social system intervention started with making the family system more congruent before formal family governance documents like a family constitution and ancillary documents where discussed.

Today, everyone feels more connected and secure. All are content with a positive change in their socio- emotional wellbeing, feel mutually accepted and more resourceful as a result.

Everyone comes to the AGM and the family officer is happy to have a more synchronised family she serves. Now it is possible to get everyone’s agreement after constructive discussions on short notice that allows her to act with agility, which is essential in a world of VUCA.

The improved family dynamics will lead to greater socio-emotional and financial wealth Now the family system has sufficient adaption capacity to bounce back from shocks, respectively to come out stronger at the other end for generations to come.

This story is fictional, names are invented. Any resemblance with real events is coincidental.

As illustrated in the example, once the inertia to act on behavioural risks is overcome and mitigated by transforming the antagonistic patterns of relationship to predominantly synergistic dynamics, more efficient social-system outcomes are possible. The danger is to adopt a static view. Behavioural risk mitigation is an ongoing process, must be managed time dynamically and embedded in constantly changing contexts of financial- and operational risks.

The next question is how to operationalise family governance, bring it alive and manage all 3 family risks along the time continuum?

Integrated Risk Management of Complex Social Systems

Managing dynamic, complex systems i.e., achieving δ ? 0 requires an integrated, iterative approach, because of the non-linear nature and the many emerging properties that may arise. All family risk domains must be addressed, combined, monitored at a micro level and at a macro-level as a portfolio of risks, because it is essential to work with the non- linear dynamics within a risk domain and the non- linear, relational dynamics between the risk domains, respectively the various impacts on the family system.

I always wished for an integrated, systematic approach to manage complex social systems with the various, constantly moving and covarying parts systemically.

At one of the great Prestel & Partner Family Office Forums, I came across the DECOMPLEX model. Like BRAMS, it is in development and will support the enactment of formal family governance and takes frequent family-system temperature checks which allows for a dynamic risk mitigation i.e., δ ? 0.

The combination of DECOMPLEX and BRAMS aims to systematically support the systemic management of family risks and to iteratively engage family members to strengthen synergistic forces for greater cohesion. It will reduce perceived information asymmetries (the main reason for conflicts!), support expectation management and increase the perceived transparency in the system. Furthermore, it will make unstructured information laid out in the family constitution operational and provide information about the emerging state(s) of the family system respectively family members for predictive maintenance. It aims to empower the family system to learn and stay integrated during transition phases.

Both – DECOMPLEX and BRAMS are work in progress and we’d invite family members to learn more about what we are building, and we are open for your input to make sure, we have a full set of information of the complexity across all levels that need to be managed.

Summary

Family risks are a non-linear system of Behavioural Risk, Operational Risks, and Financial Risks with complex dynamics intra- and inter risk domain, that need to be congruently and dynamically hedged with dynamic portfolio of suitable services.

To influence the outcome of a system, we need to understand its dynamics and start with the greatest system leverage i.e., Behavioural Risks which need to be identified, measured, and analysed e.g., with the help of BRAMS and mitigated by social-system interventions.

The outcome of social-system interventions is a more synergistic family system plus a family constitution that needs to be continuously enacted. It is essential to analyse relational system dynamics intra- and inter risk domains. The enactment and monitoring could be facilitated with the help of IT through e.g., the DECOMPLEX model.

A combination of the BRAMS model and the DECOMPLEX model will allow for a sustainable achievement of δ ? 0, because both models will efficiently support the management of dynamic, complex social systems.

 
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