Senior private banking figures who regularly comment about family offices argue that calls to regulate FOs in the wake of the Archegos blow-up are misguided and could do more harm than good.
(A version of this article appeared last Friday our sister publication Family Wealth Report. The topic mainly applies to the US, but as other jurisdictions have often copied the lead of Washington DC in regulating areas such as financial centres, the issues here are highly relevant. The ripples from the Archegos affair have hit markets around the world, and affected a number of international banks.)
Regulators and other policymakers thinking of targeting family offices after the Archegos meltdown may have legitimate worries about this affair, but it is wrong to pillory the family office sector, and the risks arise elsewhere, senior figures in the sector say.
In early April, Dan M Berkovitz, commissioner, at the Commodity Futures Trading Commission, called for tighter regulatory oversight of family offices. Berkovitz said: “Unfortunately, in the last two years the CFTC has loosened its oversight of family offices. In 2019, and again in 2020, the Commodity Futures Trading Commission (CFTC) approved rules that exempted family offices from some of our most basic requirements.” He claimed that he had objected to the change.
With Gary Gensler taking up his post as new boss of the Securities and Exchange Commission, all eyes will be on what regulators might do.
Under the Joe Biden administration – expected to hike taxes on the wealthy – and a Democrat-controlled Congress, there are fears in the wealth industry about the position of family offices. The industry, depending on various estimates, oversees a global total of as much as $6 trillion in assets. (Exact figures are hard to pin down.) In the Archegos case, the business, which was a New York-based hedge fund run by Bill Hwang, did not manage third-party money, and was structured as a family office. As a result, it avoided regulatory oversight from the SEC. In 2019 the CTFC took a similar stance – family offices don’t have to register as commodity pool operators (CPOs) or provide an annual notice to this effect.
A few hedge fund tycoons, such as George Soros and Steve Cohen, had morphed their firms into family offices over the past decade, albeit for different reasons.
Regulating family offices, rather than the individuals who take their decisions and the banks’ lending to them, will be a grave mistake; it will undermine the positive value family offices have in encouraging the use of patient capital, transferring wealth responsibly down the generations and steering philanthropy, Bill Woodson, executive vice president at Boston Private, and leader of its Family Enterprise Services Group, said in a recent note. (He co-authored that note with Richard Perez, a managing director and chief strategist at Boston Private.)
“We believe the concerns expressed by Commissioner Berkovitz, while understandable in that they convey shared disbelief and outrage that this happened, do not accurately depict family offices, the role they play in capital markets, the merits of the regulatory exemptions granted to them, or, indeed, their importance to wealthy families and, by extension, society,” Woodson and Perez said.
“Much reference has been made to the exemption family offices received from registration as an investment advisor following the 2008 to 2009 financial crisis and the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act,” Woodson and Perez continued. “It is, however, important to note that the exemption for family offices from the Dodd-Frank reforms was not because they differ from hedge funds in terms of the magnitude of wealth they control or their trading sophistication. Instead, it was because they, for the most part, do not manage money for anyone other than family members or senior family office executives. And those family offices that do manage money for unrelated third parties must register as investment advisors and/or CPOs.”
Alastair Graham, who founded and runs the UK-based Highworth Research database on single family offices, had told this publication a few weeks ago that the vast majority of family offices don’t engage in the kind of highly leveraged trades of Hwang at Archegos, and that such entities tend to be lenders of credit, rather than takers of it. They tend to be relatively conservative in their investment time horizons, he said. (This is often, in fact, why family offices are targeted by private capital markets operators, because they tend to invest in terms of decades.)
The issue of whether an Archegos-type meltdown brings systemic risk is not an easy one to resolve. Some regulators still recall the Federal Reserve-led rescue of Long Term Capital Management (LTCM) in 1998. That firm had lost billions of capital via what turned out to be wrong-way bets on equities and bond markets. In the Archegos affair, Credit Suisse, Nomura and a number of other banks, including Goldman Sachs, Morgan Stanley, Citigroup, BNP Paribas, Deutsche Bank and UBS have been hit. At Credit Suisse, several C-suite figures, including its risk chief officer, have left and been replaced.
Where the problem lies
In the remainder of their note, Woodson and Perez wrote: “The fact that Archegos was a family office should not be a factor in whether the investing activities of Mr Hwang should be more closely scrutinised and regulated. Family offices are simply extensions of private individuals which, in this case, played a conduit managerial function for a private individual over his own money.”
They cited the arguments of Howard Fisher, a former SEC senior trial counsel, claiming that focusing on family offices, a distinct form of investing enterprise aside from the private individuals who use them, is to “miss the forest from the trees.”
“Mr Hwang could just as easily have made his large bets in his own name, rather than through his wholly-owned family office management company. In this case, shouldn't the outcry be against him, the individual, instead of the entity through which he conducted his activities?” they continued.
“If so, then the focus is not on the entity through which individuals invest their own money, but instead on the systematic risk these large, individual or family, investors pose on others in the securities markets and banking system. The question, then, should be how much risk a private individual should be allowed to take with his or her own money. Or, what mechanisms exist, or should exist, to monitor these exposures as they pertain to public companies. Individual investors take large bets with their own money in both private and public companies,” they wrote.
The authors said that there are already a number of regulatory programmes in place to monitor these bets to help investors and financial services firms avoid or mitigate any systematic risks a large investor might pose, including SEC Schedule 13D, which must be filed once an investor acquires 5 per cent or more in a public company, and SEC Section 16 which requires additional disclosures from officers, directors and 10 per cent shareholders of public companies.
“Regulators are certain to focus on the actors in this tragedy, including Mr Hwang, the prime brokers (who, according to public reporting, failed to accurately assess the total amount of leverage associated with these positions), and the swap mechanisms that were used to obtain high levels of credit. However, the culprits in this tragedy are the actors themselves, not the family office entity through which their actions were conducted,” Woodson and Perez added.
(Editor’s note: in the current environment, it appears that the family offices industry must continue to educate legislators – to the extent that is achievable – about what family offices are and where the risks truly lie. As we saw in the aftermath of the 2008 financial crash, while some valuable changes and lessons were learned, the dangers of leverage, “too-big-to-fail”, conflicts of interest and regulatory arbitrage remain. In the end, if people are risking their own money and not that of others, then if they make big errors, the lessons should be salutary. It is not the job, arguably, of legislators to save people from the results of their own foolishness unless there’s a danger of systemic risk.)