Author: Jordan Waldrep, Chief Investment Officer, Trust and Wealth at Bank OZK

Introduction to Illiquidity Budgeting

Family offices face a unique set of challenges in the world of investing. Unlike endowments or pension funds, which have well defined, actuarily determined liabilities to meet in the future, a family office serves the needs of a specific family with different generations and spending patterns that make future cash demands difficult to forecast. A family office can plan for future liabilities and then suddenly face a major real estate purchase, a new philanthropic pledge, a new business opportunity, or just an unexpected life event within the family. This unpredictability arises from the unique and multifaceted considerations of the family and makes focusing on liquidity a vital part of the family’s wealth management. Specifically, in the modern world of investing, it is a question of how the illiquidity within the family office’s alternative investment portfolio is thoughtfully sized considering the broader portfolio and cash flow needs over the short and long term. Importantly, there are lessons in illiquidity budgeting that can be applied to individual investors as well.

Illiquidity budgeting is the disciplined process of determining how much of a portfolio can be prudently committed to assets that cannot quickly be converted to cash without facing substantial losses. This has become an important and misunderstood tool in family office portfolio construction. When done poorly, a family office can become hamstrung by the illiquidity of past investments. When it is done well, it allows the family to capture the return premium of illiquid assets to generate better long-term returns for the family while still preserving the flexibility necessary to meet the unpredictable needs of the family.

The Importance of Illiquidity Budgeting for Families

Illiquidity budgeting is a key part of planning for pension funds and endowments, and it is just as important for families. The difference is, as we said, the unpredictability of family liabilities. This creates positive and negative aspects for the family office when compared to institutional investors. The key advantage is timeframe. A family office can plan for multi-generational growth and can consider locking up assets for longer timeframes than many institutional investors can consider. Families can absorb longer lock-ups or investment horizons than an institutional investor with significant near-term obligations. This translates into a smaller universe of potential investors and thus less competition for such long-duration investments, increasing the potential for greater returns over time. Another key advantage for most family offices is flexibility, as they often do not have the same kinds of direct obligations that a pension or endowment must meet. This gives them more flexibility with their illiquidity budgeting over time.

Click here to read the full article.