Many businesses families have most of their wealth tied up in illiquid assets, whether it’s the buildings in which they operate or their holding company.
“All the risk is in one place,” says Jeff Noble, director, Wealth Advisory Services, BDO Canada in Toronto.
While this strategy has allowed families to amass wealth and run successful businesses, being illiquid has its downsides. Real estate, for instance, is susceptible to market fluctuations, reputational risk and regulatory changes.
“The key is having sufficient cash flow to meet all existing income needs, plus additional liquidity through marketable securities or lines of credit for emergencies,” says Arthur Salzer, founder and CEO of Northland Wealth Management in Oakville, Ont.
Then there are those families who have had a liquidity event, says Noble — the ones flush with cash who have few illiquid holdings.
Both situations demonstrate why family office advisors often suggest that families diversify their assets.
They likely need cash for estate planning, for big ticket items such as vacation properties, or for offsetting taxes with donations, says Kash Pashootan, founder and CEO of First Avenue Investment Counsel, an investment management firm and family office in Toronto and Ottawa.
Or, they should consider investing in illiquid investments to reduce market risks and reduce volatility. Whatever the case, advisors need to determine the goals of the family, what types of funds they need to sustain their lifestyle, and whether additional capital will be needed for travel, business purchases or charitable donations.
A thorough examination
Advisors need to ask clients to envision their future, says Noble. It’s important to begin with a conversation about what their goals are, what kind of vision they have for themselves and what type of cash their short-term and longer-term plans require. This conversation should also include the client’s expectations regarding investment returns.
Pashootan agrees. “Pro-active planning is required to determine the best course of action,” he says.
Next, a determination must be made as to what proportion of the client’s wealth is illiquid vs. liquid, and to establish how this mix will serve their immediate lifestyle vs. capital appreciation for longer-term goals. Pashootan says his team serves as the family’s CFO, meeting with them quarterly to review how a family’s holdings are distributed – and how much of their net worth is tied up in their business.
He says all financial matters are considered, from simpler items such as paying for the children’s or grandchildren’s educations or helping them buy a home, to multi-faceted issues such as succession planning for the business or how assets such as vacation homes may or may not be passed to the next generation.
Then the diversification plan should be introduced. “We talk with the clients about their appetite for risk and their [distaste for] risk,” says Noble. Some clients feel they take a lot of risk in their business and want minimal risk in their investment portfolio, for example.
He says in cases where clients are looking for more flexibility and risk management, they may want to develop a portfolio that has some liquidity in it. “You can do some balancing and rebalancing to manage your risk and manage volatility and ultimately manage or optimize your returns,” he says.
Salzer says that during the rebalancing process, it’s important that advisors consider that not all private market investments have significant amounts of illiquidity. “Many hedge funds are liquid in 45 to 90 days, others may have lockups for two to three years, and real estate and private equity partnerships could be a decade or longer in lifespan.”
In the case where a client has sold the business and has plenty of cash, “at that stage it’s about how we build an investment portfolio that’s diversified and provides them exposure to different asset classes,” says Pashootan. The goal in this scenario is being able to generate an income for the client that doesn’t encroach on the capital – they are living off of the investments’ return.
Estate planning, philanthropy are key considerations
Families with the bulk of their wealth tied up in a business must have cash on hand for tax obligations upon death, Pashootan says. Failing to have adequate reserves could jeopardize the future of the business.
“There are two tax returns that you file for when in the year that you pass: one is your annual tax return, and one is your terminal return,” he says. The terminal return means that when the business owner passes away, “tax on all of their assets has to be paid before it goes to the next generation,” Pashootan says.
He uses the example of the founder who passes away with the book value of his business at close to zero.
“But the market value of that business is now $150 million, and you have a capital gain of $150 million,” he says. “And with the capital gain inclusion rate going higher, that essentially means that you have even more tax to pay on it.”
In this example, the estate would have a tax bill of $53 million that year, Pashootan says.
Even ultra-high-net-worth families can face a cash crunch, he says. He said he’s seen families have to sell off their businesses in “shotgun sales” to pay these liabilities.
Pashootan uses the example of a family that has stocks worth $10 million, with an initial purchase price of $1 million. This means the family has capital gains of $9 million. To avoid triggering a big tax payout at death, he says the family could donate those assets to the charity of choice.
“The charity of choice gets the benefit of the full $10 million,” he says. Moreover, the move transfers $9 million to the business owner’s capital dividend account, allowing the family in the future to extract $9 million from their corporation without paying tax.
At the end of the day, Pashootan says, most families should develop “a whole portfolio that has some liquidity in it. You can do some balancing and rebalancing to manage your risk and manage volatility and ultimately manage or optimize your returns.”
And the holistic, integrative approach of a family office can make that happen, he says. “You’re not looking at something from a pure investment perspective, or a pure tax perspective, or a pure estate planning perspective,” he says.
“When the business owner, whether liquid or illiquid, is talking about something that’s of concern or something that’s an opportunity, or you need to end up with a solution that considers all facets – and not only considers them in isolation.”
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