Wealth management for illiquid assets like in your closely held or family business is a big deal that is ignored by too many business owners. I use the term, “Pre-liquid,” to describe this wealth because that’s how you think about it. Your company is with you today, and someday you are going to sell it. Right? Then, it will be liquid wealth. So, today, your wealth is pre-liquid.
Wealth management principles are well established for liquid assets. The picture is quite different when the typical wealth manager encounters pre-liquid assets. The typical wealth manager simply does not know how to address such illiquid assets. They do not fit into any of the typical “investment classes.”
Life insurance professionals have long attempted to work with business owners in terms of preserving business wealth, but their perspective has often been too limited. A new group of professionals, called exit planners, are now working in what is a virgin field.
Regardless, the management of your illiquid wealth locked into your closely held or family business is a big deal for you, your family, your employees and, indeed, all of your stakeholders.
Let’s review what we mean by pre-liquid wealth. First, for our purposes, we are concerned with investments in closely held and family businesses in America. They are called “pre-liquid” because, as are learning, every company will eventually be sold, liquefied in some manner, or transferred. While there are other forms of pre-liquid assets, like real estate, timber and other non-business assets, the focus of this book is on pre-liquid wealth locked up in closely held and family businesses.
Pre-liquid assets either become liquid or facilitate the creation of liquid assets when they are sold (entire businesses or partial sales). Pre-liquid assets generate potentially liquid assets when economic distributions (i.e., distributions net of associated taxes) are made to their owners.
Pre-Liquid Wealth Represents Real Money
We are talking about real money when we mention pre-liquid assets. Professors Moskowitz and Vissing Jorgensen, writing in the prestigious American Economic Review, suggest that the magnitude of private equity and public equity held by households were similar in magnitude, at least through the 1990s, the period of their study.
As of 1998, the estimated value of private equity held by households in the United States was $5.7 trillion. Yes, $5.7 trillion. Inflation adjusted, the number would exceed $8 trillion. In a book published in 2005, authors Richard Jackim and Peter Christman estimated that private businesses worth some $10 trillion would be sold in the next decade – from then.
We know two things, at least about the above. First, there is a huge amount of wealth locked into private businesses in America. We also know that the tsunami wave of business sales predicted by Jackim and Christman has not yet occurred. We had a financial crisis that severely reduced transactions involving private companies in 2007-2008 and we have not returned to pre-recession volumes.
We also know or can infer from government statistics, as compiled by Carey McMann of SME Research LLC, that more than half of all closely held and private businesses in America are owned by Baby Boomers (currently with ages ranging from about 50 to 67) and the still older Silent Generation.
I can also confirm from casual observation of our clients and business owners attending conferences around the nation that this inference of half of owners being older than 50 years of age is pretty reasonable.
I said in many speeches during the 2000s that there was increasing need for businesses to transact or to prepare to transact because so many owners were aging. It is now a decade later and the pace of private business sales has not accelerated.
My point, however, is not to predict a coming tsunami in business sales, but to talk to business owners about the reality of their current situations.
Any way you care to cut it, there is a large and growing group of business owners in the United States that are in their 50s, 60s, 70s, and even older, who will sell their businesses in the coming years, or die in the saddle and burden their families with dealing with their messes.
Henry was in his mid-80s when age caught up with him. After selling below control a few years ago in a leveraged stock redemption, Henry caused the company to continue purchasing shares from departing employees and other shareholders. As a result of these repurchases, Henry’s ownership crept up above 50%.
Henry’s estate will be valued on a controlling interest basis, rather than on an illiquid minority basis. The good news is that his wife is younger and in good health. Hopefully some good planning will take place very quickly so that the control block, which passes to her through the estate, will be reduced to a minority interest.
Most business owners think of their ownership as binary. “I own it now, and someday, I won’t.” Henry never sold his company. And today, he doesn’t own it any longer. Remember the Ownership Transfer Matrix? There’s no way outside the boxes. So it is best to plan what happens inside them.
Simply put, there is a lot of wealth tied up in closely held and family businesses, and a lot of that wealth is owned by Baby Boomers and their parents.
Was the example of Mr. Jones’ portfolio in the this previous post realistic? Listen to the professors:
We find investment in private equity to be extremely concentrated. About 75% of all private equity is owned by households for whom it constitutes at least half of their total net worth. Furthermore, households with entrepreneurial equity invest on average more than 70% of their private holdings in a single private company in which they have an active management interest. Despite this dramatic lack of diversification, the average annual return to all equity in privately held companies is rather unimpressive. Private equity returns are on average no higher than the market return on all publicly traded equity.” (emphasis added)
Do Wealth Managers Help Clients with Pre-Liquid Wealth?
Let’s look at the typical wealth manager’s considerations of liquid and pre-liquid assets for the same clients.
Very few wealth managers are involved in setting investment objectives for the substantial pre-liquid assets held by some of their clients. If they do not help set objectives, it is difficult to be involved in establishing strategies.
Worse, in many cases, the wealth manager is attempting to help his or her client without specific knowledge of what is likely the largest single asset in the client’s portfolio.
Worse still from an adviser’s viewpoint, when clients obtain liquidity from their closely held and family businesses in a “big” sale transaction, they may seek larger, better known wealth managers for this newly obtained liquidity – especially if the existing wealth managers were not involved in the owner’s decision-making process. And this very fact could call the owner’s (or owners’) decision process into question.
I recently spoke to Samantha, a successful wealth planner who works primarily with private businesses in the middle market. She observed that it is extremely rare for any business owner to hold meetings with his key advisers at the same time, and that virtually none of them have any unified concept of what the owner’s financial planning should entail.
“In fact, each of the advisers has his or her own agenda for working with business owner clients, and there is never, well, almost never, any concept of a coordinated program for the business, the owners’ estates, or for transition or succession planning.”
That’s what I’m talking about.
Do owners of closely held and family businesses typically think about their pre-liquid assets as investments? Not if my experience is representative.
The bottom line is that liquid wealth tends to be very closely managed, while pre-liquid wealth is not usually managed very closely at all.
If you are a business owner, you may be thinking: “Why, of course, my pre-liquid wealth is managed. I run the business every day.”
And well you should run the business every day – or better yet, have someone else run it for you. However, that’s not the point at all. In fact, the comment helps make the point.
- Every company, public or private, is managed (to greater or lesser degree). What we are talking about is managing the pre-liquid wealth in private companies and creating strategies for converting that wealth from pre-liquid to liquid form over time through enhanced performance, distributions, partial sales, or ultimately, the sale of the businesses.
- The business owner who manages a business every day tends not to think longer-term about when and how the wealth in the business will be realized. That business owner is seldom thinking about how to use the business to create liquid assets to facilitate diversification away from the primary asset, which is, of course, the business.
The professors quoted previously explain the need to manage pre-liquid assets:
“What we hope to convince the reader is that a complete theory of household portfolio choice should emphasize both public and private equity.”
The fact is that pre-liquid wealth is often not managed at all, and is seldom managed to the degree typically found with liquid wealth.
Disparity Between Management of Pre-Liquid and Liquid Wealth
So, what are some of the implications of the disparity of management of pre-liquid wealth and liquid wealth?
Substantial management fees paid to wealth managers for managing liquid assets. As I am writing, I received the quarterly statement from our profit-sharing and 401-k plan. A quick calculation shows that we are paying management fees of 75 basis points for the management of those tax-deferred funds in our plans.
Little use of investment principles by wealth managers as applied to pre-liquid assets. Few businesses actually calculate a rate of return for their closely held investments each year. Many business owners have never paid a distribution.
Little use of corporate finance tools for private companies. Quite often, privately owned businesses have, to use the language of corporate finance, suboptimal capital structures. Often, for successful companies, this means that the balance sheet is virtually debt-free and has a low return on equity or investment. Later, we will see how wealth, diversification, and better investment returns can literally be created with the use of moderate leverage in appropriate circumstances.
Virtually no “management fees” paid for managing pre-liquid assets. I am not aware of any financial consultants or wealth managers who work with business owners to manage pre-liquid wealth and charge fees based on a percentage of assets under management.
Inadequate attention paid to the management aspects of pre-liquid wealth. Too few business owners have a coordinated plan to diversify their wealth over time and to plan for their need for ultimate liquidity – when they either cannot or will not want to work in the future.
- Inadequate attention to basic corporate finance techniques designed to enhance value. We will talk about a number of these later in this book, but for now, I’m talking about dividend policy, balance sheet management, share repurchase plans, recapitalizations to take funds out of the business while still maintaining ownership, and others.
- Almost no attention paid by business owners to the critical monitoring and enhancing investment principles, and to the reallocation of pre-liquid wealth into liquid form. The professors point out that returns to private company equity are not adequate, on average, from a risk-adjusted point of view. It is easy to get “comfortable” with our businesses and to let important planning and investment principles slide. It is easy to let excess assets accumulate inside your business where they dampen your investment returns and “mess up” your balance sheet. It is easy to avoid paying dividends because you think, in your infinite wisdom, that it is inappropriate for your shareholders (your kids?) to have this source of return. What would you say if the public companies you invest in, directly or indirectly, did the same thing? It is easy to wait or to avoid making important management transition decisions. It is easy to let things slide.
Just to be clear, let’s ask this question directly:
What do many, if not most closely held and family business owners do to manage the wealth tied up in their closely held business?
For many, the answer to the question is “not much.”
If you are a business owner, you probably think you are different and that all of this will work out one day. After all, you can sell the business at any time, right? Well, probably you are wrong, at least at a price that you would like to accept.
Remember that bad things happen to even good companies. If a bad thing happens to yours in the period preceding your need to sell, the difficulty of selling just increased and the prospects for proceeds just decreased. Remember what I said about “Yes, but…” selling.
If you are an adviser to business owners, you know what I’m talking about. So get this post (and the forthcoming e-book) in your clients’ hands and use it as a tool to help you help your clients.