In my last post (scroll down) I set up the situation: the fourth generation of the Smith family has sold the family business, thought to be worth a little more than $100 million, for $500 million cash. Setting aside debt repayment, taxes and fees, the Smith’s have a tidy $250 million in cash.

You’d think everything would be all sweetness and light, right? Not so much. The family fought bitterly over whether or not to sell the business, and while everyone eventually agreed that the $500 million offer was too good to pass up, there are lots of bruised feelings. Worse, the family was about to find out that owning an operating company is a walk in the park compared to owning $250 million in cash.

It’s now the fall of 2007 and all that money is sitting in money market accounts in big banks, earning nothing. Meanwhile, the stock market is nearing an eight-year high and the family has decided to hire a financial advisor.

As CEO no longer of the family business, but of the newly formed family office, you’ve been advised to conduct an RFP process to find the best financial advisor. That turned out to be a gigantic pain in the you-know-what: all the RFP responses sounded exactly alike. But it didn’t matter, you knew all along you were going to hire the firm most of your friends were using, a big name institution that had been advising the rich for many years.

While the RFP process was moving along at it a snail’s pace, and the markets were going up every day while you sat in cash, all was not well back at the (former) family company. The rollup guys had cleaned house, but good. Just the other day you ran into a dear old friend who’d worked at the firm since Dad took it over – hell, you’d been godmother to his first child. The guy looked right through you, then brushed by you without speaking. Later, you learned he’d been let go with two weeks’ severance and escorted from the building like a common criminal. Well, that hadn’t happened on your watch – at least not directly on your watch.

Once you’d engaged the financial advisory firm, they cobbled together a strategy for your portfolio and promptly got you invested.

“Ah, but wait!” my faithful readers are saying, “Didn’t you just stipulate that the markets were near their all-time highs? Is this really a good time to be jumping into the market with both feet?”

Actually, I didn’t “stipulate” that the markets were high, it’s simply the case that the markets had to be high. This is a crucial point. Fourth generation family companies don’t get sold when markets are low and the economy is struggling. No one has any money then. No, if your family company has just received an impossibly high offer, it almost has to mean that the stock market is high: the hedgies are all risk-on, the corporations’ stock prices are high enough to enable them to buy almost anything, and the PE boys can leverage out the wazoo. So while people can always argue about whether or not the markets are “too high,” if you’ve just sold your family company for a lot more than you thought it was worth, guess what? The markets are too high.

But if the stock markets are too high, why did your financial advisor dump 90% of your capital into those markets (with the balance going into muni bonds)? There are three reasons, each sufficient unto itself:

Reason #1 – Your family is frantic to get invested. The markets are going up everyday and everyone down at the club is cleaning up. Meanwhile, you’re sitting in cash. It’s beyond unendurable. If your advisor won’t get you invested, the family will find one who will.

Reason #2 – Your financial advisor wants to get paid. Suppose the lead guy on your advisory team had set the family down and said something like this: “Look, folks, we don’t like the looks of this market. It’s way too high. Our advice is simple: stay in cash until the market pulls back – way back – and that will be our buying opportunity.” What would have happened? Everyone in the family would have said, “Are you kidding me? These guys are charging us hundreds of thousands of dollars a year to tell us to stay in cash? Let’s hire somebody who isn’t brain-dead.”

Reason #3 – Your financial advisor has no idea what this capital means to your family. Most financial advisors, you won’t be surprised to learn, don’t come from families with fourth generation businesses worth tons of dough. They have no idea how hard it was to build the business, what blood, sweat and tears it took, what sacrifices the earlier generations made to make it what it was. To the advisors, it’s just a $250 million honeypot screaming, “Invest me!”

So, wise or not, you’re going to sell your family business at the top of the market and you’re going to invest all the net proceeds into a market that is about to crash. That’s the way it works.

And that’s the way it worked for the Smiths. True, the market continued to go up for awhile after they got invested, but then it started going down. At first, no one cared. Markets go up and down all the time. The family would simply be “buying on the dips.”

But the markets kept going down and down, and almost overnight – it’s now mid-2008 – you’d lost 25% of the family fortune. Family members were starting to panic. A cousin was  screaming at you over the phone: “Have you gone mad? It took our family four generations to make this money and you’ve p@#!!ed it away in a few months! What would Great-grandpa and Grandpa and Dad have said? They’re rolling over in their graves!”

But you held your ground. The financial advisors were counseling patience, and you were a long-term investor. But while you were holding your ground the stock market was continuing to swoon, and eventually 40% of the family fortune had gone up in smoke. One grim afternoon you received a registered letter from the family’s law firm informing you that, as provided for under §VIII(b)(3) of the family bylaws, you’d been removed as CEO of the family office by a greater-than-two-thirds vote.

The next day all the family’s equity holdings were liquidated, immortalizing the losses. The family, deeply wounded by its brief encounter with the violence of the capital markets, then sat in cash and munis for five years, missing the entire recovery. You and your cousins, to whom you no longer speak, spent those five years suing each other.

 

Next up: How Not to Invest a Fortune, Part 3: What The Smiths Should Have Done

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.