Robert R Patterson is a member of FBN in Lausanne and is a Principal of ASC Advisory Group, Charlottesville, Virginia, USA.
Note: The article is based on several real-life cases, but names have been changed.
Good corporate governance should extend to all areas of a family business, including its philanthropic ventures
Lise had just returned home after attending a meeting in Paris of the OECD Special Committee on Corporate Governance. As a member of the fourth generation of one of the largest family businesses in Europe, she had decided to participate in the OECD meeting as part of her generation's commitment to a broader range of issues.
She had learned a great deal about corporate governance, particularly about the positive influence on corporate earnings and the quality of the work environment. In light of the Enron scandal in the US and the questionable dealings of some publicly-held companies in her own country, Lise was certain that good corporate governance should be a significant focus of her family's efforts.
The Family Foundation, now in its 15th year, held more than €300 million and was the primary vehicle for the philanthropic endeavours of the family. Lise began to realise that good corporate governance could extend to the Foundation, and she decided to focus on the fiduciary aspects of financial management and oversight inherent in corporate governance.
Since the purpose of the Foundation was to manage the money for the beneficiaries, it made sense to focus on what Lise, as a fiduciary, had to do to add value. Like a financial or operating audit, Lise felt that the Foundation needed its own fiduciary audit. She narrowed her approach down to four steps: analyse where the Foundation stands now; design an optimum portfolio; implement a refined investment strategy; institute an ongoing process of monitoring and supervision.
Step one: analyse the current position of the Foundation. How does our approach compare to others of a similar nature in Europe and internationally? How do our governing documents compare with those used by "best practices" in other countries? What impact have the changes in the EU made on our approach to managing risks and returns for our investments? Are we receiving the best return for the money spent? As part of our commitment of investment in those countries in which we do business, how does our investment approach reflect that commitment? For those countries that do not have an active capital market, how do we invest to the advantage of the local community?
Step two: design the optimum portfolio. What is the best combination of asset classes, investment styles and currency/country allocations for our needs? What are the specific responsibilities of the Foundation's board and how do they differ from those of the operating company board? How do we account for political and social risk? What objective criteria do we use to evaluate the probability of success in our planning?
Step three: implement the refined investment strategy. How do we select those vendors that best reflect our values? What sort of quantitative criteria do we use to assess the added value? What approach do we use to assess the social investment costs and balance the risk with our corporate commitment to local investment? How do we account for the movement of capital from one country to another?
Step four: monitor and supervise. What controls do we put in place to mitigate the risks involved? How do we ensure that our strategy is sound, that our vendors are the "best-of-the-best" and that we meet our social obligations? How do we monitor the vendors going forward? What sort of criteria should we use to replace a vendor?
It had been a long time since such questions had been asked and many of the issues had never been brought up for discussion at all. Lise now felt she had established the basis on which to proceed. With a disciplined approach toward the design and development of policies/procedures for the Foundation, Lise felt that the next step was to do their own internal audit. She selected an independent firm that specialised in fiduciary audits and gave it full access to the Foundation's records.
The audit took six weeks to complete. The outside firm contacted each investment vendor and asked them to provide details of their investment management activities. In particular, each vendor provided:
- Details of their investment style;
- Procedures to manage risk;
- Quarterly investment management returns for the past 20 quarters;
- An outline of costs.
The results of the surveys were collected and each vendor was matched with his peers. The total results were also compared with similar sized foundations on an international basis.
The results did not surprise Lise. She was aware of the broad reach of the Foundation and she knew that the growth of the family company, particularly in South America and Africa, meant that the investment issues had become more complex. Corporate policies set up for a local firm did not fit the needs of the developing global family enterprise.
Recent changes in the European Union, the financial uncertainty in Asia and the growing discord among the countries of the Middle and Near East meant that the policies and procedures set in place for early 20th century philanthropy were no longer adequate for a 21st century enterprise. Lise called a meeting of the Foundation's Board of Governors to review the results in detail.
"It seems to me," Lise began, "that we are ready to build on the foundation that the current generation has provided us. Much of what has been done has kept us out of trouble during the 1990s. However, I see some areas where we can make improvements to the benefit of all."
The first areas Lise discussed with the board covered the Foundation's investment policy and the management of information. As in the family business overall corporate governance structure, Lise felt that there needed to be better controls in the processes.
The Investment Policy Statement
The current Investment Policy Statement (IPS) focused on what types of investment the Foundation should use in its portfolio, and outlined the performance expectations. The Foundation could, for example, invest in any capital market as long as there was sufficient liquidity in that market. Markets with currency controls were to be avoided unless some form of currency/country hedge were developed, and the Foundation was prohibited from making any direct investments in private enterprises in certain countries.
Although the criteria used to select the various vendors was mentioned, there was little specific detail and Lise felt that a set of objective criteria was needed. For a corporate governance policy to be effective, she knew that it should be above reproach or family politics.
Management of the information
Currently, the investment vendors reported their results directly to the firm's Managing Director of Finance (MDF). The MDF in turn reconciled and consolidated the information and then prepared the reports for the board of directors.
The focus of these reports was generally on the performance of the managers versus the market indices. Few members of the younger generation were included in the distribution of the reports and even fewer members of the family had direct access to the MDF, let alone access to the account information.
Lise felt that a more open and transparent form of reporting was in order. A single bank was selected as the central clearing house for the financial details. All the manager reports would be processed by this clearing house (also known as a central custodian) and the results made available on-line to those authorised by the Board to gain access.
Besides the facility of having one place to go for the information, the use of a central custodian minimised the costs associated with using separate reporting approaches. Lise could see where the money was being invested and develop a better sense of whether the Foundation was meeting its corporate commitments.
The next area that Lise reviewed concerned the reallocation of the assets and procedures to help manage issues of risk. Lise knew that the asset allocation policy of the Foundation was reflected in its conservative nature and the company's roots in Europe. The discussion on the investment policy was enough for the board right now, so Lise had the time before next month's meeting of the board to prepare recommendations on asset allocation.
Lise decided to contact some old friends. Her first call was to Professor Grubner, her former finance tutor, to seek his advice on asset allocation. His advice was wise as always: "The first thing to remember is that there are many managers in the market – some 4,000 – and you can pick the best if you keep your mind open to the possibilities. The second thing you need to know is that there are many styles and combinations of styles of management that might work for you."
The next call Lise made was to a classmate from business school, John Svenska, who specialised in helping organisations develop investment strategies and select managers for privately held funds. John helped Lise define the investment styles she wanted. They agreed on the following minimum criteria:
- Must be a bank, independent investment advisor, unit trust and/or insurance company.
- Must have managed at least €100 million for at least five years in a multi currency environment.
- Investment performance must be above median of peer group for three out of the past five years.
- Risk profile must be above median for the last three and five years.
- Costs must be below median of comparable fund managers.
Lise set out her strategy in a memorandum to the Board. "Meeting our fiduciary obligations under the rubric of financial corporate governance," she wrote, "will reflect our ongoing commitment to being stewards not only of our own Foundation, but of the legacy of social responsibility that our family has developed over the last three generations. Where we once started with little to contribute back to the community, we can now offer financial assistance, as well as experience in developing objective professional standards for the management of private foundations that can transcend the generations."