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Depending on which report you read, we are on the cusp of a massive generational wealth transfer of anywhere between $20 and $60 trillion dollars. As seniors in the Silent Generation (born between 1928 and 1945) give way to Baby Boomers, the last of whom turn 60 this year, younger Gen Xers (1965 to 1980), Millennials (1981 to 1996), and perhaps some members of Gen Z stand to inherit large sums.
This phenomenon will not happen overnight and instead is estimated to span a 20-year time horizon.
As a result of the largest wealth transfer in history, there are lots of conversations happening within and between generations on how to best manage the family’s wealth. Entrepreneurs and business owners who created wealth are increasingly interested in engaging their family members to be active participants in managing their assets and the idea of legacy has expanded and evolved with the times.
In fact, this modern view of legacy is the topic of a book written for wealth creators by Robert Balentine and Adrian Cronje, “First Generation Wealth: Three Principles for Long-lasting Wealth and an Enduring Family Legacy.“
It’s predicated on the idea that most people who are creating generational wealth want to steer clear of the “shirtsleeves to shirtsleeves” phenomenon that says that the third generation loses much of the wealth created in one generation.
While it sounds easy in practice to maintain wealth once it has been created, studies have shown that about 70% of wealthy families lose it all by the second generation, and 90% lose it by the third.
The authors of First Generation Wealth write, “Over the course of our careers, we’ve seen clients nail the transfer of wealth. We’ve also seen clients blow it. The fact is, not all the blame of shirtsleeves-to-shirtsleeves lies at the feet of the third or even second generation. First generation wealth creators have a weighty responsibility and a priceless opportunity to influence whether their wealth and legacies defy odds and continue thriving for a fourth gen and beyond.”
One reason the shirtsleeves-to-shirtsleeves phenomenon is so prevalent is that those with newly created or newly inherited wealth often lack the investment experience necessary to protect and grow it, nor has it been modeled for them.
As a result, they are susceptible to the lure of quick-money investment promises. They see news about start-ups exploding onto the scene and imagine the impact that investing in the next Uber, Tesla, or Nvidia would have on the family’s balance sheet (and their legacy of growing it).
Here’s the thing about these kinds of investments: For every early-stage company that goes on to produce outsized, unicorn-like returns, there are hundreds, maybe thousands, of similar companies that raised capital only to flame out and return zero dollars to investors who backed them. Harvard Business School Professor Shikhar Ghose has found from his research that three out of four venture capital-backed companies fail to return initial invested capital and an estimated 30-40% fail with a total loss of invested principal.
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Not all private capital is created equally
Private capital investments refer to investments that aren’t available on the public securities exchanges — in other words, investments that are not made into publicly traded stocks or securities. The “private” in private capital refers to companies, assets, or debt securities that do not trade in the listed markets.
While it’s good to be skeptical of concentrated, speculative bets in the “hottest” private deals, the private markets can be a strong driver of excess return in intergenerational families’ portfolios. The key is for families to make diversified, right-sized investments in partnership with fund managers who have differentiated alpha in the arena they invest in.
Rather than investing in one-off, lottery ticket-style private deals, consider investing alongside managers who have expertise in the companies or assets they invest in.
One way to implement private capital investment is to focus on smaller, sector-focused fund managers who play in more defensive markets. For example, our primary buyout exposure is via a middle-market manager whose strategy is predicated on buying aerospace and defense, industrial, and environmental services companies at conservative valuations.
This means that when rates rise and multiples contract, investors can still achieve their return targets because their investment thesis is not reliant on other buyers being willing to pay a high price. This approach to private capital means seeking to acquire companies at reasonable prices, driving EBITDA growth beyond the point of purchase and expecting an exit that isn’t reliant on favorable macroeconomic conditions.
Admittedly, this is a sophisticated approach to investment that requires discernment from a wealth manager or other experienced advisor to identify and vet the opportunity.
Another approach is to work with other families and family offices who often have a mentality that is focused on wealth preservation rather than creation. By partnering with other investors who have a similar familial source of capital, we can align our risk tolerance and avoid undue investment risk.
This conservative approach to direct investments means that there is a lot of hand-sitting, but when we look back at the pile of the hundreds of deal write-ups we have done over the last half decade and reflect on the “passes” we have recommended, we take solace in the capital we have protected.
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The best deals are sometimes those you don’t do
The highs and lows of private investing over the past three years have served as a reminder to practice patience and stick to a program that works for you and your family. When the next cycle of market over-exuberance presents itself — as it does every ten to twenty years — and you are starting to question if “this time is truly different,” it is a good idea to take a step back, breathe and stick to the program.
While some of these companies will survive and become the next “Uber or Tesla or NVIDIA,” the vast majority will not. Although it lacks the excitement of seeing your investment on the front page of Bloomberg, sticking to a disciplined, conservative Private Capital program will get you to your goals quicker and without the volatility or capital destruction involved in chasing the so-called “hot dot.”
