If you are like many corporate clients of Brown Brothers Harriman (BBH), your single most valuable asset may not be your private wealth management account with us; instead, it may be the value of the equity stake you own in your private business. In BBH’s Private Banking division, we help our corporate and private clients protect and grow the value of their liquid investable wealth as well as the value of the less liquid wealth they hold in the form of a private business. Helping clients allocate their capital across multiple asset classes – including the business they own, when applicable – is among the most important services BBH offers to our Private Banking clients. This becomes even more significant when one considers that well over half of BBH’s wealth management clients currently own or operate a private company or are one generation removed from family members who did so.
In this issue of Owner to Owner, we sit down with Lewis Hart, a senior vice president in our Corporate Advisory & Banking group, to discuss how BBH thinks about asset allocation for private business owners.
Brown Brothers Harriman: How does BBH factor in a client’s private business interests when determining the appropriate asset allocation for the liquid assets the firm manages?
Lewis Hart: Many families think carefully about allocating capital within their business and within their personal accounts, but fewer think about the importance of rebalancing between what may be a highly concentrated position in an illiquid business and a diversified pool of carefully selected, readily marketable securities. We first attempt to develop as full of a picture of a client’s assets and liabilities as possible. Then, we deliver a recommended asset allocation that balances a client’s need for liquidity, appetite for risk and investment time horizon. In many cases, particularly for clients who are still generating substantial wealth in a private business, protecting the company and continuing to produce strong operating performance may actually be the family’s foremost objective. An owner’s liquid assets will be conservatively managed to preserve capital. This does not necessarily mean the portfolio will be 100% invested in fixed income but could mean it will have a below-average equity exposure compared with our typical portfolio asset allocation.
Sitting at the intersection of a business owner’s corporate and personal financial lives will in many cases equip us with the tools to help that client think through how to invest his or her liquid personal assets through the lens of also owning a substantial private company.
BBH’s Partners also think carefully about this issue as the owners of a private business themselves and as private wealth management clients of the firm who choose to invest their own personal funds alongside our clients. They are oftentimes involved in these conversations with clients given their pertinent perspective.
BBH: Let’s consider a hypothetical BBH client who works with us on the corporate and personal sides of our Private Banking business. I own a widget manufacturing business based in the U.S. Midwest region. I have significant excess cash on my balance sheet but don’t want to distribute it because I am looking at several opportunities to acquire competitors. How should I invest this cash?
LH: Our simple advice is to keep excess corporate liquidity invested in the form of assets that are readily marketable and have stable values as opposed to stretching for yield – particularly in today’s suppressed interest rate environment.
Business owners working with BBH have proven themselves to be excellent operators. However, investing financial assets may not be a core expertise for someone whose company’s mission is to make the best widgets, for example, and we help fill that gap. We would be quick to advise against reducing the liquidity profile of a company simply in search of yield.
BBH: How do I know if it’s the right time to distribute excess capital from a private business?
LH: There are a variety of factors to consider on this topic, and no two situations are the same. In an ideal world, business owners should have sufficient operating liquidity to comfortably pay their vendors, meet bank covenant requirements and avoid being forced to take on excessive bank debt.
Since unpredictable problems are unavoidable – for example, a late-paying customer or an unanticipated capital improvement that must be funded in the short term – it’s necessary to always have a liquidity buffer, whether in the form of cash equivalents or an untapped, readily available credit facility.
On the other hand, idle capital can carry an opportunity cost, even in a low interest rate environment. If a business owner cannot identify attractive opportunities to invest in his or her company – whether it’s making an acquisition, starting a new sales office or buying a new piece of equipment – the best option may be to return the capital to shareholders and invest the funds for the long term.1 Furthermore, clients may choose to return capital to shareholders in order to limit personal liability and other risks.
Even the best-managed, consistently profitable private companies carry risks, so owners are well advised to keep some capital “on the sidelines.”
What’s more, just because capital has left a business does not mean it is gone forever. In sectors where capital needs are difficult to predict, such as commodity-driven businesses where working capital needs may change with volatile commodity prices, we will often make personal loans to our clients secured by their BBH-managed assets. Our clients can, in turn, inject the cash into their company as additional junior capital that can be further leveraged.
Finally, while leverage can be pernicious in down cycles and should be carefully managed, maintaining a conservative capital structure with an appropriate amount of debt can free up capital and liquidity for an owner to take out of the business. This capital can, in turn, be invested with the goal of generating a superior long-term return vs. the cost of the debt. As most corporate finance professionals will say, equity is the most expensive form of capital; private business owners should consider replacing equity with debt in situations where the company’s capital structure is heavily weighted to equity. The current interest rate environment makes this option even more attractive, as does the potential tax deductibility of interest expense.
BBH: Since I take equity risk in my business, should my personal liquidity be predominately invested in income-oriented assets?
LH: Even for private business owners, we firmly believe that owning a relatively concentrated portfolio of carefully selected businesses that we know well and that meet our discerning criteria – and owning those businesses at a discount to our estimates of their intrinsic value2 to create a margin of safety3 – is the best way to preserve and grow wealth over the long term. As such, as a general observation, we view a healthy long-term allocation to the public equity markets as the right capital allocation decision, even for clients who own substantial private companies. While we start from this belief, BBH’s relationship managers will often adjust allocations depending on a business owner’s expected liquidity needs so that assets with strong liquidity characteristics and relative price stability can be used to fund any potential capital contributions an owner may need to make to his or her business. Clients with significant, concentrated equity exposure to a private business holding may also be better suited to an underweighted allocation to similar, less liquid alternative investments.
BBH also considers the sector in which a private business owner client operates and may adjust the portfolio allocation to ensure he or she does not have excess exposure in a single economic sector. For example, for a private client who runs a private business in the metals and mining industry, it may not make sense for that client’s equity portfolio to have significant exposure to metals and mining companies outside of his or her business.
BBH: How do I determine the value of my business when estimating my total net worth?
LH: Most business owners have a sense of their company’s value. BBH’s Corporate Advisory Group works closely with clients in helping them through the process of estimating and empirically defending a valuation range of their business, which is helpful to clients when thinking through transitions. In certain cases, the exercise results in clients receiving interest from potential buyers of their business. In other instances, clients simply are interested to know what their company may be worth. While it is impossible to determine the exact value of a private business in the absence of a willing buyer and willing seller consummating a transaction, there are techniques that can be used to establish a range, including comparable transaction analysis and discounted cash flow analysis.
BBH: How should my estate plan factor into all of this?
LH: According to BBH Wealth Planner Brad Dillon, owners of privately held businesses are hands down in the best position to do estate planning. Interests in businesses can be some of the most tax-efficient assets to gift to children or trusts for children’s benefit because of the discounts to valuation associated with the private nature of the business. Importantly, there are many ways to structure the gift such that control of the business is not prematurely surrendered to those who may not be ready or willing to take part in running it. For example, the gift could be limited to a non-controlling interest in the business, or non-voting shares of the business could be gifted. The most important point to take away, however, is that it is never too early to begin planning with business interests. Because gifts of business interests appreciate outside of the business owner’s estate, the sooner the better. For business owners interested in employing these estate planning techniques, it’s important to consider the impacts wealth transfer will have on different generations and the implications for asset allocation between an owner’s wealth in and outside of the business.
BBH: Lewis, thank you for sitting down with us to discuss your insights.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2016. All rights reserved. 2016.
1 For more information on capital allocation in a private business, see our second quarter 2016 Owner to Owner article, “Capital Allocation for Private Business Owners.”
2 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
3 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.