The highly concentrated and illiquid nature of a large family business creates significant portfolio constraints that make wealth management more complex and comprehensive than traditional asset management. The authors introduce an asset/liability management (ALM) approach commonly used in pension funds as a framework for private wealth clients that incorporates the value and risks of operating a business. Assets, including the family business, are matched against the liabilities and financial goals (implied liabilities) on a family’s life balance sheet (which includes the family’s assets, liabilities, and net worth). The authors use a detailed case study of a hypothetical ultra-high-net-worth private client to illustrate the application of the ALM framework and implications for portfolio management.

The typical Markowitz mean–variance optimization (MVO) approach to asset allocation has served wealth managers well, if one assumes that returns, volatility, covariance, and risk tolerance can all be estimated accurately. MVO, however, has its shortcomings, including that it ignores tail risks in the market and an investor’s liabilities (because it is an asset-only approach). The authors adapt a common institutional tool used in private client wealth management and introduce a framework for considering the influence of a family business on asset allocation. As in pension funds, the magnitude and character of a business’s correlation with the overall market naturally influence acceptable risk tolerance and portfolio construction.

Leverage on a family’s life balance sheet, represented by the size of assets relative to surplus wealth, has implications for investment risk and portfolio management. Greater leverage leads to lower risk tolerance. The authors’ framework begins with assessing a client’s leverage, substituting it for the risk-aversion variable in the MVO equation, and solving for the optimal overall asset allocation. Next, the client’s human capital is accurately characterized. For an ultra-high-net-worth client with a family business, that capital can be much more like equity than a typical employee’s bond-like future salary stream, although it depends on both the client’s risk tolerance and the risk profile of the operating company. When human capital is more like equity, the client’s allocation of financial assets should likely be more conservative.

All assets are then matched with or assigned to each liability (or investment goal) according to priority. To minimize exposure to the family business asset, lower priority goals and/or discretionary wealth (surplus) should be matched first. High-priority investment goals are best managed by minimizing the volatility of the surplus (i.e., the relationship between assets and liabilities) and not the volatility of the assets alone. Therefore, high-priority goals (e.g., maintaining the family’s lifestyle) need not necessarily be achieved entirely with bonds. Risk-free assets might not be characterized solely by volatility in the ALM approach but rather by their effectiveness in hedging the client’s liabilities and investment goals. Although there are multiple approaches to minimize the volatility and hedge the influence of the family business, one approach is to hedge the industry risk that the high-priority investment goals are exposed to.

The authors rely heavily on the concept of the family life balance sheet from Wilcox (Journal of Portfolio Management 2000 and Journal of Wealth Management 2003) and Wilcox, Horvitz, and diBartelomeo (Research Foundation of CFA Institute 2006), which define and describe implied assets and liabilities for the private client (e.g., future wages and expenses). They use a hypothetical case study of an ultra-high-net-worth private client with a large operating family business to illustrate the application of an ALM framework that incorporates the family life balance sheet.

The authors present a clear and concise illustration of the merits of using the ALM framework for private clients with a family business. Through their use of a detailed hypothetical case study, they describe several important considerations that almost all wealth and asset managers would find useful, regardless of whether their clients have an operating family business.