Behavioural Risks in Successions and the ‘Lucky Warrior’
‘Every Kingdom has a lucky warrior’ said Prince Michel of Yugoslavia in a panel discussion at the 6th Global Family Office Summit, hosted by the Ritossa Family in June 2018.
I like this expression very much because it implies that to create fortunes, it needs someone who is brave enough to take risk and it insinuates, that luck is of the essence. We tend to forget the contribution of luck to wealth and overemphasize our perceived skills. Our lucky warrior is endowed to what he has created: a kingdom and a family to which he wants to pass on the kingdom one day. Sometimes it isn’t even a kingdom at this stage but a fiefdom which, over generations expands into a kingdom. This brings us to the topic of succession planning. Our lucky warrior is the founding entrepreneur and patriarch who wants to pass on the financial wealth to the next generation. Usually, succession planning is dominated by lawyers and tax advisors who help structure the wealth transition. To involve these disciplines is important, but what about the behavioural risks? After all, financial wealth cannot be created without the contribution of individuals (human capital) respectively the ability of humans to contribute collectively and make human capital more efficient (social capital). It is conceivable that if human capital and social capital are at the core of financial wealth that they also can be the Achilles heel. The patriarch and his family live and die by the very sword that can cut the heel. These are behavioural risks all families face. They can ruin successions, regardless of what the professional tax and law advisers hatched out.
In this article I will highlight some of the behavioural risks we need to address in every wealth transition, independent of the format (i.e., operating business or other containers of wealth and risk)
The transition of wealth be broken down in two problems:
1) The allocation of wealth
2) The governance of wealth
The allocation of wealth
Let’s assume we have two players, the patriarch and his daughter and he is about to share the pie. Because emotions get in our way, we cut them out and assume two rational players. The patriarch makes an offer of α: 0 < α ≤ 1 and the daughter can either accept and the patriarch keeps (1- α) or the daughter refuses to take the offer and the patriarch donates his share (100%) to charity. In this case both, the patriarch and the daughter end up with nothing (0).
A purely rational daughter would accept any α > 0 because it is better than nothing. Many experiments revealed, that human beings do not follow the prediction of that so called, Ultimatum Game. Instead, probands refused the offer of α < 0.2 half of the time and punished the patriarch at their own cost. The acceptance rate in these games rose for α: 0.2 < α ≤ 0.5[1]. This shows us that human beings have something like a ‘fairness preference’ and retaliate when they feeltreated unfairly at their own expense (altruistic punishment). Researchers even found, that human beings derive pleasure from punishing others as it stimulates the reward centres in our brains. None of it is compliant with the assumption of being rational.
What can we learn from that for our allocation problem:
1) We prefer to be treated fairly
2) We feel treated fairly of unfairly
3) We like to punish those who we feel treated unfairly by
Fairness is an emotion. It may be against common believe, but emotions are not innate nor do they have unique fingerprints e.g. in our facial expressions or location in the brain[2]. Fairness is a perceiver-dependent experience. When we categorise our feeling as ‘unfairly treated’, we are looking for revenge which may manifest itself also in non-monetary actions that could lead to loss of e.g. reputation for the patriarch and the rest of the family (reputational risks!).
But how do we create emotional concepts like ‘fairness’?
Human beings have four basic feelings (affects): It feels either good or bad or we feel aroused or calm. Based on these affects, we create an affective reality where feelings become facts and we act on them (affective realism). But evolution has equipped the human race with creating emotional concepts that we use to categorise our feelings depending on context and our goals. The creation of these emotion concepts as part of our personal and social reality is driven by our belief-system, as well as others and become an integral part of us. Belief-systems are mental representations of our world that drive human beings and these systems can differ significantly from individual to individual as well as over generations in the same family (belief-system asymmetry). We humans tend to be ‘trapped’ in our different belief-bubbles, which can hinder agreements e.g. on what is ‘fair’. After all, ‘fairness’ is a socio-emotional concept which is constructed by our belief-system which has many influence factors: social environment, upbringing, education, cultural evolution etc. Emotion concepts are also handed down from generation to generation which is highly relevant, especially in a primogeniture succession context, which is still prevalent in the world of aristocracy. In this case it is fair what has been done for generations and without preference reversals of individuals, it is less likely to lead to retaliation attempts. Members of families who grew up in a world of meritocracy are more likely to react adversely if a primogeniture succession strategy would be applied because in their belief-system, a pure primogeniture succession strategy wouldn’t be ‘fair’.
With that in mind, we can say that there is no such thing as ‘fairness’ per se. Fairness is a constructed concept and a categorisation that solely exits in the head of the beholder. It means, that fairness or rather the perception of fairness and other emotion concepts can be re-constructed and thus, re-categorised to mitigate behavioural risk exposures in family dynamics.
The Governance of Wealth
Basically, the situation can be described as a Principal-Agent problem under the assumption of irrational players. The irrationality starts with the well-established endowment effect[3], a situation where human beings think because they already own an asset respectively built it (IKEA effect), it is worth more than the market price. The patriarch is prone to overvalue his company, in particular in terms of non-monetary values and, the successor is more likely to apply (lower) market standards. With that in mind, the patriarch becomes the principal who mandates the successor to manage the wealth with a delegation rate of ẟ: 0 < ẟ ≤ 1 and the successor becomes the agent who accepts the delegation rate of ẟ, the patriarch retains (1-ẟ). This may be in conjunction with a share α: 0 < α ≤ 1 in the company and the patriarch retains the interest of (1-α). We discussed the company share α in the previous section but inevitably, it influences the degree of commitment the successor will demonstrate and may also influence the delegation rate ẟ. The more the patriarch retains in company shares the less he might delegate. But I think there are even more factors that drive the delegation rate ẟ and the degree of commitment the successor is willing to give. Analogous to the classical model, we have to deal with information asymmetry between the both.
The effectivity of delegation
The delegation rate is the degree of a management mandate given by the patriarch and so far, we implicitly assumed that the successor is 100% committed and accepts the delegation rate 100%. However, the successor might accept less of ẟ and hence, is reluctant to give his commitment in full. Let’s define the commitment rate of the successor λ: 0 < λ ≤ 1. The effectiveness of the delegation E[delegation] = ẟ*λ. A commitment rate λ < 1 lowers the effectiveness of the delegation and the patriarch may fill the gap which can lead to inefficiencies.
The next questions are, what determines the delegation rate ẟ and the commitment rate λ?
The patriarch determines the delegation rate ẟ. He’s endowed to the business he created but also to his way of doing things and his status. Like every human being, he has a need for significance and a need to contribute[4]. With delegation, he invests trust in the successor and expects him to deliver a return, not only on financial terms but also to keep and build the reputation of the business and the family, just as he had done over the past 40 years or so. With every unit of delegation ẟ, he may fear to lose the ability to contribute, and he may feel he gives up significance units and therefore, erodes his status! His endowment to his way of doing things respectively to his persona as he perceives it through his belief-system, can be a limiting factor to the delegation rate ẟ.
The successors commitment rate λ is probably dependents on the delegation rate ẟ, as the successor can interpret it as amount of trust invested in him, but I think even more important is the communication between the patriarch and the successor to reduce information and belief-system asymmetries. The more the successor feels treated fairly and supported by the patriarch to transmute his own dreams and plans the higher λ will be. On the contrary, if the patriarch selects a high ẟ but patronises the successor because either he does not trust him or cannot give up his self-endowment, λ will be rather low.
In my view it would make sense to professionalise the relationship between patriarch and successor and clearly define the roles as principal and agent as you would do in the world outside family businesses with clear, objective accountabilities and the required transparency. Family roles should be kept separately. This is easier said than done and I’d strongly advise to hire a coach for the transition who works with the patriarch and the successor to align interests and structure the wealth transition from the behavioural side to contain behavioural risks in wealth transitions.
[1] Behavioural Game Theory, Experiments in Strategic Interaction by Colin F. Camerer, Princeton University Press
[2] How Emotions Are Made (The Secret Life of Brain), Lisa Feldmann Barrett, Pan Macmillan
[3] Thinking Fast and Slow, Daniel Kahneman, Macmillan
[4] Safe Space: Governance in Action, Francesco Lombardo
