Family Wealth Report spoke to an executive Citi Private Bank about an interesting trend that has caught the eye of many industry figures in recent years: hedge funds converting into family offices.

A well-documented trend in the financial world in recent years has been the morphing of hedge funds into family offices.

Two of the most prominent examples are George Soros, the investor and philanthropist worth an estimated $23 billion, and Steven Cohen, who was forced to wind down his hedge fund, SAC Capital, after the company pleaded guilty to insider trading charges in 2013 (see more on that here).

Soros closed his Quantum Endowment Fund to non-family members in 2011 to avoid tougher regulatory scrutiny under Dodd-Frank financial reforms, such as registration with the US Securities and Exchange Commission. The reforms were designed to improve investor protection, but also elevated compliance and reporting costs for hedge fund managers (source: The Financial Times).

More recently, in December last year, it was reported that Scott Bommer, founder of SAB Capital Management, is returning all client money from his hedge fund after 17 years so that he can focus on managing his own wealth (source: Bloomberg).

Indeed, there are numerous reasons why hedge fund principals might opt for a family office structure. They may simply feel it is time to focus on different things, enabling them to pursue philanthropic ambitions and invest more broadly than a hedge fund might, for example. And sometimes it's just a personal decision; they want to step away slightly from the limelight, scrutiny and pressure, said Bill Woodson, head of the North America family office group at Citi Private Bank.

Citi has worked with up to a dozen clients that have gone through this process in the past couple of years, Woodson told Family Wealth Report. “While the raw number of hedge funds converting to family offices is in the tens, not the hundreds, they tend to be very big families. The importance is not in the volume, but in the significance of the relationships, and the amount of money they have to deploy.”

With this trend in the limelight nonetheless, Woodson cautions that there are a number of challenges for the unwary that could spring up during the hedge fund-to-family office conversion process.

Some of the technical challenges relate to the hedge fund's transition from being a prime brokerage client to a private banking client, involving the migration of transactions and trading activities, for example. Then there are more “traditional” challenges that bubble up in relation to the running of a family office – from hiring and retaining key employees, integrating family members and dealing with different ways of reporting, tracking and communicating with third-party advisors, Woodson explained.

It has been widely reported that tighter regulatory scrutiny is one of the most notable reasons why some hedge fund principals have decided to wind down their operations and become a family office. But on the flip side, they may actually face tougher rules as a private banking client with respect to personal information disclosure and KYC procedures.

“Sometimes these principals are a little surprised by those changes,” Woodson said, “They [the changes] tend to be modest, but they [the principals] have to get used to a little bit of a new world in terms of the way that regulators view and work with them.”

Other challenges center more around what it is like to have and run a family office. “An immediate challenge tends to be in staffing,” Woodson said. “Whereas a hedge fund is intended to grow in assets and therefore offers upside from a career development standpoint, when you're running a family office, your assets are going to grow, but they're not going to grow as exponentially and therefore, oftentimes, the opportunities for people you hire aren't the same.”

While the types of people interested in working at a family office tend to be slightly different than those that might work for a hedge fund, this is of course not to say that there aren't talented people in the industry who would embrace the opportunity to work within a family office-former hedge fund environment, Woodson noted.

Another challenge may emerge as newly-formed family offices start investing more broadly in different asset classes (in terms of reporting, for example), while on the “softer” side issues around pursing family goals and lifestyle management bubble up. At this stage, families also tend to start buying fine art and additional homes, etc. – assets which require careful oversight and management.

“There are risks that come as you spread your assets; it's harder to keep track when more people are involved – you don't have the same level of oversight and control you enjoyed when running a hedge fund,” Woodson said.

Then there are the crucial tax and estate planning aspects, and working with multiple advisors, he added. “Wealth creates complexity...I think a lot of hedge fund principals that were exclusively focused on managing their hedge fund and raising funds, as they move into the family office world they think it ought to be simpler, but they find in some cases that it's more complex.”

Woodson's advice to hedge funds that are perhaps thinking of making this transformation is to tap into the family office industry and learn from others who have already made the transition.

“I would also advise them to emphasize simplicity so they can truly reap the benefits that setting up the family office was intended for, whether that's being able to focus on a trading strategy and execution, to develop a philanthropic ambition, getting involved in politics or involving children,” Woodson said. “All those things take time, effort and resources. A lot of hedge fund principals, and just wealthy individuals generally, don't appreciate the complexity, and the risk of getting caught up in the complexity.”

Asked if Citi has, conversely, seen any cases where a family office has decided to re-open to external investors, and what the procedure for this would be, Woodson said the firm has not seen such a move previously.

“One variation on this we have seen is where a family office (whether a former hedge fund or not) has a chief investment officer or trader who develops an internal investment strategy he/she manages. Over time, they obtain experience and generate a performance track record,” he said.

“At some point they [may] hope to use the experience, contacts and track record with the family office to launch their own fund (with the family office becoming a possible part owner and/or investor). We might see more of this as former hedge funds convert to family offices and hire or retain traders who might have ambitions to ultimately launch their own fund.”