(FORTUNE Magazine) – Must a fortune erode? Every truly rich family at one time or another confronts this question. Unfortunately, the mathematics of keeping it all in the family are ultimately unforgiving. Federal and state estate taxes alone can gobble up more than 50% of an heir's inheritance, while inflation eats away at the remainder. And as a family grows, the pie is cut into more pieces, and all the slices become thinner. Preserving the wealth is a top priority, but as time passes and a family expands, a passive portfolio of stocks and bonds is unlikely to preserve anything except the distant legacy of a once grand family era. ''You have to create in order to preserve, and to do that, you have to think in relatively aggressive terms,'' says Jan Greer. He ran the Frank Russell Co.'s private investments division for three years until last spring and now manages personal investments for former Treasury Secretary William Simon, who does quite all right enlarging his fortune. In an age when billion has replaced million as the touchstone of great fortunes, an estimated 1,500 families boast at least $100 million, and several thousands more around $50 million. Among these families, many of whom saw their fortunes rise dramatically in the 1980s, wealth creation -- and not just preservation -- is the ongoing investment philosophy. They are not content to leave the family hoard in a bank trust department; they use their wealth as a lever to pile on more. This boom in family wealth is injecting new life into an old and formerly exclusive institution -- the Family Office. Long a private luxury enjoyed by America's capitalist blue bloods such as the du Ponts, the Mellons, and the Rockefellers, these red-carpet offices tailor to the needs of individual family members while exploiting the economies of their collective wealth. They are not only growing in number; many also are taking on outside, nonfamily clients. Family offices provide a range of integrated financial and personalized services: investment and trust management, tax and estate planning, accounting, insurance, property management, bill paying. Much of this is available from banks and financial service agencies. Family offices, however, are driven solely by the family's needs. And the most innovative of them tend to be expert in the ''smart money'' esoterica of markets, such as spread trading, convertible arbitrage, leveraged buyouts, and venture capital. It is this expertise, this calculated risk-taking, that families new to their wealth are seeking. And the long-established family offices -- whose fortunes under management have been splintered by family growth and whose management costs have escalated -- are hoping to provide it for them. Offices like those of the Pitcairns (descendants of the founders of Pittsburgh Plate Glass, now PPG Industries) and the Pews (descendants of the founder of Sun Oil) have come out of their wood-paneled closets to offer their services to outsiders, promising the same confidentiality afforded members of the founding family. This path was originally blazed in 1975 with notable success by the Phipps family's Bessemer Trust. Many more families -- among them the Rosenwalds of Sears, the Waltons of Wal-Mart, and the Whittiers, who once owned Belridge Oil -- are in the process of doing the same. Even the Rockefellers, whose Room 5600 at Rockefeller Center in New York City is considered the model of a full-service family office, have taken on outside money. What's more, wealthy families and their hired professionals are networking -- comparing notes, swapping investment ideas, and, increasingly, investing in one another's private deals -- on a national scale for the first time. ''Families are finding that it's possible to learn from other family offices,'' says Sara Hamilton, a consultant whose Family Office Exchange in Chicago is a clearinghouse for the emerging industry. This trend is spreading despite the habitual desire of rich families to keep a low profile. Many once sleepy offices serving old-money families are changing gears. ''I think the protracted inflation of the later Seventies and early Eighties rudely awakened a lot of fifth-generation inheritors out of their stupor,'' says one family office manager. ''They were so busy going to polo games and charity events when they began to realize that on an after-tax basis they were losing money. They had to do something about it.'' That dawning realization was helped along by the stellar example of the Bass family office, an altar to wealth creation in its purest form, and its high priest, Richard Rainwater. When Rainwater joined Sid Bass, a Stanford business school classmate, as head of investments at Bass Brothers Enterprises in 1970, the family held a considerable Texas fortune of about $50 million. By the time Rainwater left the Basses to start his own investment firm in 1986, that fortune had multiplied about 80-fold to $4 billion. Rainwater accomplished this feat by tracking down the smartest operators in diverse niche markets and in financial specialties, such as venture capital and leveraged buyouts, setting them up in partnerships, and leaving them alone. Typically, the specialist invested his own money and took little or no fee, but had generous profit-sharing incentives. While some family offices have in-house portfolio managers specializing in plain-vanilla investments like stocks and bonds, many prefer to farm out the money. One outside firm that has quietly provided superior returns to wealthy families for 20 years is Cramer Rosenthal McGlynn, which manages about $400 million and has about 30 families as clients. The three founding partners -- Gerald Cramer, Edward Rosenthal, and Ronald McGlynn -- set up shop in 1972 with the pooled wealth of three New York families, including the family of Rosenthal, whose grandfather was John D. Rockefeller's lawyer. The family has 82 accounts with the firm. (The two other New York families declined interviews.) The three families have a unique arrangement with CRM; they share a floor in an office building in White Plains, New York, but all activities and staffs are separate. CRM has had sustained success in its market investments -- the firm claims annual returns averaging 22.1% in the 15 years from 1975 to 1989 in its equity investments, compared with 16.6% for the Standard & Poor 500 index. But as with most managers of ''quiet money,'' as family wealth is known, it's the private investment arena that really quickens the CRM partners' blood. They look off the beaten path, relying on word of mouth and the old-boy network of wealthy people to find deals. The strategy has paid off, with special investments returning on average 24.7% annually over the past 15 years. In the 1970s, says Gerry Cramer, 60, when oil investments were hot, ''a member of one of our families lived in New Orleans and introduced us to some people he knew in the oil patch. We got inside the industry and met people who had never traveled to Wall Street to look for syndicated money.'' CRM formed partnerships for its client families to invest in oil properties. When oil prices took off, the clients exited with handsome profits. By the early 1980s, CRM spotted leveraged buyouts as an opportunity. The partners met with Henry Kravis but turned down an opportunity to invest with the then relatively small buyout firm of Kohlberg Kravis Roberts. CRM instead located its own leveraged buyout specialist and set him up in a partnership, structured along lines similar to those of Richard Rainwater and the Basses -- the specialist invested his own money and also shared in the profits. ''It's a principal philosophy rather than an agent's philosophy,'' says Ed Rosenthal, 56. ''This makes for a very healthy investment climate. You're going to watch the kind of risks you take if it's your own dough.'' This attitude is common among wealthy families, who value control over almost anything else and tend to avoid blind investment funds. The firm's clients provided 90% of the buyout fund, and the limited partnership ultimately completed an ''extremely successful'' leveraged buyout of a peat moss manufacturer. AS TROUBLE began to loom in the junk bond market during the late 1980s, CRM used the same formula to form Neptune Partners for investments in bankruptcy situations. ''We found a young lawyer and a young credit analyst and brought them over here,'' says Gerry Cramer. ''I had their resignations in my drawer and we gave them $15 million and watched them like a hawk.'' The partnership has been successful, says Jay Abramson, the firm's newest partner. Neptune Partners won't divulge its performance, but it is currently raising money for its sixth fund. More typical of the recent groundswell in the family office business is Asset Management Advisers of Palm Beach, Florida. The office, which handles more than $200 million for six families, was created last spring by Ellen and Henry ''Hap'' Perry. A large portion of that is Perry family money, which originated with an inheritance from Hap's grandfather John H. Perry, who owned a chain of Florida newspapers that the family sold in 1969. The Perry family later moved into the cable television business. When it sold those operations in 1986, the family -- Hap's father and siblings -- suddenly found itself with a significant amount of liquid wealth and in need of a place to put it. ''We couldn't find anyone who addressed our issues in the manner we wanted,'' says Ellen Perry, 32. ''There were some esoteric asset classes we wanted to invest in like physical gold and international equities that no one was willing to do.'' Once the Perrys decided to open their own office, they had to convince their own relatives and the five outside-client families that their idea had merit. That not only required them to explain their investment philosophy but to address as well what they called the ''human issues'' associated with wealth: encouraging communication among family members, resolving disputes over money, counseling patriarchs about wealth transfer, and teaching younger family members about the value of pooling their money. On the financial side, the Perrys are a manager of managers. They select specialists in a number of asset classes -- fixed income, value, foreign equities, growth, and short selling -- and use an asset allocation menu to match the risk/reward profile to each client. Says Hap Perry, 42: ''We work closely with the individual client to define whether he wants to waltz or rock-and-roll.'' Investment performance alone, however, isn't enough. Family offices that pay too much attention to wealth creation without integrating the traditional methods of preservation -- tax and estate planning -- are, like Sisyphus, fighting a losing uphill battle. At Stillrock Management, the impact of taxes is integral to the way an investment is structured. Stillrock is controlled by descendants of a nephew of John D. Rockefeller and a daughter of James Stillman, a founder of Citibank; it is run by David Elliman, 39, a family member. The firm, which spun off from another family office, called Indian Rock, in 1982 to focus on mostly private investments, manages about $1.5 billion in assets for family and, since 1987, nonfamily clients. ''You have to ask, What are the special needs of the client that go beyond just performance,'' says Elliman. ''It's highly complex to come up with some quantitative measure of post-tax returns, but we're at least sensitive to tax issues.'' When Stillrock recently made an investment for one client in a leveraged transaction, the managers recognized that the client's account would suffer because like many states, Connecticut, where the client lives, doesn't recognize interest expense as a tax deduction. So Stillrock put the investment into an offshore corporation, on which the taxpayer is required to pay taxes on only net income, after the interest expense has been deducted. Transferring wealth to the next generation has actually grown out of favor in some quarters. Some entrepreneurs have stated they won't pass their money on to their children. But Ed Rosenthal, who himself inherited a large estate, takes a different view. ''Philosophically, my goal in life has been to pass on to the next generation what I inherited plus inflation. It's a very difficult goal. But I think history has shown that by educating the next generation, you have a better shot at them having an opportunity to handle the wealth with dignity and in fact to make money with money.'' Many of the old methods -- generation-skipping trusts and estate tax freezes -- have been restricted or eliminated, but there are ways to get the money down and limit the bite of estate taxes. One such method is to place some of the wealth in assets, like land or private companies, that aren't traded in a regular market. ''Nonmarketable investments have a tremendous advantage when it comes time to negotiate the estate tax,'' says Elliman. ''They don't have a defined value on the date of death, which creates an opportunity to pass it along at a low value. With a listed stock or bond, everybody knows what it's worth.'' An emerging concern among families -- particularly new-money families and the younger generations of old-money families -- is how to educate the next generation about wealth. ''Educating the children is the most difficult of all the issues faced by wealthy families,'' says Sara Hamilton of the Family Office Exchange. Inheritors may not like money or they may like it too much, but they often find all kinds of ways to lose it. ''The odds are greatly increased that if you do not educate the next generation, they could lose the money,'' says Hamilton. ''There are only a handful of professional people who have focused on this and really tried to address it. Most families are stumbling around in the dark.'' John Levy, one consultant who helps families cope with inherited wealth, says inheritors often take longer to mature, lack motivation to do serious work, have low self-esteem, and are gripped by fear of failure. Ignoring the topic, says Levy, carries consequences. ''If wealth and its eventual transmission to the children are dealt with covertly by the parents -- as so many parents did in avoiding the topic of sex -- children are apt to see the money as something dark and shameful.'' The family office may be one of the most useful ways to involve younger family members in the world of money. ''The office ought to be viewed like a business, even though it may only have investment assets,'' says Ross Nager, head of family wealth planning for Arthur Andersen. ''As such, it ought to have shareholder meetings that inform the children about the family business and seek their input. In that way it helps to educate them on the issues that must be addressed in investing money.'' In many cases, however, younger family members are locked into trusts that may be well-intentioned but instead breed resentment among beneficiaries. Bryce Rhodes, 36, is a great-grandson of M. H. Whittier, a turn-of-the-century wildcatter whose descendants ultimately sold Belridge Oil in 1979. Rhodes, a geologist with an MBA and the only member of his generation employed full time by the family office, says there was never any doubt during his upbringing that he would work for a living. In part, he says, that's because the family didn't come into serious liquid wealth until he was already in his 20s. But Rhodes expresses a typical view held by younger generations toward their trusts. ''My grandmother set up trusts that will benefit my children,'' he says. ''I have no control over that, and to some extent that bothers me. I would like to have a say and be able to make suggestions when my children come into dollars that they can control, because I'm very much concerned that they be responsible and independent individuals and not solely dependent on inherited wealth.'' Must a family fortune erode? As a family grows larger, says Ed Rosenthal, ''a family fortune must erode in terms of individual net worth. But a family fortune does not have to erode if you take all of the members of the family and keep them together. Then I think it can be avoided.'' The emerging industry of family offices is betting on that philosophy.