Editor’s note: The Family-controlled Businesses investing topic was the theme of the panel at the Ben Graham Value Conference that included Tom Russo, Chris Davis & Paul Isaac. We did not make them or the conference the focal point however. Rather we made the broader theme of investing in family-controlled business the focal point because we concluded that, as (our readers are) investors, that is the article that we would be most likely to read.
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Companies in which founders and their families hold controlling stakes have the rare ability to maintain a long-term view. That can be a huge advantage, particularly when it comes to capital allocation. Should you be investing alongside them?
According to data compiled by the Boston Consulting Group (BCG), nearly one-third of all companies with sales in excess of $1 billion are family-controlled Further analysis of the same data conducted by researchers at the Center for Management and Economic Research suggests that family-control can have a positive impact on the performance of a business and lead to superior long-term results for investors:
“Our results show that during good economic times, family-run companies don’t earn as much money as companies with a more dispersed ownership structure. But when the economy slumps, family firms far outshine their peers. And when we looked across business cycles from 1997 to 2009, we found that the average long-term financial performance was higher for family businesses than for nonfamily businesses in every country we examined.” (Source: Boston Consulting Group)
But what exactly is a “family-controlled business”? There is little consensus when it comes to choosing a specific definition since the criteria used are often varied. Involvement in the business is an oft cited measure, but in many instances the family simply maintains a presence on the board, allowing outside executives to tend to the day-to-day. Large ownership stakes are another common criterion, but whereas some families retain majority positions, others are content with a minority stake of sufficient size to yield effective control.
As recently as 2010, McKinsey & Co. cited a specific ownership threshold of 10% when determining what qualified as family-control. A substantially higher threshold of 20% was used in a 2012 study of family-business conducted by researchers at IE Business School. A 25% voting stake is currently the minimum threshold according to the European Commission’s official definition of “family business”, and a floor as high as 32% has been used in analysis by leading consultancies as recently as this year.
Despite the lack of consensus regarding what explicitly constitutes family-control, material economic interest coupled with a voting stake sizeable enough to influence the board are reasonable requirements. There seems to be greater accord surrounding the qualitative attributes of a family-controlled business. Even McKinsey seems to accede, having recently shifted to a more ambiguous description: “We define a family-owned business as one in which a family owns a significant share and can influence important decisions, such as the election of a chief executive.”
Approximately 20% of the Fortune 500 and 30% of the S&P 500 meet these criteria. So too do 40% of French and German companies with sales in excess of $1 billion and over than half of Indian companies of similar size. Another 4,000 companies are poised to join these ranks within the next decade. It therefore seems sensible for investors to have an informed view when it comes to the particulars of investing alongside founders and their families.
The primary difference between family-controlled and founder-controlled businesses is that the former have successfully negotiated a transfer of the founder’s stake to heirs. This may seem like a trivial distinction, but the success rate is rather low. It’s important to keep in mind that approximately 50% of all new businesses fail within 5 years and nearly 70% fail within a decade. As Warren Buffett says, “in order to succeed you must first survive.” Of the few founder-owned businesses that survive to the point at which a progression to family-control is pertinent, an even smaller number are prepared for the transition. According to a 2016 survey conducted by PwC, only 23% of family-controlled businesses have a succession plan in writing that has been communicated to stakeholders. Instances of successful transitions from founder to family-control are somewhat rare and often when ostensibly discussing family-controlled businesses, what we are really talking about are first generation, founder-controlled companies.
Expanding the definition of family-control to include founder-control allows some of the largest and most visible companies in the world to be included, such as Facebook, Amazon and Google. The founders of each of these companies retain significant economic interests and voting stakes large enough to influence any major decision made by the board. Thus, they meet the criteria previously mentioned for family-control, but have yet to successfully transfer economic and voting interests to the heirs of the founder. All the same, whether investing alongside controlling founders or controlling families, a uniform suite of advantages and drawbacks is typically available.
Family-Controlled Business – The Potential Drawbacks
One major drawback to investing alongside a third-party with a controlling stake is that there is little to no recourse in the event of sub-par results, whether due to ineffective operating decisions or poor capital allocation. Activism is impractical and acquisitions by financial or strategic suitors are subject to family approval. Nepotism can occur and emotional attachments to products, regions, and business lines can exist. Family members that have a significant portion of their net worth tied up in company shares can be risk averse to a fault when it comes to major decisions regarding the future of the business. Consequently, a proactive culture can give way to a reactive one and innovation may suffer.
The Potential Advantages to Investing in a Family-Controlled Business
The risks however, appear to be worth bearing in the pursuit of long-term outperformance. In 2012, researchers at the IE Business School in Madrid examined a sample of 2,423 publicly-listed European companies and found that those in which an individual or family held at least 20% of the shares outperformed by an average of 5.00% per annum during the decade ranging from 2001-2010.
Source: IE Business School, Banca March
A McKinsey study analyzed 154 publicly-traded companies in the US and Western Europe with greater than 10% family ownership. Total shareholder return for these companies was compared to that of relevant indices for the period from 1997 to 2009. The family-controlled companies in Europe outpaced the MSCI Europe index by approximately 2.00% per annum, while returns for the US-based companies exceeded those of the S&P 500 by approximately 3.00% per annum.