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.
Source: McKinsey & Co.
Though these specific examples are insufficient to irrefutably confirm that family-controlled businesses consistently outperform, they do suggest that, in some instances, this is in fact the case. In determining why, it’s logical to start by analyzing the key points of differentiation between family-controlled businesses and their peers.
First of all, family-controlled businesses tend to be less levered. As a result, they may underperform during peaks in economic, business and credit cycles, but they also tend to exhibit more staying power during troughs. Entering the 2008 credit crisis, family-controlled businesses were substantially less levered than the average company in the S&P 500:
Source: McKinsey & Co.
This disciplined attitude towards debt served family-owned businesses well during the crisis and it continues to be a defining feature. A 2016 BCG study found that the financial leverage of family-controlled businesses was 27% lower on average than that of comparable peers.
A second key point of differentiation is the approach to capital allocation. Family-controlled businesses tend to be more committed to the long-term when it comes to setting goals, as well as more prudent when it comes to spending and less apt to engage in acquisitions.
At the 4th Annual Ben Graham Value Conference in New York in June, Tom Russo managing member of Pennsylvania-based investment manager Gardner, Russo & Gardner, shared his theory as to why this is typically the case: “Often times reinvestment discipline is better [at family-controlled businesses] because the family is less concerned with the upside versus the downside…a CEO might act differently if he or she is still trying to get rich.” Russo submitted that companies without a substantial founder or family presence often focus too heavily on the short-term. They suffer from agency issues that arise from a misalignment of shareholder and management interests. In contrast, family-controlled companies have the “ability to do nothing” in Russo’s words, and when they do act they don’t have to consider the impact of their actions on short-term earnings as their competitors often do. When making capital allocation decisions, family-controlled businesses have the ability to look out years, or even decades. On the contrary, many of their competitors are forced by diverse, but short-term oriented shareholders to prioritize the next quarter at all times.
Russo also stressed that to the extent ownership of the company has already passed on to the heirs of the founder, there is a strong possibility that the company is mature, generates ample cash flow and is therefore self-funding. In that situation, there is no need to raise external capital, and thus no reason to tailor the company’s capital allocation policy to appease third-party shareholders. The family can often continue to collect a portion of the cash flow in dividends for generations without diversifying or diluting their stake.
The importance of capital allocation policy to investors can hardly be overstated and management teams with the ability to maintain a long time horizon have an enormous advantage. In a recent report entitled, ‘Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance’, Michael Mauboussin, former head of Global Financial Strategies at Credit Suisse, asserts that “capital allocation is the most fundamental responsibility of a senior management team of a public corporation.” In preparing the report, Mauboussin analyzed extensive historical data to determine the effectiveness of capital allocation decisions made by corporate managers. He found the average performance to be lacking:
“The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. The proper goal of capital allocation is to build long-term value per share. The emphasis is on building value and letting the stock market reflect that value. Companies that dwell on boosting their short-term stock price frequently make decisions that are at odds with building value.” (Source: Credit Suisse)
These findings are particularly troubling given the nature of today’s investing environment. “Capital allocation is always important,” Mauboussin argues, “but it is especially pertinent in the United States today given the high return on invested capital, modest growth, and substantial cash on corporate balance sheets.”
Warren Buffett voiced his concerns on the matter in his 1987 Letter to Shareholders: “The heads of many companies are not skilled in capital allocation,” Buffett observed, noting that “the lack of skill that many CEOs have at capital allocation is no small matter.” “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.” To Buffett, the root cause of this sub-optimal state of affairs was obvious:
“Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.” (Source: BRK 1987 Letter to Shareholders)
Chris Davis has been investing in founder and family-controlled businesses for decades in his role as the head of Davis Advisors, a New York-based investment firm with over $25 billion under management. Speaking alongside Tom Russo at the Ben Graham Value Conference, Davis explained to the audience why he agrees with Buffett: “In the end, it’s the quality of capital allocation that you pay for when you buy a stake in a company,” Davis professed. But quality is sorely lacking and poor capital allocation continues to be the norm among corporate managers. Per Mauboussin’s research, managers allocate more capital to M&A than anything else, despite the fact that M&A is the least efficient option:
“M&A is by far the largest source of redistribution of corporate resources of all the alternatives,” Mauboussin writes, “for many companies, M&A is the most significant means to pursue strategic goals and the most costly way to do so. …M&A creates substantial value but most of that value goes to the sellers, not the buyers.”
Analysis from McKinsey & Co. reaches the same conclusion:
“It comes as no surprise to find conclusive evidence that most or all of the value creation from large acquisitions accrues to the shareholders of the target company, since the target shareholders are receiving, on average, high premiums over their stock’s preannouncement market price – typically about 30 percent.” (Source: Valuation: 6th Ed. (McKinsey), pp. 570)
That is not to say there aren’t also cautionary tales of family-controlled companies that failed due to reckless spending (Davis highlighted the unfortunate story of Stroh Brewery Co., for example). However, when founders or their families have effective or outright control they can veto large outlays for things like M&A that would otherwise be approved by management.
In his remarks, Tom Russo provided the example of Heineken NV. It is his firm’s sixth largest position and the founding family continues to control over 50% of the company’s shares. The family used its sway to ward off an acquisition offer from SABMiller in 2014 and Russo points to the acquisition of Brazilian brewer Kirin Holdings Co. earlier this year as an example of patient, prudent capital allocation. Heineken NV purchased the company for approximately $700 million, a substantial discount to the $2.6 billion paid by the sellers just 5 years prior. In a study of all M&A transactions with greater than $500mm of total deal value that occurred in the US and Western Europe between 2005 and 2009, McKinsey found that while the average deal involving publicly-traded, family-controlled acquirers was approximately 15% smaller, the impact on the acquirer’s market value was nearly 4.00% higher.
These findings would likely come as no surprise to Russo. After all, Heineken NV isn’t the only family-controlled business with which he is familiar. His fund, Gardner, Russo & Gardner, is highly concentrated with just 10 names accounting for over 75% of AUM. True to form, half of the top 10 positions exhibit substantial insider ownership.
“Family-owned businesses are often overlooked and often mispriced,” says Russo. Part of the reason is that investors are frequently afraid of an “idiot uncle” or “spendthrift nephew” gaining control of the company and destroying value. Yet most investors are quite willing to absorb the agency costs that plague other public companies where insiders own considerably less.
Mauboussin notes that “understanding the incentives for management is crucial.” Misalignments of interests between shareholders and management all too commonly arise at public companies where executives own relatively little stock. When executives own minimal equity, outside shareholders with short time horizons hold disproportionate sway. Managers inevitably begin to prioritize short-term initiatives in an attempt to appease the shareholder base and maintain their jobs.
Not so in a family-controlled business claims noted value-investor Paul Isaac. In his comments at the Ben Graham Value Conference, Isaac, the CEO of New York-based hedge fund Arbiter Partners, contended that family-controlled businesses are avoided by many investors because they are effectively long-duration assets. Accordingly, investors with short-duration liabilities, and therefore short time horizons, cannot own them. For investors with longer time horizons, however, family-controlled businesses can represent an attractive choice Isaac admitted, particularly when there is an option to reinvest capital in the business on a tax-deferred basis. Nevertheless, Isaac stressed that family-control is not inherently “good”; it depends on the circumstances. Russo echoed Isaac’s concerns. While there are many potential benefits to family-control, Russo concedes that “it is neither necessary, nor sufficient.”
Chris Davis is living proof. He is both an investor in family-controlled businesses and the heir to one. His grandfather, Shelby Davis, started his career some 50 years ago with $100,000 in capital. He grew it to an amount in excess of $800 million by the end of his investing career then proceeded to give most of it to charity. According to his grandson, the elder Davis “didn’t want to rob his grandkids of the opportunity to make a living.”
As the current leader of a business that traces its roots back to his grandfather, Chris Davis admits that nepotism can be a real risk. “You can become the employer of last resort for people with the same last name,” he cautioned. Even so, Davis acknowledged that “a good farmer farms for his own children,” and that with the proper ownership structure in place, a founde or Family-controlled Businessescan make for an ideal investment.
Family-controlled Businesses – Ownership Structure
Amazon.com, in Davis’ estimation, represents the best of what founder-controlled companies can be. In his letters to investors, Amazon founder and CEO Jeff Bezos clearly communicates how he intends to build long-term value. Plus, Bezos continues to be the company’s largest shareholder – holding the same class of stock as every other investor. “Jeff has set the example,” Davis asserts, “one share, one vote.”
In contrast, Davis condemned, in no uncertain terms, the use of multiple classes of stock and super-voting shares to maintain control. He is highly critical of founders that issue shares with unique voting privileges and singled out the recent Snap Inc. (SNAP) IPO as a particularly egregious example. Participants in the IPO received shares with no voting rights at all. Pre-IPO investors retained shares with some voting rights while SNAP’s founders maintained control of the company via exclusive super-voting shares. “Bill Gates ran Microsoft for years with impunity without super-voting shares,” Davis reminded the audience. Davis holds similar disdain for the 2013 management buyout of Dell Computer, referring to it as “unconscionable” and “almost a breach of duty.”
Data to support Davis’ strongly-worded views are available. In a 2012 report, the non-profit Investor Responsibility Research Center (IRRC) compared the total shareholder returns generated by companies with controlling shareholders to those without. Companies with controlling shareholders were split into two buckets: those with multiple classes of stock and those with a single class of stock. Companies with a controlling shareholder, but a single class of stock generated the highest total shareholder return during the 10 years ending in 2012, outpacing companies without controlling shareholders by 4.50% per annum. Controlled companies with multiple classes of stock underperformed.
Source: IRRC, ISS
Tom Russo juxtaposed Davis’ unfavorable examples with Berkshire Hathaway Inc. (BRK), which all three speakers agreed was an archetype of effective family or founder-control. BRK is the largest position in Russo’s portfolio and he believes it will prove to be an interesting case study in generational ownership transition upon the death of its CEO, Warren Buffett.
Buffett founded the company over 50 years ago and is still the largest shareholder. Although for the last decade, he has been distributing 4% of his shares annually to charity as part of the Giving Pledge. The biggest recipient has been the Bill & Melinda Gates Foundation, which has received anywhere from $1.25 billion to $3.17 billion worth of BRK shares annually since August 2006. As a result, the Gates Foundation holds nearly 5% of BRK’s Class B shares, which accounted for approximately 28% of the Foundation’s assets at calendar year end 2016.
Bill Gates is both a good friend of Buffett’s and a BRK director, which means insider-control of BRK really extends beyond Buffett’s personal stake. It’s worth noting though that the Gates Foundation has agreed, in the coming years, to sell sizeable amounts of the shares they’ve received from Buffett to adhere to regulations that require charitable foundations to give away a pre-determined portion of their assets annually. Still, the foundation will remain one of BRK’s largest shareholders, even after Buffett’s passing.
Bill Gates’ influence at BRK and his presence on the board are therefore assured for the foreseeable future. Moreover, upon Buffett’s passing, his son, Howard Buffett, will assume the role of Chairman. These two men will be entrusted to ensure that, even under new management, BRK will continue to approach capital allocation in the prudent and effective manner that has been its hallmark for half a century. Still, it remains to be seen how successful this highly visible transition from founder-control to family/insider-control will be.
Family-controlled Businesses - Conclusion
The number of publicly-listed companies in the US has declined precipitously over the past 20 years and currently sits at just half of the all-time high reached in 1996. Meanwhile, the number of publicly-traded companies with controlling shareholders appears to be rising. In 2002, IRRC estimated that 87 companies in the S&P 1500 had shareholders with ownership stakes of 30% or more. By 2012, that number had grown to 114, 79 of which had multiple classes of stock with unequal voting rights. In the period from 1995-2012, of the 27 controlled companies that completed IPOs, 20 had multiple share classes. And newly listed companies aren’t the only ones that seem to increasingly prefer multi-class capital structures. Companies with some of the largest market capitalizations in the world, including Google and Facebook, have added additional share classes with unequal voting rights recently.
There is considerable, if not indisputable, evidence supporting the theory that family and founder-controlled businesses with a single share class outperform over the long-term. At a minimum the data are sufficient to warrant studying the traits that make family-controlled businesses unique and to consider under what conditions they may be safe for investment. After all, the trend appears to be toward businesses with controlling shareholders becoming a higher percentage of the investible universe for most market participants. Developing an understanding of their distinctive characteristics, good and bad, and an awareness of the material impact different ownership structures can have on total returns will leave investors better off.