Family-controlled companies are the predominant form of business enterprise worldwide and, according to the Family Firm Institute, account for as much as 90 per cent of global GDP annually.
In the Middle East, it is estimated that family businesses worth more than $1 trillion will be handed down to the next generation within the next five to ten years. These companies will need to consider how to facilitate this power shift while dealing with the financial and intellectual capital demands of globalization. Local firms are increasingly likely to turn to external capital, and savvy investors may be the beneficiaries.
Research suggests that family control, on balance, is favourable for minority shareholders. Long-term shareholders of family-controlled firms such as L’Oreal Group and Novartis AG, would probably agree, based on the market-beating returns these companies have delivered over the past decade.
What constitutes family control?
Family control can come in the form of equity ownership, board representation, or senior management positions, and amounts to the degree to which a family is able to exert influence over the strategic direction and management of a company.
On a global basis, it is generally thought that equity ownership of at least 5% equates to control. By that measure, roughly one-third of the S&P 500 Index constituents and 40% of the 250 largest companies in France and Germany are family-controlled.
The Pearl Initiative, the GCC-based organization into corporate governance, and PwC, the leading professional services organization, recently found that among 100 family firms surveyed across the GCC, only 24% had raised external capital at some point in their history. This is likely to expand going forward as 55% of family firms said that they would be seeking external capital in the future.
Why do family-controlled firms perform better?
According to Warren Buffett, “Family-owned businesses share our long-term orientation, belief in hard work, and a no-nonsense approach and respect for a strong corporate culture.” His point is that family-controlled firms tend to be more patient and less beholden to the quarterly expectations of investors than companies lacking a strong family influence. Additionally they can be less tempted to resort to accounting gimmickry.
The relative financial conservatism of family-controlled companies also extends to the balance sheet, as they have been found to carry comparatively little leverage. And, perhaps surprisingly, dividend payout ratios are lower among family-controlled companies. Low employee turnover, which allows for higher productivity and a stronger corporate culture, is another calling card of family-controlled firms. This long-term vision and focus on sound financial stewardship undoubtedly enabled family-controlled firms to navigate their way through the recent financial crisis better than most companies, as chronicled recently in the Financial Times.
How does the financial performance of family-controlled firms compare?
Numerous studies conducted over the past two decades have drawn a link between family control and enhanced company financial performance, as measured by return on assets and Tobin’s Q ratio, a valuation measure based on the replacement value of a firm’s assets. Researchers attribute this collective outperformance to those firms in which the founder serves as chief executive, or as its board chairman with an outsider as chief executive.
A less cheerful picture exists in multi-generation dynasties as descendant chief executives have been found to detract from firm performance. Financial performance also seems to peak once family ownership approaches one-third of a company’s outstanding equity, at which point the risk of entrenchment arises.
There can be drawbacks to family control and paramount among these are the agency risks which minority shareholders assume when investing in a family business. Excessive compensation, self-dealing, expropriation of assets, and related party transactions are examples of such exploitative behavior for which shareholders need to be vigilant. These agency issues can be mitigated, by a strong and independent board of directors.
Nepotism, either real or perceived, is another common threat to family-controlled firms. While there may be no better advocates of a company’s core values than the founding family members, a meritocratic workplace is best suited for attracting both a qualified workforce and loyal investors. Family-controlled firms and investors alike need to be wary of the deleterious effects of patronage based on a common last name.
What are the key considerations for investors?
Founding families, kept in check by an independent board, tend to exert a positive influence on companies, particularly when the founder remains actively involved in setting strategic direction. Family-controlled firms are more inclined to have a long-term perspective, conservative financial management, and a strong corporate culture, all attributes conducive to long-term share outperformance. The better financial returns reported by family-controlled companies don’t go unrecognised by investors. Studies have shown the stocks of family-controlled firms outperform the broad market over time. But investors need to keep in mind that investing in the shares of family-controlled firms is not without risks. As with all prospective investments, thorough due diligence is essential.
— Dave Larrabee is director of corporate and member products at CFA Institute and Amer Khansaheb is president of CFA Society Emirates