Family Firms, an Opportunity for Minority Investors?
Family-owned firms are not just key drivers of economic growth, but also key employers. But do they generate returns comparable to benchmarks, and what type of specific risks do they pose for external shareholders?
To find out whether family firms generate returns comparable to non-family-owned peers, the Credit Suisse Research Institute analyzed financial data from the CS Global Family 900 universe, a proprietary basket composed of 920 family-owned businesses located across the globe. (See box below for additional information about these 920 firms) From an investment point of view, sector-adjusted share price returns show that since 2006 family-owned companies have delivered superior performance: The CS Global Family 900 universe has generated a 47 percent outperformance compared to the benchmark MSCI ACWI index. This equates to an annual excess return of 4.5 percent over the nine-year period to the end of April 2015, according to the Research Institute's study "The Family Business Model." (See adjacent figure)
How About Their Profitability?
Considering profitability in terms of return on equity (RoE), superior RoEs were seen in family-owned companies both in Asia and EMEA (Europe, Middle East and Africa), while US- and European-based family firms posted lower returns on equity (RoE) than benchmark. "Lower RoEs in more developed markets are indicative of more conservative strategies as well as broader priorities for family ownership beyond simply financial returns," explained Richard Kersley, Head of Global Equity Research Product for Credit Suisse's Investment Banking division. But looking beyond a simple RoE analysis, data showed that the family firms in the CS Family 900 universe, excluding banks and regulated utilities, generated annual cash flow return on investment (CFROI) averaging 130 basis points higher than companies in MSCI ACWI. (See adjacent figure) Over the longer term, family firms have generated twice the economic profit (earnings in excess of the opportunity cost of using assets or capital) than the benchmark.
Lower Leverage and More Stable Business Cycle
US- and European-based family firms use less leverage than their non-family-owned peers and showed faster deleveraging following the recent financial crisis compared to benchmarks. Asian family companies, however, operate with higher leverage than the benchmark. Globally, family-owned businesses delivered smoother and more stable business cycles than the benchmark. "Sales growth is less volatile through the cycle with lower peaks and less pronounced troughs," said Julia Dawson, an equity analyst at the bank's Investment Banking division. (See adjacent figure) Annual sales growth has also been higher in family-owned firms – 10 percent compared to 7.3 percent for MSCI ACWI companies since 1995 – and less volatile during both the Internet bubble and the financial crisis. "A longer term corporate strategy is fundamental to the structural nature of this higher and less volatile (sales) growth," Dawson said. "The importance of product or service quality, the development of long-term client relationships and brand loyalty, along with the focus on core products and innovation in these products rather than diversifying are all elements explaining this outperformance," she underlined.
Less Investment in R&D and M&A
Family businesses typically invest less in research and development (R&D) than non-family firms. "In the US, R&D intensity is just 25 percent of benchmark levels, while in Europe it is 20 percent below benchmark," Kersley noted. "While this is indicative of a more conservative management style, we also believe that it reflects more efficient R&D given the relatively limited difference in returns." Family firms also tend to focus on organic sales growth. Since 1990, mergers and acquisitions (M&A) account for only 2.1 percent of their sales compared to 5.8 percent at non-family firms. Credit Suisse data showed that when acquisitions are carried out they are better and cheaper, as they generate better growth and returns in the three-year period following the acquisition.
Risks Include the Inability to Control Corporate Governance
"The negatives linked to family-owned businesses mainly relate to corporate governance shortcomings and the inability of minorities to control or exert good influence over owner-managers," said Dawson. "Related party transactions, conflicts of interest in assets ownership, a relatively closed pool of managers and directors can present a risk to minority investors," Dawson explained. "The employment of overpaid, under-qualified family members is typically cited as another specific risk at family companies," she added. But such corporate governance concerns are generally overstated. Investors should not underestimate the importance of reputation and integrity to many family business owners. Credit Suisse's HOLT data showed that the accounting quality of the CS Global Family 900 universe was generally superior to those included in the CS HOLT database, which is composed of over 20,000 listed companies.
Succession & Survivorship Issues
"Succession and the business risks around succession within a family-owned company are cited as a key potential cost to external investors," Kersley noted. Assuming a generation to be 25 years (or longer in the case of the original founder), survivorship rates in the 920 firms analyzed indicate that half of them transition to the second generation, a fifth to the third generation and a 10th to the fourth generation. These survivorship rates are, however, sector related. Families inheriting businesses based on intellectual property (IP) rights such as health care and information technology (typically dependent on the founder's know-how), sell at an earlier stage than those operating in sectors with tangible assets (such as consumer discretionary and staples businesses). The role of the state also has a major impact on the development of family ownership. In Germany, for example, its very beneficial inheritance tax laws allow families to retain full or highly concentrated ownership, which is not the case everywhere.
When Is It Most Interesting to Invest in Family-Owned Firm?
A founder's premium was established when analyzing the CS Global Family 900 universe. Over the past nine years, first generation companies have delivered a share price compound annual growth rate (CAGR) of 9 percent. Share price returns are indeed the highest in the first generation, when investing alongside the founder, and then decline as family ownership passes down successive generations and the companies mature. "It pays to invest alongside the company founder, in the early years of a company's existence that is likely to correspond to a period of high growth," Dawson concluded. (See adjacent figure)