The Fourth Asian Roundtable on Corporate Governance
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The Fourth Asian Roundtable on Corporate Governance. Shareholder Rights and the Equitable Treatment of Shareholders. Robert Zafft OECD. “Large, Family-Run Firms: the OECD Experience”. Mumbai, India 11-12 November 2002.

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The Fourth Asian Roundtable on Corporate Governance

Shareholder Rights and the Equitable Treatment of Shareholders

Robert Zafft

OECD

“Large, Family-Run Firms: the OECD Experience”

Mumbai, India

11-12 November 2002

The views expressed in this paper are those of the author and do not necessarily represent the opinions of the OECD or its Member countries, the ADB or the World Bank


Good corporate governance matters even for families that control and manage their own firms l.jpg
Good corporate governance matters, even for families that control and manage their own firms

  • Large, family-run firms (both listed and privately held) play a major role in OECD economies

  • To succeed, family-firm owners must grow, diversify and pass on their wealth

  • These three challenges become harder where governance is poor

  • By improving governance, policy makers and owners improve both the functioning of firms and the welfare of the families that run them


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Family-run firms predominate in OECD economies control and manage their own firms

Proportion of OECD Firms That are Family-Run

Percent

  • Over 85% of EU/US businesses are family run

Source: Nancy Upton and William Petty, “Venture Capital Investment in Family Business,” Venture Capital, 2000, Vol. 2, No. 1, pp. 27-39


Family run firms contribute disproportionately to business profits l.jpg
Family-run firms contribute disproportionately to business profits

Profitability of Family-Run and Non-Family-Run Firms, 1970-1990

Percent

Average non-family-run profit-ability = 100

  • US-UK family-run “premium” ranges from 30%-80%

180

100

130

100

Source: BDO Stoy Hayward


Family run firms both listed and private make up a significant percentage of all major firms l.jpg
Family-run firms (both listed and private) make up a significant percentage of all major firms

Family-Run Firms among US S&P 500

Percent

244 OECD multi-generation family-run firms have revenues over US$ 1 billion*

  • Family-run firms constitute 40% of the US S&P 500

* Excludes firms like Microsoft and Berkshire Hathaway that are still run by the founding generation

Source: University of Notre Dame and IMF Institute; Family Business Magazine


While privately held large family run firms are 30 smaller than their listed counterparts l.jpg
While privately held, large* family-run firms are 30% smaller than their listed counterparts...

Average Revenues of Large, Family-Run Firms

Billion Dollars

* “Large” means annual revenues greater than or equal to US$ 1 billion; comparison excludes Ford (US$ 170 billion) and Wal-Mart (US$ 191 billion)

** US companies only

Source: Family Business Magazine


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...They are as numerous... smaller than their listed counterparts...

Listed v. Privately Held Large Family-Run Firms in OECD Countries

Percent

  • Half of all large, OECD family-run firms are privately held

100% = 244

Source: Family Business Magazine


And comparably represented across industry sectors l.jpg
…And comparably represented across industry sectors smaller than their listed counterparts...

Distribution of Large, Family-Run Firms across Sectors

No. of Firms

  • Listing does not appear to confer any clear advantage across sectors

Source: Family Business Magazine; OECD Analysis


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Whether family-run firms are listed or privately held, to succeed, their owners must access capital, diversify wealth and manage succession

Challenges for Family-Business Owners

Challenge

Issues

  • Finance growth

  • Balance debt/equity

  • These challenges and issues exist for all closely controlled firms

Access Capital

  • Manage risk

  • Provide liquidity

Diversify wealth

Manage succession

  • Appoint competent directors/managers

  • Adjust shareholdings pursuant to inter-generational hand-over

  • Finance share transfers

  • Balance jobs/compensation for family employees with returns to family shareholders

Source:OECD Analysis


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Although firms going public most commonly cite accessing capital to finance growth as a motivation for listing...

Frequency of Rationale Appearing in IPO Prospectuses, Sweden 1980-90

Percent

Growth rationale

Source: Kristian Rydqvist and Kenneth Hogholm, “Going Public in the 1980s: Evidence from Sweden,”European Financial Management, Vol. 1, No. 3, 1995, pp. 287-315


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...IPO data indicate that access to capital has not been a major problem for mid-size and large, family-run companies

Average Age at IPO

Years

Primary v. Secondary IPO Shares, Select European Countries, 1980-90*

Percent

  • Late average age at IPO shows firms have not needed to tap public equity markets

  • Almost 60% of all money raised in IPOs is used for cashing out the owners rather than growing the business

* France, Germany, Italy, Netherlands, Sweden, Switzerland, and UK

Source: Rydqvist and Hogholm


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Family members can diversify their wealth by expanding firm operations or by passively investing dividends and compensation in other companies.

Active

Passive

Operational v. Portfolio Diversification

Operational Diversification (“Conglomerate”)

Portfolio Diversification

SH

SH

Co. 1

Co. 2

Co. 3

Co. 1

Bus 1

Bus 2

Bus 3

Bus 2

Bus 3

Bus 1

  • Investing in other companies offers fuller diversification than creating a conglomerate because it diversifies senior management and directors, as well as sectors of activity and business-unit managers

Source: OECD Analysis


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The fact that conglomerates comprise only 3% of large, family-run firms evidences a clear preference for portfolio diversification

Family-Run Conglomerates in OECD Countries

Percent; Number

  • Portfolio diversification is preferred over operational diversification

  • The competitive advantage of family-run firms is deep sectoral experience and contacts that cannot be exploited in the conglomerate structure

100% = 244

Source: Family Business Magazine; OECD Analysis


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Succession represents the biggest challenge to family-run firms.

Intergenerational Succession, UK

Percent

  • Only one in six family-run firms survives to the 3rd generation

  • One in eight family-run firms survives to the 4th generation

Source: Per-Olof Bjuggren and Lars-Goran Sund, “Strategic Decision Making in Intergenerational Successions of Small- and Medium-Size Family-Owned Businesses,” Family Business Review, 2001, Vol. 14, Part 1, pp.11-24


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However, successful succession can also mean selling all or a part of the firm at the right price

Sales Price for a Family-Run Firm

Return on Invested Capital

Return from offer to buy firm

Return from family firm

  • The owners’ goal should be maximising family welfare.

  • Sell the family firm when the marginal return from the offer meets or exceeds the firm’s marginal return

Capital Invested

Source: Utpal Bhattacharya and B. Ravikumar, “Capital Markets and the Evolution of Family Businesses,” JEL: G10, D92


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Where public and corporate governance are poor, the challenges of accessing capital, diversifying wealth and managing succession become harder.

Effects of Bad Governance

Challenge

Effect

  • Harder to start firm

  • Harder to grow firm

  • Harder to sell firm

Access Capital

Diversify wealth

  • Portfolio diversification becomes less attractive

  • Firm becomes overcapitalised, increasing risk and lowering performance

  • Harder to import talented outside managers

  • Harder to remove disgruntled or superfluous family shareholders and employees

  • Lack of alternative employment and increasing number of family employees worsens infighting over succession

Manage succession

Source: OECD Analysis


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If governance is poor, potential investors will discount the firm’s returns more steeply

Effect of Governance on a Firm’s Extrinsic Value

  • Extrinsic value is less than intrinsic value

Net Present Value of Cash Flows (“Intrinsic Value”)

Extrinsic Value

X

  • Investors’ Confidence in Ability to Determine and Enjoy Cash Flows

  • Political risk

  • Corporate Governance Risk

Source: OECD Analysis


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This discounting reduces access to capital firm’s returns more steeply

Effect of Governance on Access to Capital, 49-Country Survey

Percent of GNP

Market Capitalization of Minority Equity

Percent of GNP

  • Firms in countries with poor governance must finance operations and growth internally to a much greater degree

Value of Debt*

Percent of GNP

* Private sector bank debt plus outstanding non-financial bonds

Source: Rafael La Porta, et. al., “Legal Determinants of External Finance,” The Journal of Finance, Vol. LII, No. 3, July 1997, pp. 1131-1150


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Without good governance, portfolio diversification becomes less attractive...

Active

Passive

Operational v. Portfolio Diversification

Operational Diversification (“Conglomerate”)

Portfolio Diversification

SH

SH

Co. 1

Co. 2

Co. 3

Co. 1

Bus 1

Bus 2

Bus 3

Bus 2

Bus 3

Bus 1

  • Owners discount investment opportunities in other people’s companies just as other people discount investments in the owners’ company

  • Owners need not apply corporate governance discounts on returns from businesses they control and manage

Source: OECD Analysis


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Discounts on outside diversification opportunities also encourage family-business owners to invest more capital in their firms than they otherwise should

Capital Invested at Time of Sale

  • The extrinsic value of returns from offers to buy the family firm is less than their intrinsic value

  • Sale of part or all of firm is delayed and the family continues to invest capital in the firm as marginal returns diminish, impeding both performance and risk management

Extrinsic return from offer to buy firm

Return on Invested Capital

Intrinsic return from offer to buy firm

Over-investment

Capital Invested

Source: Bhattacharya and Ravikumar,


Poor governance also hinders succession by nurturing an insider only culture l.jpg
Poor governance also hinders succession by nurturing an insider-only culture

Correlation of Insider-only Culture and Poor Public Governance, Select European Countries

/Preliminary Data/

R2=0.76*

  • Firms in insider-only cultures are less willing to bring in talented outsiders

  • Family members (talented or not) are less likely to find employment outside the family firm

  • Lack of outside job opportunities pressures owners to maintain and expand the firm as a source of family employment

* T test is 5.2, based on limited data set

Source: Sue Birley, Entrepreneurship: Theory and Practice, December 22, 2001, Vol 26, No. 2, pp. 63; Transparency International.


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Over time, the rising complexity of succession necessitates either formal governance mechanisms or takeover of the business by one branch of the family, with possible expropriation of the other branches’ wealth

Succession in Family-Run Firms

  • Good corporate governance becomes necessary to run the business and to preserve family harmony

Complex

Cousin Consortium

Evolutionary Succession

Sibling Partnership

Devolutionary Succession

Controlling Owner

First Generation

Second Generation

Third Generation

Simple

Source: Paul Westhead and Carole Howorth, “A Comparison of Ownership and Management Practices in First and Multi-Generational Family Firms,” 24th ISBA National Small Firms Conference, 2001


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Promoting good governance will therefore better enable family-business owners to meet and overcome the challenges for long-term success

Benefits of Good Governance

Challenge

Effect

  • Easier to start firm

  • Easier to grow firm

  • Easier to sell firm

Access Capital

Diversify wealth

  • Firm functions with optimal capital

  • Portfolio diversification becomes more attractive

Manage succession

  • Easier to import talented outsiders

  • Easier to remove disgruntled or superfluous family members

  • Exit and cash out options reduce infighting over succession

Source: OECD Analysis


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