Research suggests family-owned businesses tend to carry less debt and outperform the wider equity market
What exactly constitutes a family-owned business? Opinion varies. In a 2009 report, for example, the European Commission found there were more than 90 different definitions of what makes a family business within the EU. Pictet talks about public companies where one person or a family owns a minimum of 30 per cent of voting rights; UBS goes for 50 per cent, or 20 per cent of voting rights plus top management or board influence.
But wherever the bar is set, two things become clear: there are lots of these companies – perhaps two thirds of all businesses worldwide are family-owned, generating about 70 per cent of GDP – and they tend to outperform the broader market.
For example, the Credit Suisse ‘Family 1000’ database of more than 1,000 publicly-listed family or founder-owned companies shows that from 2006 up until June 2020, these firms outperformed non-family-owned companies by an annual average of 370 basis points. Revenue growth was higher, as were profits, and these superior returns can be observed across all regions globally.
Cashing in
But why is this? In May 2020, Pictet Asset Management launched the Pictet-Family fund which looks to capture that outperformance. In constructing this fund, Pictet put in some caveats. In developed markets any market cap was allowed, but in emerging markets there is a minimum of $10bn. Plus all stocks must have a daily liquidity of $5m.
“So we took a huge universe and took it down to about 500 stocks,” says Adam Johnson, senior client portfolio manager at Pictet Asset Management. “And when we ran our analysis, we found they had outperformed the MSCI ACWI by a cumulative 88 per cent since 2007.”
This selection of stocks is “hugely” underweight North America, which has been the best performing region over the time period, and while sector allocation did provide some performance, it was clear the majority was stock specific, he says.
“We would like to call this the ‘family factor’,” says Mr Johnson. “The drivers we boiled it down to were based around human values and active ownership.”
This means the owner’s drive and ambition, their “entrepreneurship”, is deeply embedded within the company’s culture, he explains. Plus there is also evidence of “stewardship”.
“Family members are inheriting these companies and don’t want to be the ones blamed for messing things up. Their mindset is to invest now for the benefit of future generations,” adds Mr Johnson.
The concept of “socio-emotional wealth” is also important, he says. This refers to the non-financial aspects that meet the family’s needs. “It is about identity, reputation, legacy. The families have so much invested in these companies, it is about them and who they are. They have skin in the game.”
With so much wealth tied up in their businesses, how family-owned businesses act and how they invest tends to be very different from non-family owned businesses, and they operate on very different time horizons.
“Family businesses tend to put a large proportion of their profits back into the company, either through reinvesting or deleveraging the balance sheet, than non-family owned businesses,” says Mr Johnson. “And when they do invest, they tend to do it much more strategically and with better outcomes. And yet they do this with lower leverage. They are much more cautious.”
There are pitfalls though, he says, especially surrounding governance, which explains why many of these firms often score poorly in ESG ratings. There are risks that can come with the presence of a dominant shareholder, who might ignore the wishes of those who hold less equity. There is also the risk of individuals or a family confusing personal wealth with operational assets, putting family interests in front of corporate ones.
“Nepotism is a fear that investors often think of,” says Mr Johnson, explaining that to identify and avoid the risks in this sector you need to take an active, qualitative approach.
Conservative mindset
Family-owned companies do indeed tend to have a longer-term view, agrees Eugène Klerk, head of global thematic research and equity research product manager, Europe at Credit Suisse. “This is partly driven by the fact that family-owned companies tend to be more conservatively financed and in addition their cash flow returns tend to be more stable.”
Furthermore, the bank’s research suggests these companies, when going through a recession, do not tend to diversify but rather focus on their core business. “They stick to what they know best,” he says.
The fact that family owned companies tend to have higher quality or more defensive characteristics was a key reason for their outperformance last year, says Mr Klerk, and there has been growing interest from investors as a result.
“Against the background of volatile market conditions, family-owned companies provide more robust returns,” he explains, adding that the fact the founder or the family’s wealth is tied up also provides investors with comfort that no radical decisions are likely to be made.
Yet Mr Klerk cautions that as Covid-19 becomes less of a factor, some of this outperformance might reduce, given that investors could focus on a rebound in equities which underperformed during the pandemic.
Asset manager Liontrust, as part of its Economic Advantage process, likes to invest in companies where management holds a stake in the businesses they are running, as this gives a clear alignment of interest between investors and management. The firm looks for at least 3 per cent ownership, though the average tends to be closer to 20 per cent.
These owner-manager companies tend to avoid debt, says Alex Wedge, a co-manager of the Liontrust UK Smaller Companies and UK Micro Cap funds, as they do not want to destroy their own, or their families, wealth in one cycle by being over geared. They also tend not to do strategic or very large acquisitions for the same reason, he says, as buying something very large often means taking on debt, which brings a lot of risk.
“The funds tend to perform well in steep market declines,” says Mr Wedge. “One reason being those strong balance sheets. We have quite a big bias towards quality. That tends to do well when people are fearful.”
They also tend to do well in normal times, he reports, when that quality bias means they are meeting or beating expectations. “When they don’t do well is steep cyclical rallies, as we saw after the positive news on the vaccines. So we had a year of two halves.”
Looking long term
Many companies, and investors, place great importance in quarterly reported earnings numbers, says Obe Ejikeme, co-manager of the Carmignac Portfolio Family Governed fund, which launched in 2019.
“Now we are obviously happy when the numbers are good, but even the corporates will tell you there is a frustration around what is a ritual, something that is essentially designed by regulators to stop things from going wrong.”
This focus can blur the line between what is in a company’s best interest over the long term, he claims. “Sometimes it is better to divest some of your business, to make big long-term investments which are really negative to earnings for one quarter or half a year, in the interests of being a better business.”
Family-owned businesses are much more likely to make those decisions, ploughing cash back into their own company through, for example, increased spending on research and development.
Family businesses often tend to be in the small and mid-cap space, says Mr Ejikeme, partly because larger companies often see control shift away from the family members or the large founders.
Smaller companies often get overlooked, he says, so can bring opportunity, although this does bring natural liquidity risk. “We have all heard the stories of fund managers that have got into trouble because they bought illiquid assets that they cannot sell in times of trouble. So we just don’t invest in companies that trade under a certain level of liquidity.”
Although Mr Ejikeme says that if an investor simply bought into a fund which was playing the family-owned theme and nothing else they could expect decent performance over time, he stresses that it is essential to apply traditional selection processes on top of that.
“We are looking at how profitable the businesses are and how much they are reinvesting for the future as opposed to paying back shareholders through dividends,” he adds.
It could be argued that companies which follow these cautious business models might miss out on certain opportunities, says Simon Moon, co-manager of the Unicorn UK Income Fund and Acorn Income Fund and lead manager of the Unicorn Smaller Companies Fund. But this is not really something he believes.
“At the end of the day, if you have missed out on half a per cent’s growth because you didn’t indebt the company or buy that one business you weren’t entirely convinced by, is that such a bad thing?” he asks. “If a clear focus on cash generation means the business grows more slowly but in a less volatile fashion, I think I would probably rather that, in a high conviction portfolio like we run.”
Family union
There is a natural fit between family offices and family-owned businesses, says Maximilian Kunkel, chief investment officer for UBS Global Wealth Management’s Global Family Office, both in public, but also increasing in private, markets.
“We often find family offices wanting to make direct investments with a particular view to be able to fully understand and to some extent potentially influence the decisions made in another family business,” he explains.
On the other hand, for the family-owned business, by increasingly raising capital through private markets, they are able to partner with investors that are like-minded and can potentially bring something to the table that accelerates or enhances the value proposition of the business.
“So family offices often invest in businesses that are either complementary to their main business, or in a relatively similar industry where they can add expertise, or funding and distribution networks,” says Mr Kunkel.
It is certainly true that family-owned businesses tend to outperform, he says, though noting that this advantage is diluted somewhat as a company is passed down through the generations.
“We find that first, second and to a certain extent third generation businesses tend to do better than when you move into fourth and fifth generation ones,” says Mr Kunkel.
One reason for this is that as a business becomes more mature, it becomes less growth-oriented, while it is also the case that the focus of later generations sometimes shifts onto new ventures.
Older businesses also tend to have extended family members getting involved, he says, and can lose sight of the company’s values. “And with that missing, the business tends to outperform less consistently,” he adds. “We find that statistically, but also anecdotally.”
