The Fourth Asian Roundtable on Corporate Governance

1
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
2
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

3
Family-run firms predominate in OECD economies
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
4
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
5
Family-run firms (both listed and private) make
up a significant percentage of all major firms
Family-Run Firms among US SP 500 Percent

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

• Family-run firms constitute 40 of the US SP
  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
6
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
7
...They are as numerous...
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
8
And comparably represented across industry
sectors
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
9
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
10
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
11
...IPO data indicate that access to capital has
not been a major problem for mid-size and large,
family-run companies
Primary v. Secondary IPO Shares, Select European
Countries, 1980-90 Percent
Average Age at IPO Years

• 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
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• 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
13
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
14
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
15
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 family firm
Return from offer to buy firm

• The owners goal should be maximising family
  welfare.
• Sell the family firm when the marginal return
  from the offer meets or exceeds the firms
  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 firms returns more steeply
Effect of Governance on a Firms 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
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
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• Owners discount investment opportunities in
  other peoples 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
20
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,
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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/
R20.76

• 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