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The Fourth Asian Roundtable on Corporate Governance

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

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  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 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

  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 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

  12. 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

  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 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

  16. 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

  17. 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

  18. 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

  19. 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

  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,

  21. 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.

  22. 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

  23. 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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