David Reeb is an associate professor of finance and a Fuller research fellow at Temple University's Fox School of Business and Management Ron Anderson is a professor at American University, Washington DC
Their research on the outperformance of family firms versus their non-family counterparts in the S&P500 was revelatory – but as David Reeb and Ron Anderson explain, it also uncovered some serious governance issues and highlighted the need for outside input
Conventional business wisdom indicates that publicly-traded companies, with many small shareholders and professional managers, outperform or out-hustle those companies where family managers and owners continue to dominate a firm. Family ownership and management of public corporations raises several red flags in the eyes of investors; one of these flags comes from families awarding senior management positions exclusively to family members, thereby potentially excluding better qualified and more competent outside managers. Parmalat and Adelphia – two names in the global business world are extreme examples of companies which, in their time, were under family management that resulted in ruin for the firm's investors. Another concern for investors regarding family management arises from families holding the power (either psychologically as the founders and majority owners, or literally as unchecked masters of their own dynasties) to loot company coffers and "steal" wealth from their firm's public stakeholders.
In our 2004 research on board composition and familial influence among family business constituents of the S&P500 index (with a sample from years 1992-99), we found that family ownership and control is prevalent among US firms, with founding families holding onto stakes in about 35% of index constituents, at an average outstanding equity stake of nearly 18% (see table). Even with these large ownership positions, families often delegate day-to-day management operations to external non-family managers. That said, we found the chief executive role was still held by a family member in 45% of firms, with hired hands holding the remaining seats. So we examined how family ownership affects corporate performance, and what mechanisms exist to balance family power. Although family firms tend to outperform their non-family counterparts, recent events such as those at Adelphia Communications, Parmalat, or Martha Stewart Living (60% of which is controlled by Ms Stewart's family) suggest that something should counterbalance family power and prevent them exploiting minority investors. One potential power base for minority shareholders in opposing family opportunism is independent directors. These are people whose only relationship to the firm is their directorship, and who usually concurrently maintain senior managerial roles in other unrelated firms, therefore contributing a strong business background and an implied reputation for fair dealing. Independent directors are responsible for representing and promoting the best interests of all shareholders – not just the interest of the family. But our examination of the effectiveness in family firms of such a board bore some interesting conclusions. We found that family firms contain far fewer independent directors (44%) than non-family firms (61%) and that inside directors held significantly more seats in family firms (39%) versus non-family firms (23%). Within family firms, family members appear to occupy nearly 20% of all board seats. But we found also a correlation between family firms with greater independent director representation, and a higher stock valuation; in one case, we found that this variant – in a company whose board was 75% independent – increased its stock value by 16%.
We interpreted our results to indicate that outside investors prefer to have an autonomous voice in the firm to protect their interests from large controlling shareholders. Families can and have expropriated company wealth or other tangible resources in many ways, from overly generous pay contracts, personal loans, special dividends, or lucrative business contracts with other firms affiliated, however loosely, to the family. Numerous accounts in the popular press have damned the activities of founding families like those behind Marriott and Rite Aid for allegedly engaging in activities that enriched the family at the blatant expense of outside investors. The destructive conduct of these families reinforces the traditional image that family ownership and control is an inefficient organisational form, hindering firm performance and the survival of the corporation.
The destructive effects of families however, depict only one side of the story. While not widely known, founders and descendants of corporations continue to hold sizeable stakes in many of the largest publicly-listed companies in the USA. Sam Walton's heirs hold nearly one-third of the company's issued stock in the world's largest company, Wal-Mart; similarly the DuPont family reportedly holds a 15% stake in the chemicals giant that was established in the late 1700s. Although sometimes the only financial sustenance of descendents who may have little or nothing to do with the management of the business, these large, long-standing shareholdings still commonly fuel considerable incentive for family groups to watch quite closely the strategic direction of the company; an example being the decision in 2001 to replace Ford's non-family chief executive, Jacques Nasser, with fourth family generation Bill Ford. After all, they want to protect their investment and incomes. In Ford's case, though, this June's junk bond rating on Ford's autos and credit businesses, plus vast production cuts under Bill's tutelage – which saw him waive his right to take a salary from the company – could perhaps be taken as illustration that family does not always know best.
Beyond their day-to-day management of operations, families can provide other benefits to the company. A multi-generational presence in the firm, for instance, reinforces the notion of investment for the long-term, relative to the typical chief executive of a non-family led listed corporation whose tenure lasts an average five years. Families will endure the demanding years of waiting for investments to bear fruit – theirs is 'patient capital'. In general, the family's oversight, multi-generational presence, concerns about reputation, and influential voice on company matters indicates that these large, often undiversified investors can play an important and unique role in shaping the direction and performance of publicly traded companies.
Casual observation shows that family ownership has led to numerous well-documented instances of corporate ruin on both sides of the Atlantic, and these pervade the enduring memory of the ever-critical public markets. Additionally, this has an effect on certain industries where it seems family businesses are prevalent, like printing and publishing, food stores, clothing and accessory stores, eating and drinking places, and retail distribution. Conversely, the prevalence of family ownership in these industries seems to provide some particular advantage, such as a quality assurance. For investors, perhaps the most important question arising from family ownership concerns performance. Economic theory suggests that families, with their substantial ownership and control positions can extract undue cash or benefits from the firm at the expense of their public benefactors. Other theories say that large shareholder groups have ample monetary incentives to increase performance and the value of public holdings in their firm.
Do families make any difference to performance? When measuring performance using return on assets – net income divided by total assets – family firms return 6.65% more relative to non-family firms. Stock-market based measures indicate that family firms are about 10% 'more valuable' than non-family firms. Focusing on the impact of family members leading the firm indicates that founder CEOs provide the greatest gains, while smaller but positive gains accrue when descendants run the company. So we conclude that, in the U.S at least, it can make a positive difference versus non-family firms.
So which of the competing views – constructive or destructive – more definitively depicts the role that family ownership and management plays in business? Our examination of board of director effectiveness in family firms bore some interesting conclusions. In terms of simple descriptive statistics, we found that family firms contain far fewer independent directors (44%) than non-family firms (61%) and that inside directors hold significantly more seats than in family firms (39%) versus non-family firms (23%). Within family firms, family members occupy nearly 20% of al board seats; suggesting that they have a strong voice in protecting and promoting family interests. The results of our investigation revealed that family firms with greater independent director representation tend to be the most highly-valued by outside investors. For instance, a family firm with 75% independent directors on board was valued 16% higher by the stock market than a family firm with only 25% independent directors on the board (assuming the family has an equal stake in both firms). We interpreted our results to indicate that outside investors prefer to have an objective, autonomous voice in the firm to protect their interests from large controlling shareholders.
However, the story isn't that simple. Earlier we noted that family firms tended to be better performers than non-family firms, suggesting that the family must provide some benefit. On the other hand, we argue that investors want highly independent boards to protect themselves from negative family influence and control. We also discussed how the most highly valued family firms are those combining a mix of family and some mechanism to control the family; in our case, independent directors. Specifically, we found that the best firms are those whose ratio of family to independent is one to every two. Once family representation exceeds this proportion, firm values quickly fall – suggesting that too much family influence harms firm performance but some influence provides substantial benefits.