​Do family-owned companies make better investments?

Recent research conducted by Credit Suisse has shed light on the compelling advantages of investing in family-owned businesses. Credit Suisse defines a family-owned business as one where the founder or their family owns at least 20% of the company’s share capital or voting rights.

Their findings reveal that family-owned businesses possess distinctive characteristics that set them apart in the market, consistently demonstrating superior top-line growth, making them a reliable avenue for higher returns.

Family-owned businesses generated an annual sector-adjusted excess return of 300 basis points since 2006.

In this article, we delve into the reasons underpinning the success of family-owned businesses and their unique characteristics that render investing in these businesses a distinctive and promising venture.

Risk-averse nature

The risk-averse nature embedded in the operations of family-owned businesses is a defining characteristic that sets them apart from other businesses. This ingrained caution is rooted in a profound desire to safeguard the family legacy and ensure the enduring sustainability of the business.

Unlike their non-family counterparts, which often rely heavily on debt to fuel expansion, family-owned enterprises exhibit a more conservative approach to leveraging. This deliberate strategy imparts greater financial flexibility and bolsters resilience in the face of economic downturns.

Owner-operators tend to be more deeply invested in their business’s success and continuity, thus inherently exhibiting a heightened sensitivity to these aspects. Beyond reducing perceived risks, the reduced reliance on external capital, be it debt or equity, resonates with the overarching goal of maintaining essential control over the business’s direction and long-term trajectory.

Conservative R&D spending

Innovation is a pivotal cornerstone in pursuing business success, yet family-owned businesses exhibit a more cautious approach to research and development (R&D) spending. This strategic choice reflects a conscious effort to mitigate unnecessary risks, opting for proven strategies and incremental improvements over radical innovation.

Source: Credit Suisse

Several factors contribute to the divergence in R&D attitudes between family-owned and non-family-owned companies. Family-owned businesses are often perceived as having a lower willingness and ability to take risks. This stems from a more conservative capital structure, concentrated family wealth, and a notably generous dividend policy to be used as a source of cash flow for family members.

Source: Credit Suisse

Additionally, family-owned businesses tend to demonstrate a more efficient utilisation of resources such as human and social capital attributed to prolonged employee tenures. Despite criticisms of potential nepotism, these businesses often maintain high levels of employee retention, particularly among the senior executive team. This extended tenure contributes to a robust social capital, encompassing intangible assets such as industry knowledge and relationships.

This social capital proves instrumental in driving innovation, fostering valuable connections for advice, communication, and simplified development processes. The effective resource allocation facilitated by long-tenured CEOs, prudence, and a desire for close control amplifies the impact of R&D spending, positioning family-owned businesses as both efficient and innovative players in the business landscape.

Potential risks

Governance risk

While family businesses typically shine in the environmental and social dimensions of ESG scores, showcasing a commitment toward sustainability and social responsibility, their corporate governance practices often lag behind those of non-family-owned counterparts. This governance shortfall poses a significant risk for investors, potentially giving rise to potential challenges such as nepotism, conflicts of interest, and a blurred distinction between ownership and management roles.

Motivated by a deep-rooted desire to preserve familial legacies and wealth, family businesses may prioritise family interests over adopting optimal corporate governance practices. This inclination towards maintaining familial control can introduce decision-making biases and impede the establishment of robust governance structures.

ESG scores for family-owned businesses compared favourably to non-family businesses and have improved steadily over the years; however, governance scores continue to fall behind when compared to non-family-owned counterparts.

Therefore, Investors navigating the landscape of family-owned businesses should evaluate not only the financial performance of these businesses but also the governance structures in place, ensuring that transparency, accountability, and shareholder interests are safeguarded.

Succession risk

Succession risk stands out as a critical factor that often influences the performance of family-owned business. The dynamics reveal a stark contrast in outperformance among the early generations, particularly generations 1 and 2.

Performance of family-owned companies in generations 1 and 2 have delivered compound returns double that of Generations 4 and 5 or later.

This performance divergence could be attributed to the entrepreneurial lifecycle, where early generations often experience robust growth and higher innovation output, setting the stage for substantial returns. Conversely, later generations face a formidable hurdle in the form of succession challenges. As family businesses transition across generations, the seamless transfer of leadership and strategic vision becomes increasingly complex. If not navigated adeptly, these challenges can impede the sustained high-level performance witnessed in earlier generations.

In certain regions, such as Asia, a notable shift occurs in later-generation family businesses, adopting a more conglomerate nature. While this evolution may seem strategic, it brings forth a potential dilution of focus. Diversifying various business sectors can lead to a lack of strategic clarity and focus, adversely impacting overall returns. For investors, recognising the implications of a business becoming less focused as it traverses successive generations is paramount. This factor will significantly influence the overall returns on investment, underscoring the need for a nuanced understanding of succession risks when evaluating family-owned businesses.

The fifth perspective

Despite low-risk appetite and innovation spending, family-owned businesses tend to generate better performance due to its higher innovative output thanks to longer employee tenures, stronger social capital and a more efficient operating model. For those keen on a comprehensive exploration of this subject, I highly recommend interested readers to explore the full report on family-owned businesses available on the Credit Suisse website. This extensive resource promises a more detailed and nuanced analysis, providing a comprehensive view of the opportunities and challenges that define the landscape of family-owned businesses.

Wang Choon Leo, CFA

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that can connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. Choon Leo is a CFA charterholder.

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