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family business governance scores

March 2021
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ESG agency misconceptions about family business governance

ESG agencies and the financial markets are wary of family-owned companies' governance structures. But  this is a result of some fundamental misunderstandings.

01

The governance issue

For all the attractive returns family-owned1 companies generate, investors remain cautious. 

A common refrain is that family-run firms have weak governance structures – a perception that’s reinforced by third party rating agencies that routinely pronounce on such matters. 

Our contention is that a rigid application of rating agencies’ governance metrics is much too crude a way of judging how family-owned firms are run and managed. 

Not only do these metrics ignore many of the advantages that family ownership brings to corporate management, but they also lose sight of the empirical evidence: family-owned companies generate better returns at lower risk to capital employed (see Fig. 1).

FIG. 1 - Happy families
Universe of family companies* vs MSCI All Country World index (rebased 31.12.2006=100)
Family firm returns vs broader market
*See footnote 1. Source: MSCI, Factset, Pictet Asset Management. Data from 31.12.2006 to 31.12.2020.
 

Rating agencies’ criticisms hinge on three dimensions of family company governance: board structure, shareholder rights and executive compensation. But we show that notwithstanding lack of board independence, family companies tend to have higher returns while maintaining lower financial leverage. Given that financial discipline is one of the key rationales for board independence, family companies shouldn’t be marked down on these grounds. As for shareholder rights, independent remuneration, audit and nomination committees are more crucial than overall board independence. And finally, there is no evidence from chief executive pay that families use their insider advantage to reward themselves excessively.

02

Scoring badly

Publicly listed, but significantly family-owned companies consistently score well on ESG rating agencies’ environmental and social measures relative to non-family companies but underperform on governance (see Fig, 2).2 Outperformance on E and S is likely to be down to the fact that families are particularly protective of their brand, which often it has their names on it. So they will make exceptional efforts to avoid social or environmental scandal.
 
FIG. 2 - Governance issues
Sustainalytics governance sub-index scores
Governance scores
Source: Sustainalytics. Data from 31.01.2021

But the poor governance score comes despite the fact that family firms register considerably fewer controversies – which is to say, incidents that are likely to hurt stakeholders, the environment or the companies’ operations,  many of which tend to centre on governance – than other firms (see Fig. 3).3 And the fact they tend to have stronger fundamentals and performance characteristics, such as return on invested capital – characteristics that would normally suggest they are better run than non-family companies.

Agencies typically look at four key characteristics when assessing corporate governance: board structure; shareholder rights; executive compensation; and audit. And they tend to mark family firms down on the first three of those. Only in terms of audit – which is to say risk control – do they think that family-owned companies manage as well as non-family companies.

By and large these perceived governance flaws are inherent to family companies because of the very nature of their development. After all, family-run firms have a distinct structure and identity that derives from their closely-held origins. In fact, we will show that they are frequently strengths rather than weaknesses as we take deeper look at each of these three main criticisms agencies have of family firm governance.  
FIG. 3 - Uncontroversial
Sustainalytics controversy overall score (lower = fewer controversies)
Family Fig. 3.png
Source: Sustainalytics. Data from 31.01.2021

But first it’s also worth noting that there are significant limitations with ratings agency ESG rankings. To begin with, there is a lack of consistency in data disclosures from companies. This often leads to larger companies and those in developed markets receiving higher rankings than small firms and emerging market companies. Many elements of the ratings tend to be backward looking and sometimes very out of date. The way that ESG factors are measured varies. And agencies don’t apply the same weightings to ESG factors, even in the cases where the data is standardised, which leads to different rankings. As a result, ratings agencies often disagree in their results – in a review of six ratings agencies, one paper found that the average ratings correlation was just 0.54.4

In effect, there’s a substantial margin of error in corporate ESG scores attributed by ratings agencies – potentially broad enough to give very misleading results, even without considering the flawed reasoning behind their criticism of family company governance. 

03

Structuring boards

 

FIG. 4 - Safety first
Net debt to earnings before interest, tax and depreciation allowance for family companies vs MSCI All Country World Index
Net debt to earnings before interest, tax and depreciation allowance for family companies vs MSCI All Country World Index
Source: MSCI, Factset, Pictet Asset Management. Data as at 31.12.2020.
 

Rating agencies all hold that board independence is a cornerstone of the ideal corporate governance structure. A majority independent board and sub-committees, such as remuneration and audit, are considered to be crucial to protecting the interests of minority shareholders. Specifically, to protecting minority shareholders’ capital.

Family firms are typically less geared than their rivals, based on the ratio of net debt to adjusted earnings.6 That’s important, because balance sheet strength is an important measure of capital protection.

As such, board independence should be a good indicator of relative corporate performance. But it’s not. The evidence shows that although family-owned businesses typically have less board independence, they also have better returns and higher standards of financial discipline than non-financial companies (see Figs. 4 and 5).

FIG. 5 - Many happy returns
Return on assets for family companies vs MSCI All Country World Index
Return on assets for family companies vs MSCI All Country World Index
Source: MSCI, Factset, Pictet Asset Management. Data as at 31.12.2020.

Research from HSBC shows that at a regional level, there’s no correlation between board independence and corporate performance – differences are likely to boil down to variations between countries in how shareholder rights are enforced.7 But there is one on a sectoral level, which we analysed by focusing on the luxury goods sector because these companies tend to feature substantial ownership stakes by dominant families.8 We found that within this sector there is an inverse correlation between board independence/governance scores and shareholder returns (see Fig. 6).

Our findings suggest that while the presence of a major shareholder can reduce board independence, it will also bring other advantages to minority shareholders, namely a more conservative approach to decision making, greater prudence and a board whose objective is the company’s long-run success rather than quarterly targets. Research on Asian family-owned companies found that a 38 per cent independent board was optimal for maximising shareholder returns, along with separation of the chairman and chief executive positions and the establishment of separate audit and remuneration committees.9

So rather than being wedded to the independence of the board, investors would do better to focus on the composition of corporate governance sub-committees whose primary role is to protect minority shareholder interest – namely audit, remuneration and nomination committees. That is why at Pictet Asset Management, we feel it is sufficient for family-owned companies to have at least 30 per cent board independence rather than the minimum 50 per cent mandated by ESG agencies, as long as the board’s sub-committees are independent.
 
FIG. 6 - Family luxuries
Total shareholder returns CAGR vs ISS board independence scores in luxury goods segment
Total shareholder returns CAGR vs ISS board independence scores in luxury goods segment
Source: ISS, Refinitiv, Exane, Pictet Asset Management. Data from 01.01.2011 to 12.11.2020.
04

Taking control

Rating agencies also have difficulties assessing the structures families put in place to retain control of family companies, even when they have less than majority ownership. These can take the form of special legal vehicles – such as joint-stock companies, KGaA in Germany, foundations and others – pyramidal structures or dual class shares. 

While it’s true that these structures carry obvious risks – namely that controlling shareholders will extract private benefits – they also bring advantages that are too frequently forgotten, such as stability. Yet it is this stability that allows family companies to pursue very long-term investments and to maintain strategic focus.


There is a growing recognition that companies perform better under the stewardship of long-term investors

There is a growing recognition that companies perform better under the stewardship of long-term investors. In recent years, leading authorities on corporate governance such as Al Gore, the former US vice president and pioneer of ESG investing, McKinsey Managing Director Dominic Barton,10 and Vanguard Group founder John Bogle have all advocated bolstering the voting rights of long-term shareholders or, conversely, withholding them from short-term investors.11 And several European countries have implemented regulations giving “loyal” shareholders extra voting influence.12
Silicon Valley offers numerous examples of how such an approach can be successful for shareholders – albeit often outside of the public markets. For founders of tech firms there is often significant tension between the need for fresh capital and the need to maintain control to keep projects with very long-term payoffs on track. Institutional investors are frequently willing to accept lower governance standards in exchange for longer term rewards. Indeed, such ready access to private markets has halved the number of publicly traded companies in the US since the mid-1990s. And even when these tech companies do go public, institutional investors are frequently willing to accept reduced control. For instance, at its initial public offering, Snap, a social media company, only gave outside investors access to a class of shares with no voting rights, reserving voting shares for co-founders, employees and early-stage investors. 
FIG. 7 - Unequal performance
Premium or discount companies with unequal voting rights show relative to companies in the MSCI All Country World Index for key performance criteria
Premium or discount companies with unequal voting rights show relative to companies in the MSCI All Country World Index for key performance criteria
Source: CFA Institute “Dual-Class Shares: The good, the bad and the ugly”, CFA Institute August 2018, Pictet Asset Management. 

The research on dual share classes or unequal voting rights presents conflicting views.13 One school of thought is that these share structures have a negative impact on corporate value creation by entrenching the interests of voting shareholders, leaving them able to extract outsized benefits.14 The second school is that dual-class structures encourage value-creating entrepreneurs and investment in human capital, and that control over decision-making leads to investment in projects that show long-term value that can be costly or difficult to communicate15 – not least because they allow management to look past short-term targets such as quarterly earnings.16

A discussion paper produced by the CFA Institute in 2018 found that companies with dual class shares (DCS) outperformed firms in the MSCI ACWI Index on nearly all financial indicators investigated (see Fig. 7). They delivered stronger earnings growth, higher profit margins and stronger returns on equity to investors. They only fell short in their profit distribution to shareholders.17

Although some of this outperformance is attributable to systemic factors, like country of domicile, sector and currency effects, there are still company-specific effects – which is to say, related to the dual share structure. They account for 4 per cent of positive return in North America and all of the positive effects in emerging economies.

05

Executive pay

Rating agencies’ third key governance criticism focuses on the risks that corporate insiders will take advantage of powerless shareholders for their own personal financial benefit. Agency theory, or the principal-agent problem, contends that agents will use their powers to further their own interests to the disadvantage of principals. In other words, the fear is that agents with executive roles would tend to pay themselves disproportionately.

Large listed companies minimise this risk by giving their executives a combination of attractive cash-based fixed pay together with a performance-based element in shares, options or both. Stock options are meant to align the interests of management with those of other shareholders. This framework has become the benchmark for executive pay practice and thus a requirement for a strong ESG rating.18

What ratings agencies fail to recognise, though, is that these compensation schemes are mostly just an effort to reproduce the sort of shareholder-manager alignment that already exists within family-owned companies. A vast majority of family firms appoint their chief executive from within the family, and therefore someone who already has a significant stake in the firm. Furthermore, a recent Chief Executive Research survey of 1631 companies shows that remuneration of these executives is on a par with that of non-family companies (see Fig. 8).19

FIG. 8 - Remuneratively average
Chief executive compensation by enterprise type (2018, USD ‘000)
Chief executive compensation by enterprise type
*Includes perks, benefits, equity gains, new equity and bonus. Source: Chief Executive Research, CEO remuneration report 2018, Pictet Asset Management. 
 

Another complaint by ratings agencies is that family firms are less transparent on executive pay than other companies. But here too, there often good reasons for the disparity. 

Executives in family-controlled firms tend to have significant stakes in the companies and their salaries represent a comparatively minor contribution to their wealth. This means it is natural for family owned businesses to place greater emphasis on shareholder value as a source of return than on pay performance indicators. 

Meanwhile, the remuneration structures rating agencies favour are also flawed. A key device for aligning managers’ interests with those of shareholders is to reward executives with stock options. But as an incentive, options carry no downside risk. Managers may gain nothing if the share price falls below the options’ strike price, but they also don’t risk a drop in their existing wealth if their efforts fail – unlike long-term shareholders. 

The nature of these options – no downside but potentially huge gains – can distort managers’ preferences towards taking significant risks in order to generate outsized corporate performance, typically over the short term. Family firms tend to dislike this type of skewed risk. They have a preference for wealth preservation strategies and thus tend not to use incentive structures that encourage management to take undue risks. They are equally averse to the diluting effects of using stock options to give management a significant stake in the company. For family firms that hire non-family executives, the structure of their remuneration tends to include transparent long-term targets that coincide with the family’s own aims.

For all types of companies, investors should focus on whether the remuneration committee is independent and therefore exists to protect the interests of minority shareholders. 

06

A subtle approach

Given the systematic flaws in how rating agencies assess corporate governance, it would be short-sighted to base investment decisions on such metrics alone. 

At Pictet Asset Management, we have created our own customised family governance score to help us interpret family business’ governance structures (see Fig. 9). The score is based on the main factors identified by academic research that influence the performance of family-owned businesses: ownership, long-term vision, controversies and committees.

Family companies are an excellent and too often overlooked investment.

Key to our analysis is to determine a family-owned company’s stability and preparedness for the future. We do this by considering whether the founder is in charge or whether management is in the hands of a younger generation. And we assess the structure of the firm’s succession planning – whether continuity is clearly communicated in the family firm’s constitution and reflected in the firm’s voting rights.

Rather than focusing on the one share one vote principle that ESG data providers rely on, we dive more deeply into the way shareholder control is exerted to consider whether these are exaggerated structures or prone to abuse – be that through financial levers of pyramidal approaches or extreme divergence between voting and economic rights.

We consider whether the company is being run on the basis of a long-term vision by checking how much stock the chief executive holds and whether the executive board’s remuneration is structured around payouts contingent on long-term performance targets. And we assess the company’s corporate culture as well as its history of financial discipline.

Rating agencies may not like family companies’ lack of board independence, but we see this as a potential advantage. Strong family leadership through stable and significant ownership tends to foster long-term thinking, geared towards capital preservation and away from moonshot gambles. To protect our interests as minority shareholders, we instead look at the independence of the company’s audit, remuneration and nomination committees.

And finally, we pay attention to whether the firm has attracted controversy, particularly related to third-party transactions or unjustified remuneration. While this is a backward-looking indicator, it also gives an indication of the quality of corporate governance and helps us avoid firms with dominant shareholders who put family interests in front of the company’s interests.

FIG. 9 - Pictet's family model
Pictet family governance model
Source: Pictet Asset Management.
Family companies perform so well relative to other companies that there must be serious questions over why they score badly on rating agencies’ governance rankings. Is it reasonable to believe that family companies are less well run than their non-family peers despite consistently generating better shareholder returns at smaller risk to investors’ capital? We don’t think so. As a consequence, we believe that these companies are an excellent and too often overlooked investment, particularly once their governance structures are subject to deeper, more penetrating analysis. 

Acknowledgements

Alain Caffort, Vineet Chhibber, Cyril Benier and Adam Johnson contributed to this article.