Families, Foundations & Founders
Investors often favor family, foundation, or founder control — But controlling owners can settle for credit-like returns — Outside investors bear equity risk and require equity returns.
FAMILIES, FOUNDATIONS & FOUNDERS
Family, foundation, or founder ownership of public companies is often viewed as a benefit. Many investors, most notably Tom Russo, prefer to invest in businesses with this type of ownership.
These owners tend to have long-term investment horizons and can insulate businesses from shareholders focused on the short term. They are typically conservative in their management, focusing on preserving the business for the long term. This risk-first approach is key to surviving in the public markets for extended periods.
As with most investment heuristics, though, there are downsides to investing in companies controlled by families, foundations, and founders.
No Risk, No Return
It is possible to be too risk averse. Family and foundation owners, particularly second- and third-generation members, tend to prioritize the longevity of the business over the actual returns delivered. This is less often a problem with founders themselves than with the generations that follow.
Many families are more than capable of living off recurring dividends and view the controlled business as an ATM. The desire to preserve dividend payments for the long term often leads to missed opportunities.
Outside investors, though, by choosing to invest in equities, desire both income and growth. A business generating only a 5% return for its shareholders is a failure as an equity investment, even if the family is thrilled with the cash delivered to its bank accounts.
Often, controlled businesses are operated in such a risk-averse manner that the return profile looks more like a bond than an equity. But non-controlling equity investors still bear equity risk, making this tradeoff a disappointment.
Control for the Benefits
Why would a controlling shareholder settle for credit-like returns while holding equity risk? There are numerous ancillary benefits to this position that are unavailable to outside investors.
Management and board positions are often given to family members or friends. Control of a public company allows these valuable positions, and the compensation attached to them, to be directed back to the family. There is nothing illegitimate about these arrangements if a family truly does control the business.
A family may see a credit-like return on its shares, but these benefits make the investment more attractive despite equity risk. Outside shareholders see none of these benefits.
The Rest of the Wealth
Controlling shareholders, particularly after generations of business ownership, can have different allocation incentives than traditional equity investors. After receiving years of dividends, these owners may have built an aggressive equity portfolio outside of the controlled business.
In this situation, the family could view the controlled business, even though it is an equity investment, as a credit-like instrument to be held and preserved for generations. The family’s overall portfolio may be structured around this business.
Once again, outside investors rarely have this perspective. Money is generally allocated to passive or active equity managers with the expectation of an equity-like return. Dollars allocated to these controlled, credit-like businesses naturally underperform outside investors’ expectations.
Pick & Choose
In general, we are interested in businesses operated with long-term returns in mind and with appropriate balance sheets. But even with our risk-averse investment approach, we are still cognizant of the equity returns we are seeking to earn.
Investing in equities is risky, and trying to make it not so ultimately defeats the purpose. In situations where controlling shareholders are more interested in preserving the past than in investing for the future, we view their control as detrimental and look elsewhere.
