A Digital Magazine by American University's Kogod School of Business
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Blood in Business

    If “The Godfather” truly provided the answer to any business question, there would be a lot less angst about how to motivate employees. It’s not a stretch to contend that business was simpler under the Mob’s thumb. Processes and procedures were understood: family came first. The appearance of propriety was paramount. No Sicilian could refuse a request on his daughter’s wedding day. And if gambling debts aren’t paying the bills, it’s time to diversify the business. Why not try an emerging market?

    But imagine how turbulent the markets would be if a violation of respect resulted in literal bloodshed. It would make 2008 look like a banner year.

    The key was that in the gangster-ridden world of Old New York, everyone in the “organization” had aligned goals: preserve pride, profit, and a pulse.

    The same can’t be said for modern-day firms. This indisputable fact has given rise to the field of corporate governance, which endeavors to mitigate the myriad conflicts between managers and shareholders.

    It all boils down to a matter of diverging interests.

    Shareholders’ first priority is to maximize their own wealth: stock prices should go up, dividends should be paid.

    “Shareholders are often thousands of miles away; they generally don’t want to know about the day-to-day operations…there is a separation between management and ownership,” said Professor Ronald Anderson, who has spent the last decade researching corporate governance, particularly in family firms. Anderson holds the Gary D. Cohn Professorship in Finance.

    On the other hand, no one is entirely sure what company managers hold sacred. “They should be focused on maximizing shareholder wealth, but they have a natural tendency to protect themselves and maximize their own utility,” Anderson said, citing examples like the implosion of Enron and scandal at Tyco. “It’s a problem that has reared its head a lot over the last 10 to 12 years.”

    A company’s ownership structure should be a superfluous ingredient in its success, but Anderson and his colleagues have proved that family owners are of a unique flavor. Firms with controlling family owners (those who wield sufficient power to enforce decisions) are singularly motivated. Though the family members may not be as hands-on as Vito Corleone, their firms make distinctive investment choices, and flourish—or flounder—in certain circumstances.

    Spurred by the lack of research on family firms, Anderson and colleague David M. Reeb, now at the National University of Singapore, began in the late 1990s to evaluate family ownership and its connection to firm performance. Their findings changed the way academics and practitioners view this previously underrated demographic.

    Further research at Kogod has investigated family firms’ transparency, proclivity for insider trading, investment choices, and the impact of “family-style” debt. The surprising findings serve as indicators of how this inimitable slice of the business world stands apart.

    In hindsight, families should have gotten acclaim beyond the box office for their business skills. After all, family owners are highly incentivized to pay attention: on average, family owners have held their shares for more than 78 years, and have 69 percent of their personal wealth invested in the firm. They have a vested interest in ensuring that the managers running their companies are protecting their assets.

    Anderson and Reeb proved that despite their bumbling portrayal in the media (see: the Bluths of HBO’s Arrested Development), family firms are more valuable than diffusely owned firms, which are held by a large number of shareholders and investors.

    Family businesses are also highly prevalent. Thirty-five percent of Fortune 500 companies and 60 percent of publicly held companies in the US are family-controlled, according to the advocacy group Family Enterprise USA.

    It turns out family presence cannot be ignored. Just as overbearing families tend to weigh in on decisions “for our own good,” firms with actively engaged family owners generally outperformed firms without an active family member. Decades after public firms’ initial offerings, many family members continue to hold hands-on positions in day-to-day operations.

    The findings ignited a flurry of attention from academic and mainstream media, including a Businessweek cover story. For Anderson, the next questions quickly took shape: Why are these firms more valuable—and under what circumstances?

    In their recent article in the Journal of Financial Economics, the pair invited Associate Professor Augustine Duru to study the effects of corporate transparency on family firms. Thanks to his prior research on the use of accounting information in CEO compensation, Duru had expertise in measuring transparency through an accounting lens.

    Like many others, Duru had initially assumed that family firms would be less valuable than diffusely owned firms. “But my colleagues’ empirical work showed that, certainly, family firms were more valuable. It seemed counterintuitive,” Duru said.

    Past research has demonstrated that corporate transparency is crucial in order to protect share¬holders and mitigate conflict between large and small investors. But no one had studied transparency specifically within the context of family firms.

    “When they decided to bring in the accounting perspective,” Duru noted, “the question became: If we believe that accounting information is important to firm performance, what would happen if there was a lack of information?”

    While all publicly traded firms must comply with mandatory accounting disclosures, the authors acknowledge that there is still substantial variation in what firms choose to reveal—as well as in the amount of outside scrutiny they receive. Firms can also elect to engage in voluntary disclosures.

    “Transparency is clearly a choice; there are public companies that are not as transparent as they could be,” Anderson said. “But some of it is market-driven, and some of it is shareholder-driven as well.”

    To test their theories, the researchers built an index that ranked the opacity of the largest 2,000 US firms. Family involvement was defined as firms in which the founders or heirs maintain influence, usually through an equity stake. About 22 percent of the firms in the sample were founder-controlled, and another 25 percent heir-controlled.

    Opacity was categorized using four factors that indicated the levels of both internal and external opacity:

    Trading volume and bid-ask spread, which lend insight into the amount of information uncertainty
    Analyst following and analyst forecast errors, which help explain the availability of firms’ information

    The researchers determined that both types of family firms are significantly more opaque (by about five percent) than diffuse shareholder firms. “Their shares trade less than those in diffuse shareholder firms and exhibit significantly less analyst following,” they wrote.

    Analysts are important because they play a monitoring role. Large, publicly traded multinational firms are subjected to scrutiny; “multiple monitoring” keeps controlling families on their best behavior, just as the looming threat of the Five Families did in the Godfather’s world.

    How does opacity impact other shareholders’ wealth, beyond the family? Since family firms are more valuable—and tend to be more opaque—then was opacity more valuable?

    The opposite was true.

    Where a positive relationship existed between family ownership and performance, it was limited to firms with a high level of corporate transparency. When the corporate information environment was opaque, however, family firms ceased to be as valuable as firms without family owners.

    “When it’s harder to see what’s going on inside the company, it is much harder for the market to monitor the family, and as a consequence maybe the family can misbehave,” Anderson said. Opacity reduces the ability of outsiders to police opportunism by family firms. Simply put, the top-performing family firms are also the most transparent.

    Think Walmart. The Walton family’s massive multinational is currently followed by 36 analysts, all of whom are listed on the Walmart website, along with extensive stock information, historical pricing, and governance documents. The world’s largest retailer is also covered widely in the news media. For Walmart, there is no escape from scrutiny.

    The researchers also looked at CEO types in these transparent top performers. In their sample

    • the original founders held the top spot 37.7 percent of the time;
    outsiders, like Campbell Soup Co.’s Denise Morrison, 34.2 percent; and
    heirs, such as Nordstrom Inc.’s Blake Nordstrom, 28.1 percent.

    Transparent family firms led by an outsider performed best, followed by those led by founders and then heirs. Yet all three types of these trans¬parent family firms still outperformed transparent, diffusely owned firms.

    In the absence of a highly transparent environment, there was no evidence of a benefit attributable to family ownership. In fact, in more opaque family firms, there was a negative relationship: as opacity increased, performance fell. Opaque family firms performed worse than any other type of firm. In those muddy waters, families can exploit control to extract private benefits at the expense of smaller investors.

    It’s clear that shareholders—and thus the S&P—value founder or heir involvement only when those family values include financial transparency.

    As it turns out, informed trading may also be a family affair. And when there are short sales, there’s gonna be trouble.

    Anderson’s latest project, with coauthors Reeb and Wanli Zhao of Worcester Polytechnic Institute, finds that family firms boast “substantially higher” volume of abnormal short sales, where traders bet on a company’s poor performance.

    “There appears to be a lot more informed trading going on in family firms; given the magnitude of it, some of it is likely illegal,” Anderson explained.

    Prior studies have found that family owners are among the best informed of shareholders. Anderson postulates that this is attributable to a few factors. For instance, they are likely to know about skeletons in the family closet. Also, family members who do not serve in senior management at the firm can fly under regulators’ radar more easily, and potentially avoid detection.

    Of course, outside investors could play a role in these antics by gleaning information from a family member and using it for personal benefit. Or perhaps the short sales are a product of disgruntled employees who perceive family domination as hurting the firm.

    Take the case of Robert Chestman, a stock¬broker convicted on insider trading charges following the 1986 takeover of Waldbaum Inc., a New York-based grocery chain now owned by the Great Atlantic and Pacific Tea Company. The Securities and Exchange Commission (SEC) asserted that Mr. Chestman had received nonpublic information from a member of the Waldbaum family, which he used to trade 11,000 shares of company stock.

    But Chestman was by no means the only one selling. In the days before the company’s announcement, the trading volume in Waldbaum stock skyrocketed. In two days, trading climbed from 2,300 shares to more than 77,000 shares traded daily, according to The New York Times and the SEC.

    Insider trading hardly capped in the 1980s. In 2005, former senator Bill Frist, heir to the for-profit hospital chain HCA, raised the SEC’s ire. The commission conducted an 18-month investigation into Frist’s sale of his blind trust of HCA shares, but ultimately did not press charges. Frist ordered the sale during a peak in the stock’s trading; weeks later, a less than stellar earnings report drove the share price down by nine percent, according to USA Today.

    Relative Leaders

    Information leakage was at the center of Anderson’s study. At the root of short sales is the spread of nonpublic information. By identifying and homing in on the times when short sales preceded negative earnings surprises, the researchers made the issue empirical. The question: Does family presence aid or impede informed trading?

    They analyzed short sales that occurred prior to earnings surprises, merging the SEC’s short-sales database with their own information on family ownership in the largest US firms. The resulting sample was 1,571 strong, with family firms making up more than one-third of the sample.

    Rather than focusing on the motivation of the sellers, the researchers simply sought to uncover whether insider trading was more prevalent in family firms.

    It was. “Family firms experienced almost 17 times more abnormal short selling preceding negative earnings shocks than nonfamily firms,” the authors wrote. These firms also had marginally fewer abnormal short sales before positive surprises— indicating that more sellers were hanging on to their stock in anticipation of good news.

    This was no coincidence. The presence of family members as managers or board members increased the likelihood of short sales. The researchers contrasted family ownership with that of hedge funds, private equity funds, and other large-block shareholders, but did not find the same results.

    There are regulatory implications. Despite the researchers’ findings, the SEC’s enforcement actions of late have focused on hedge funds, with 22 enforcements between 2006 and 2008 against the funds, and zero filed against family owners. Further investigation reveals zero enforcements filed against family owners through early 2012.

    Certainly, the SEC takes abuse of short sales seriously. The commission has held numerous public hearings, enacted new rules on “naked” short sales, and required more transparency about the short-selling process. The focus on short sales is warranted: the SEC says that short selling comprised almost half of US equities volume, based on data provided by exchanges for June 2010.

    “Our analysis suggests that regulations to reduce informed trading, while potentially limiting such activity in nonfamily firms, appear substantially less effective in family firms,” Anderson concluded.

    Of course, in order for earnings surprises to occur, firms have to play a role in the action. That could mean an acquisition or investing in a new business venture. And the latter often requires firms, and their managers, to borrow money.

    Debt can be a tricky business, and all debt is not equal—now that debt is no longer traded in Mafia-style personal favors, that is.

    No one knows this better than Associate Professor Parthiban David, whose expertise focuses on the impact of corporate governance on firm performance. David holds the Collins Chair in Strategic Management.

    David, along with coauthor Jonathan O’Brien of Rensselaer Polytechnic Institute, examined how the type of firm debt is related to growth. The pair chose Japanese firms to make up the sample, due to their predilection for growth.

    On its face, growth is a noble goal—but there can be too much of a good thing. Excessive growth can harm profits if managers don’t share the resulting wealth with investors, and instead funnel it back into the firm.

    Debt helps to keep managers in check: they have to make interest payments, repay the balance at the end of a contract, and face the threat of default. Just as family-owned firms are inherently anchored in relationships, forms of debt can also have a relational quality. And debt plays an important, pseudo-parental role in corporate governance.

    Exhibit A: Bank loans are built on relationships. Business owners have a rapport with the bankers who invest in the growth of their businesses. Loans are not merely dollars and cents to the bank (or so they would have us believe); rather, banks assess the complete picture of the borrower and company.

    They also consider the possibility of ancillary business relationships that might form down the line; loans could be a foot in the door to a more robust, potentially lucrative relationship. Often bank representatives will hold seats on the firm’s board of directors, provide other business services beyond lending, and have relationships with the firms’ customers and suppliers.

    “Bank loans are long term,” David said, explaining that both sides build trust and may act as partners. “Banks have business relationships; growth is important to them, because more growth means more business.”

    In contrast, bonds are transactional, impersonal forms of debt. Bonds allow lenders to keep their borrowers at arm’s length. These securities are diffusely held, and lenders are focused solely on the returns they earn.

    Consider the case of Columbia Sportswear Co., a family-owned business that began selling hats in 1938.

    After the 1970 death of the family patriarch, the near-insolvent company struggled to stay afloat; it had already taken a $150,000 loan from the Small Business Administration. Within two years the company racked up a negative net worth of $300,000, according to Funding Universe.

    Yet the Boyle family was able to draw more credit from its bank; bank officers even suggested the family consult an adviser, which was the “first step on a path toward stability and then growth,” the owners told Family Business magazine. The infusion of credit happened to pay off; Columbia has come a long way since then, projecting revenues of $1.7 billion in 2011.

    There is no question that relational debts are beneficial to firms that invest substantially in R&D. The long-term relationship between lender and borrower allows continuity of investment; the bank can step in more easily if the firm were to default.

    Transactional debt was more effective in preventing overinvestment in firm growth than relational debt. While relational debt may lead to more growth, the growth may hurt profits, David and O’Brien concluded.

    This may be best understood with an example— one that’s all too familiar.

    In 1980s Japan, stock and real estate markets peaked, and real estate was all the rage. Many firms that previously had never invested in real estate were tempted to get in on the action.

    As Northwestern’s I. Serdar Dinc discovered, firms that had relational debt were more likely than those with transactional debt to make real estate investments. When the bubble burst less than 10 years later, they were hurt badly. Parthiban David’s work implies that the “leniency” of those relational lenders led to that overinvestment, which ultimately weakened the firms.

    If debt is to be used effectively for corporate governance, then managers—and shareholders, family or otherwise—need to understand the vast differences provided by these two diverging forms of debt.

    Debt was something that J. Willard Marriott detested. When the founder of Marriott International wanted to focus on growing Hot Shoppes, the family’s modest restaurant chain, his heir saw the promise of hotels. Getting into bed with the hospitality industry meant going into debt, something the elder Marriott avoided at all costs.

    “Debt was something that [my father] didn’t understand, and he hated it…he didn’t want anything to do with it,” Bill Marriott once told The Washington Post. Luckily for travelers, J. Willard’s son went to the mattresses for the company, now valued at around $10 billion.

    In the first six years after Bill took over the presidency, the company quadrupled in size, surpassing Howard Johnson and Hilton Hotels in both revenue and profits. The younger Marriott acquired Big Boy and Roy Rogers restaurant chains, and made the company international with an acquisition in Venezuela. He also invested heavily in research, which informed the decision in 1983 to target the mid-priced hotel market with Courtyard by Marriott.

    Still, J. Willard’s conservative business strategies are consistent with Anderson, Duru, and Reeb’s findings from a recent study of the ties that bind family ownership and investment decisions.

    The authors examined dueling potential motivations behind investment decisions: an aversion to risk was one possibility, or an extended “investment horizon.” With Duru’s help, the team focused on accounting disclosures required by regulators, including R&D and capital expenditures.

    What was the family’s biggest influence?

    The researchers discovered that family firms preferred to construct their future in physical assets, like new restaurants, as opposed to riskier ventures— such as expanding into a new industry segment.

    “We found that family firms invested less in R&D; they are more risk averse,” Duru said, explaining that family firms devote less capital to long-term investments than do diffusely owned firms. Compared to their peers, family firms also receive fewer patents per dollar of R&D investment.

    Rather, they seem to prefer doubling down on reinforcements that strengthen their core business. Take Carnival Corporation, which has 101 ships among its brands and 10 new ships on order, focusing on expansion into Europe, Australia, and Asia. The Arison family retains 35 percent of company stock in the world’s largest cruise ship operator.

    The reluctance to pony up for long-term investments may be counterintuitive. Tales of family business owners often hinge on the notion of their far-reaching view of the future and their financial sacrifices, made to prop up the business. It is possible that there is less spending on R&D in family firms simply because family oversight makes firms more efficient.

    Efficiency is something that Richard Lenny, the first outsider to serve as CEO of Hershey Foods Company, understood. Lenny increased company profits by closing six underperforming plants in the US and Canada in 2007, cutting 3,000 workers, and outsourcing the production of cocoa.

    It was a far cry from the utopian community that Milton Hershey envisioned for his employees and their families. When the Great Depression hit and sales plummeted 50 percent, Hershey did not lay off a single worker, but instead used employees to pursue growth opportunities. His ideals were as popular as his company’s sweets; more than a century later, the town’s identity is still tightly wrapped in silver foil with a tidy bow.

    Milton Hershey’s focus on protecting employees was not the norm for corporate America, but it is representative of many Japanese firms, which often increase their investments in growth when demand for their products falls.

    “Given a choice between cutting dividends or workers, CEOs there generally say their employees and suppliers are the most important stakeholders,” David said. “It’s almost a family situation.”

    The reason behind firms’ diversification—and whether the motivation differed by the identity of its owners—was the focus of David’s recent study.

    In the same way that types of debt can be considered either relational or transactional, domestic and foreign owners also display these characteristics.

    Prior research on corporate diversification and its implications for firm performance had treated all owners as if they had the same end goal: profit.

    Not so, David and his colleagues found, in a paper published by the Academy of Management in 2010. Diversification is also a means to other ends, such as career advancement opportunities for employees, higher compensation, and lower employment risk.

    Using data from four sources, and excluding small firms and those in highly regulated sectors, their sample resulted in 1,180 unique firms.

    It turns out that relational owners emphasize growth, while transactional owners emphasize profit for shareholders. The differences are considerable: on a share-per-share basis, transactional owners “are over three times more effective than relational owners in pressuring managers to improve profit.”

    “What we found is that when there is more relational ownership, the firms are less likely to cut their wages or lay off people, even when performance goes down,” David said. “But with transactional ownership, they are more likely to do so.”

    For domestic owners, he believes, it all comes down to stakeholder relationships. Firm growth means new business, which keeps firm employees and their suppliers working. But firms with foreign ownership are more likely to diversify the business in order to collect more profits.

    David was quick to point out that domestic owners are not blindly making poor business decisions. “There is a self-interest here also,” he said. “It is not irrational altruism. There is an economic incentive for domestic owners to support growth; once again, more growth means more business.”

    The project helped to reframe a central question about firm performance, which previously had been viewed only through the profit lens.

    Like his colleagues’ work, the findings from David’s team had significant implications for governance literature.

    Taken together, the emphasis that Kogod’s faculty have placed on researching the value of family firms has highlighted the firms’ critical value to the US economy.

    Beyond their profitability, family businesses also employ 63 percent of the US workforce. As regulators look ahead to a November election in which the key issue is jobs, they should pay a visit to these firms for counsel on how policy will impact expansion and job creation, said Ann Kinkade, CEO of Family Enterprise USA, in Forbes.

    Questions remain. Will the SEC step up its focus on short-sale trading in these valuable firms? Can larger firms in the US gain access to relational funding to fuel firm growth, traditionally a more popular investment choice for small businesses? How can family businesses be encouraged to add jobs?

    As Clemenza argued to Michael Corleone, “At least give me the chance to recruit some new men.”



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