Research: Diversification, legacy issue top family business concerns

By Richard Ryffel

Starting a family business and sustaining it for generations is hard work

You get rich through concentration. You stay rich through diversification.

This is an old wealth management adage, but it’s never been truer. We live in an ever-globalizing, highly competitive economy given to shocks from financial crises, wars, pandemics, governmental policy intervention, restrictive monetary policy, labor shortages and supply chain constraints. In this environment, how could any business leader be confident that past performance will predict future success? While it’s not a given, the future success of family businesses is largely dependent upon keeping an open mind, establishing a clear vision, exploring new avenues for growth and having the right advisors in your corner.

In a recent family business survey by First Bank of 552 business owner respondents, we found that maintaining a family legacy was principal among their concerns and misguided perceptions were that family businesses were easy-to-manage cash cows. Starting a family business and sustaining it for generations is hard work. While “Shirtsleeves to shirtsleeves in three generations” (the perceived inability of future generations prudently managing generational wealth)may not be the rule, the celebrated stories of dynastic companies do not take survivorship bias into account.

Impediments to Diversification

Over the years, upon hearing my advice, some families have responded with “We’re different,” or “We’ve thought of that and planned for it,” even if they hadn’t. My goal is not to scare anyone into thinking their business is at risk, nor to insult anyone by implying family business leaders are not excellent managers.

As with everything in life, one size does not fit all, and every family is different.

Outside management is often cited as a way families can rise above some of the considerations I’m raising. While that’s true, with family-owned businesses, there is no escaping the fact that even if the owners are not present in the business day-to-day, the ownership thumb is often on the management scale, even if owners think it is not. Ownership speaks loudly, even when not speaking. The same is true of outside boards, which are often subject to “capture” (the tendency to reflexively agree with the owners) and may not be truly independent. What’s more, many family businesses have no outside boards.

Overcoming the Risk of Home Bias

Many unintentionally apply “home bias” (the tendency to overinvest in familiar areas) to business and investment decisions. Perhaps this bias is even applied to vacation planning, college selection and residence decisions. While home bias is not necessarily hazardous, one must at least be aware that it’s a powerful force in decision making. The downside of home bias is the potential for overconcentration of assets, which can inject unnecessary risk into one’s financial picture.

The antidote to overconcentration is diversification (the only “free lunch” of investing). Often, the family’s business ownership strategy flies in the face of diversification. Diversification requires liquidity (or the potential sale of the business in the extreme case). Releasing assets (cash) to family members and putting them outside the comfortable, controlled fence of the business may complicate governance. Further, the source of that liquidity — often from sales of equity to others (like a private equity investor or silent partner) or the incurrence of bank loans — can introduce non-family members into the mix.

Interestingly, some studies show that the introduction of debt on a company's balance sheet can instill financial discipline on management, which serves as a useful management compass. The same might be said of private equity (PE) investors, though much depends on the share of equity owned by outsiders, their voting rights and whether they have the stereotypical impatience of some PE investors.

Success Hinges on Unique Skillsets

A commonly cited reason for not diversifying away from the family business is the belief that the family has unique skills that will allow them to (1) succeed in the long run and (2) outperform managers of other companies (which is what one is saying when they elect not to invest in something other than their business).

As businesses are passed from generation to generation, the lore becomes that “it’s in our family’s DNA.” While it may be possible that knowledge is passed from founding mother to son to granddaughter, it’s also highly likely that mean reversion will take hold. Or, perhaps, equally likely that no interested child will enter the business, forcing either a sale or greater reliance on outside, non-family management.

Skill is also cited when business owners are asked why they haven’t established a family office (or contracted with a multi-family office). The notion that skill running a widget company, even a successful one, will transfer to public market investing or the selection of private equity investments, even in related fields, is questionable. In this analysis, “control” may be a significant consideration and shouldn’t be discounted. The desire for control is understandable, but one should consider that such control may have a financial cost.

A Game of Survivor (What the Data Show)

All this said, what can we learn from public companies? A recent study by J.P. Morgan found that across all industries, 44% of Russell 3000 companies from 1980 to 2020 suffered a “catastrophic loss” — a 70% unrecovered decline in stock price. Should this make us more or less comfortable keeping all of our wealth eggs in the family business basket? Remember, these companies have access to the most skilled management and vast pools of capital, yet many suffer the same fate.

True, some will merge or be bought by leveraged buyout and PE firms, but in those cases entire enterprise sales and mergers are capitulations to the reality that someone else might be better able to manage the company in a manner that will yield market-level returns. The data also show us that individual companies (stocks) do not tend to outperform a diversified market basket of equities.

We can look at the industries that were leading the pack at different points in time. The rise or demise of any company in each sector certainly depends on the skill of management, but it also depends on being in the right place at the right time, catching a trend early and pivoting into the next hot thing. One example of this done successfully would be Apple, which invented or reinvented (or so the legend goes) the PC, the smartphone, music streaming and apps. An example of a similar company doing this poorly would be IBM, which missed the cloud, internet and mobile.

So, what could cause a well-run company to fail (or to simply not fare as well as the diversified market basket we discussed earlier)? The corporate world is populated with executives who attended the best business schools and had years of experience, yet still stumbled —not because of a lack of experience managing to all of the identifiable roadblocks or a lack of confidence that they were capable of doing so. Rather, they fail because of factors outside their control (regulation, technology or global competition) or from what former Defense Secretary Donald Rumsfeld referred to as “unknown unknowns.”

The pandemic was a lesson in “what’s up can be down quickly,” and vice versa. Trends can whipsaw, substitutes are constantly being developed, technology advances rapidly and the unimaginable becomes commonplace (I think this as I look at my Dick Tracy watch).

Another note about skill and home bias. Families try to diversify and look for “adjacent” investment opportunities. A family that owns a chain of restaurants invests in another restaurant with a comfortable format. The family that made a killing in strip malls moves into multi-family housing or enters another geography. While there’s no question that running a successful business gives one useful knowledge about an industry, a market or leadership that may bode well for them in moving into other areas, the threshold questions are (1) whether they are relying solely on that and not enlisting outside advisers and (2) whether they ever check the counterfactual case to see if the elections they did not make may have fared better. Remember, the competition has ready access to expert networks.

The Benefits of Diversification

Outside managers are not only easier to benchmark but also have statistical skill where private investments and less efficient markets are concerned. They also have more resources to perform diligence, can switch out underperforming management,and have unfettered access to capital.

•       Liquidity can ease governance tensions and simplify dividend policy

•       Easier for family members to exit (or be exited)

•       Liquidity invested in other assets can provide uncorrelated returns and enhance long-run family financial returns

•       Liquidity invested in other assets can (1) be a lower-cost, lower-risk source of leverage and (2) be tapped in times of business distress

The Benefits of Professional Advice

•       Reduces home bias

•       Provides continuity across generations

•       Acknowledges luck

•       Brings skill to the extent skill exists and aids in manager selection

•       Brings an objective voice to investment decisions

•       Can be held accountable in ways family cannot (easily)

•       Allows for disproving the counterfactual case

•       Allows family to focus on business and family — outsources bills, household management, family meeting logistics, etc.

When recognizing biases and unique family preferences, one may find that running a business and a family unit with an eye toward diversification is the best way to ensure a family’s legacy and, ultimately, the enjoyment of the fruits of the family’s labor for generations to come.

Richard Ryffel is the executive vice president of wealth management at First Bank, a family-owned bank based in St. Louis. He is also a part-time professor of finance practice at Washington University in St. Louis.




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