"Though defensive violence will always be 'a sad necessity' in the eyes of men of principle, it would be still more unfortunate if wrongdoers should dominate just men." ~ St. Augustine
Exclusive to STR
Enron. WorldCom. Tyco. Arthur Andersen. These names have become shorthand for the rise (or perhaps more like the exposure) of a private looter class of managerial bureaucrats (to match their political counterparts in the state) that trade more in corporate spin, PR, and pyramiding sales and profit inflation than in productive enterprise. Add to these as well innumerable bubble-ized dotcoms ' Global Crossing, Pets.com, TheGlobe.com, and the absurdity of AOLTimeWarner. Billions in phantom inflated profits. Billions in wasted capital. And mazes of shady deals and off-budget accounting structures, just like in D.C. Yet, the conventional wisdom persists that a company is cleaner, more ethical, and more profitable when it is a publicly listed firm run by professional managers than it would be if it remained under the control and influence of the original founder or his descendents. The assumption is that second and third generation family-owned and/or run businesses are prone to nepotism, abuse of funds and sweetheart deals for friends, cronies and family members. But is this the case? Two finance professors, American University's Ronald Anderson and Temple University's David Reeb, looked into this. What they found was that family-controlled publicly traded companies had significantly better accounting and market performance than companies controlled by managers. Their research found that family firms had a higher return on assets and higher market valuation. The two professors based their study on the bubble years of 1992 to 1999, and updated it through 2001 and published it on the Journal of Finance. The study contains some surprising numbers. Families control 141 of the 403 S&P 500 companies they examined (ignoring utilities and banks) and constitute 35% of the S&P's $10.5 trillion market value. 45% have a family member as CEO, and in those that don't, the family has considerable influence over the selection of who gets the top job. In these firms, the average equity stake by the families is 18%, but their share of board seats are three times that, with an average duration of 75 years. Surprisingly, in the land of rugged individualism, of the 3,000 largest publicly traded corporations in America, more than half are family-run. Family-run firms even enjoy lower interest rates than non-family firms. Not surprisingly, the professors trace the better performance of family companies to their having a longer investment time horizon, i.e. lower time preference. Family members are less likely than hired hands to be motivated to manipulate earnings in the short term in order to increase their stock options or golden parachute. The Du Ponts, for example, have held an equity stake of at least 15% in Du Pont Chemical for almost 200 years. In an interview on CNN, where I first heard about this study, the co-author David Reeb was asked why he thought family firms do better on average than non-family firms. He answered, '. . . I think it has to do with this notion that the family -- if they stay in the firm, they have a large stake invested in the firm. They'll typically have 70 percent of the wealth invested in the firm or more. They'll typically own a large, undiversified stake. So they have incentive to pay attention to what is going on. They're monitoring the managers.' He later added '. . . descendants, whether they take an active role in management or more passive role by sitting on the board, are really kind of -- think of them as a committed investor in the firm. So it is not so much that they had to have great management skills. It may just be that they are a committed investor in the firm that will really make the manager perform.' What is interesting is the comment by Thomas Russo, a partner at Gardner, Russo & Gardner, an investment firm that specializes in family-run businesses, with stakes in the Dutch brewer Heineken, and in Brown-Forman (Jack Daniels and Southern Comfort), as well as in Comcast. 'Finding the right company is very labor intensive,' Mr. Russo said. 'But when you find them, their strategy is often far more long-term oriented than companies with professional management.' Family-controlled companies 'want to preserve the franchise for future generations and are less likely to risk long-term value for short-term gains.' This isn't really all that surprising after all. Everyone is self-interested and reacts to the incentives they are presented with, in particular the extent of their liability and the impact their actions will have on their financial status. Human nature being what it is, one will desire to acquire more of what they value, whether they already have it or want it, whether it's financial security, political power, religious sanctity (or even the lack of desire itself). The key difference between a family-owned company and those controlled by hired managers is one of owners and caretakers ' of having ownership of the assets in the present and the future, and only having control of those assets in the present. The owners of the firm because they own the capital and benefit from it in the present as well as the future can plan for the future enjoyment of that capital. In contrast, the caretaker who only controls but does not own, has no incentive, no financial interest, in maintaining the capital value of the assets he controls beyond the term of his control. As Hans-Hermann Hoppe put it in reference to this phenomenon in electoral politics, what the politician doesn't loot now, he might never get to loot later. Because the caretaker only has the benefits of using the capital, it is in his interest to maximize its consumption in order to benefit himself, his reputation and his private gain, and cares little for the future effects of his behavior on the condition of the firm. The distinction between owners and mere caretakers is the same as someone who owns the house and those who rent. The case Hoppe makes against politicians, bureaucrats and military (or militarist) dictators and in favor of private ownership also applies to corporate ownership as well. Revelations of abuse, fraud and wasted capital and resources are a recurring theme, whether during an inflationary bubble or not. The corporate managerial model seems to encourage high time preference in the same way democratic politics does, and instead of preserving and increasing the capital value of the assets for future generations, managers often waste this precious capital.