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L’Aparté - Closely held companies: a hidden factor in share performance

Closely held companies

What do the top-five-performing Paris stocks over the past 20 years (i.e., Sartorius Stedim, Wavestone, Eurofins Scientific, Hermès and Esker) have in common? They all have a controlling shareholder – a family, an acquirer or a group of managers – who is closely involved in their governance. In contrast to groups that have no controlling shareholder, these companies have been the top performers on the Paris equity market over the past two decades. And this is no French anomaly. Something very similar can be found in other European countries, such as Germany, Italy and Spain, to cite just the main urozone countries. This illustrates the hypothesis put out by the brilliant writer Nassim Taleb in his famous book Skin in the Game, and is so striking that it calls for an explanation. Why do closely held companies act differently, and, more to the point, what do they do that is different?

First of all, it is worth pointing out that closely held companies are sometimes regarded with suspicion by investors. They are accused of excessively concentrating powers, of lacking transparency (in the case of ESG data, this often comes to their disadvantage), or of potentially mismanaging succession in the case of family companies. All these risks do exist, and some companies do manage such situations better than others. Even so, the risks are moderate and are by far offset in most cases by the strong alignment of interests created organically by the capital structure. Investors also blame closely held companies for sometimes turning a deaf ear to the equity markets’ siren song. But that may be where one of their main strengths lies – the ability to resist the siren song of the equity markets, which operate on their own terms and their own time horizon. Indeed, many investors are just “passing through”, and their interests are incompatible with certain strategic projects.

A Credit Suisse study updated early this year found that, since 2006, its sample of 1000 family-controlled companies had outperformed other companies on average by 3 percentage points. Outperformance was greater for small caps (5.4 points) than large caps (2.3 points). These statistics were compiled worldwide, and its findings are rather similar in all regions. Moreover, family-controled companies generally carry less debt, something that has been corroborated by other studies that have found they outperform over the long term while taking fewer risks.

Many studies, often focused specifically on family-controlled companies, stress their advantages, particularly their decisionmaking focused on the long term. There is copious literature on this subject. Such companies make different choices for various reasons: 1/ the owners’ personal wealth is often tied up entirely in their company, personal wealth that is meant to be passed on to future generations; 2/ their investment is laden with emotions, given that – to paraphrase Churchill – they have put their sweat, labour and tears into their company; and 3/ the company may even be intertwined with their own sense of self, as it has been consolidated around the family for generations and sometimes even carries the family name; and the company’s actions may even put family members’ very reputations into play. None of these intrinsic motivations can be replaced by a «management package».

"Unforced error: a fault committed by a player without being constrained to commit it."

Moreover, the fact that closely held companies – family-controlled or not – statistically outperform over the long term may also be because they avoid certain costly errors that other companies often make. As in tennis, they make fewer unforced errors than other companies, which naturally gives them an edge in terms of performances. Excessive financialization, unreasonable leverage putting shareholders at risk when economic difficulties hit, shortterm optimization of results compromising the future, or even accouting manipulation. These risks appear to occur far less in closely held companies than in other companies.

By way of illustration, let’s take two companies facing the same strategic problem – automakers’ inevitable shift to electric vehicles. Let’s go back to the summer of 2021, when the businesses of two French autoparts makers, Forvia (exFaurecia) and Plastic Omnium, were heavily exposed to internal-combustion engines, one via exhaust systems and the other via fuel tanks. Faurecia had just become completely independent after Stellantis’ distribution a few months earlier of the shares it had held in the parts maker. Plastic Omnium, in contrast, was closely held by the Burelle family, with 60% of its shares. Reducing their dependence on the internal-combustion engine, a market that will ultimately disappear, was an essential strategic challenge. Both companies had to reposition themselves and both expanded into lighting (inside and outside the passenger compartment), a business line that does not depend on vehicles’ choice of propulsion system. Recall that both companies were in a sector that was ailing after the pandemic and whose market valuations were in the doldrums. In short, they were financially challenged.

In the summer of 2021, Faurecia announced the acquisition of Hella, a very well managed German company specialising in vehicle lighting. But it came at a price – more than 1 time revenues, whereas Faurecia’s stock was trading at half that much. The market initially cheered the deal because of its undeniable boost to the Faurecia’s strategic profile, and the stock gained 8% when the deal was announced. Investors (who, remember, were just “passing through”) were ecstatic. However Faurecia had pledged to its banks that it would issue new shares to help finance the deal, but market conditions worsened, and it was unable to do so until several months later at a price of less than half its share price when it announced the deal. In other words, Faurecia had to issue twice as many shares as it originally planned on. True, the circumstances did not help, but this was a typical “unforced error” (defined by Webster’s dictionary as a missed shot or lost point (as in tennis) that is entirely a result of the player’s own blunder and not because of the opponent’s skill or effort). Faurecia was thus forced to overpay for an asset by issuing new shares in itself at a very low valuation. Faurecia did indeed improve its strategic profile drastically, but at what cost? The ownership share of its legacy shareholders was diluted down by one quarter in the merged group (i.e., a shareholder that had held 1% of the group and did not buy any new shares owned now just 0.75%), not to mention that Faurecia had to sell off certain “non-strategic” (but profitable) assets to reduce its debt.

A few months later, in April 2022, Plastic Omnium paid 520 million euros(2) for Varroc Lighting Systems, a distressed company in the same sector that intended to mobilise the industrial prowess of the Plastic Omnium group to return to a more standard level of profitability within two or three years. Plastic Omnium paid a lot less (0.65x revenues) and paid in cash, with no need to issue new shares, as the target was digestible and valued at a reasonable price. In exchange, Plastic Omnium shareholders had to accept collateral damage to the profit & loss statement during Varroc’s convalescence. This was an unpopular strategy with the markets in the short term, as it needed time and increased the debt burden without providing any immediate boost. But it will potentially be far more value-creating, as it protected the interests of long-term shareholders, as long, of course, as the industrial and financial rescue pans out.

It is still early, and the future will tell which of the two companies has chosen the better path. Plastic Omnium is currently seeing its operating performances dragged down by this “penalising” acquisition, whereas Faurecia naturally fared better operationally, as its results were driven by its new acquisition; however, its debt burden and financing costs are very heavy. Both companies have high-level managers and strong market positions, but it is interesting to note how much a company’s capital structure can change its strategic approach. As for us, while there is so far no meaningful gap in the two companies’ share performances, we much prefer the strategy of Plastic Omnium, which did not dilute shareholders or undermine its balance sheet. A shareholder-manager has a structural edge over a professional manager, who is himself accountable to a board of directors consisting of professionals. He is indeed far more likely to benefit far down the road from investments he makes today. According to the Credit Suisse study, 40% of managers of family-controlled companies have been at those companies for more than 10 years, vs. 15% at non-family-controlled companies. When LVMH bought Tiffany, it wasn’t because Bernard Arnault thought that would please the financial markets, but because an industrial vision helps create true long-term value.

Let’s take an example that is in the news right now, the sad case of Atos, which looks like a case-study of the problems that arise from a lack of alignment between managers and shareholders. Atos has no controlling shareholder and has been managed by a series of CEOs who were in a headlong (i.e., short-termist) rush to prop up Atos’s P&L and cashflow via acquisitions, an approach that played to the markets. Moreover, when things seemed to be going well, Atos paid out huge sums to its then-managers in the form of share awards, as well as fees to armies of investment bankers. A few years later, employees and remaining shareholders stood by helplessly as a structure of more than 100,000 persons collapsed, unable to win investors’ trust because of the constant emergence of skeletons in its closets. Atos’s untenable position led some to call for its nationalisation, given the importance of some of its services to the French state. Nassim Taleb wrote “Skin in the game keeps human hubris in check”. Atos might have been managed differently if its longstanding managers had had the perspective that comes from remaining significant equity investors for many years and if they had not been compensated in a form that allowed them to personally benefit from short-term gains in the share price without exposing themselves to its long-term declines. Acquisitions would have been fewer, better integrated and done at reasonable prices, while proper management of the company’s operations would have been higher on the list of priorities.

"Skin in the game keeps human hubris in check."

In our pre- and post-investment analyses we keep a close eye on how well the interests of minority shareholders are aligned with those of the managers. This serves as a guardrail to everything that is less visible within organisations. To paraphrase a former candidate for the French presidency, we also try to understand “what the manager thinks about while shaving in the morning». What is he focused on: the share price in the coming week or preparing the company for what it will be in several years? As Jeff Bezos, the founder of Amazon said in 2017, “When I have a good quarterly conference call with Wall Street, people will stop me and say, ‘Congratulations on your quarter,’ and I say, ‘Thank you,’ but what I’m really thinking is that quarter was baked three years ago.” .

Quarterly and half-year releases nonetheless pace the lives of publicly traded companies, even closely held companies. While managers should not yield to the markets’ siren song, they should nonetheless use that to prod them forward and not allow issues to drift. Light is the best disinfectant, and the markets clearly play this role of transparency. Share prices are a kind of indicator of investors’ opinions at a given moment. Investors ask questions, criticise, and raise touchy issues that managers may be unconsciously trying to sidestep, and compare the company with others from the same sector. They are often wrong and overdo it in both directions, but the messages they send out are generally very valuable to those managers willing to listen to them. As a pugnacious manager of a company that has since been delisted said a few years ago at an investor meeting, “you taught me everything». Companies that are both closely held and publicly traded thus have the best of both worlds – listed and non-listed. A controlling shareholder gives them advantage of rolling out a strategy over the long term, while a public listing allows them to raise the capital needed for development while remaining constantly in the gaze of the financial community.

A big challenge for minority shareholders is how to keep a management team from acting in its own interests rather than those of shareholders, which the academic world calls an «agency problem» (the agent being the person who acts on others’ behalf). In the case of entrepreneurmanagers, this alignment is clear, as shareholder compensation is management compensation. Jérôme François, chairman and CEO of TFF Group, the world leader in wine-ageing barrels, receives no variable compensation, as he believes this role is played by his dividends and the company’s value creation.

This attempt to align interests is a clear choice of our strategies, as can be seen, for example, in our Sextant PME fund, which invests in European small caps. Of the fund’s top 10 holdings, eight have a controlling shareholder with more than a 10% equity stake.

"Alignment of interests is a guardrail to everything that is less visible within organizations."

The other two (Kontron and SAF-Holland) are headed by managers who are significant shareholders and who bought their shares on the open market but hold less than 10% stakes. In comparison, only three of the top 10 stocks of the fund’s benchmark index meet this standard. This bias is even greater in Sextant Entrepreneurs Europe, the latest fund in our range, which invests in a selection of midcaps held in part by a controlling shareholder. When a company is not held by controlling shareholders, managers’ decisions to buy their own shares often speaks volumes. For example, it is often revealing to hear managers insist that their companies are steeply undervalued but who don’t necessarily put their money where their mouth is by purchasing their own companies’ shares. When managers are not themselves significant shareholders, that really raises a red flag. In contrast, when managers buy their companies’ shares in significant amounts, that is a very good sign, although obviously there are other criteria to be considered (managers are far more aware of how well their company is doing than investors, but they can be mistaken). Even so, such share buying and selling may change our view of an investment completely, as illustrated by our investment in SAF-Holland.

We had always steered clear of SAF-Holland, a German supplier of parts for heavy vehicles. Its business is sound (its OEM business is exposed to the state of the economy, but most of its profits come from in its noncyclical replacement parts business), but we had concerns about its governance. None of its managers or board directors were shareholders; and it showed little hesitation in issuing new shares or dilutive instruments (such as convertible bonds) to meet the needs of its sacrosanct strategic plan. Being a creditor of such an organisation is a rather nice place to be (as it is shareholders who are asked to pony up upon the slightest difficulty), but being a shareholder seldom pays off in the long term. We were nonetheless struck by the complete overhaul in approach between 2019 and 2020, when the newly appointed CEO built up a stake of almost 1% within a few a month for 2 million euros, followed by other managers, and aggressively added to his stake during the March 2020 crisis. For the first time since it was first listed, SAF-Holland seemed to be managed in the shareholders’ interests.Its operating performances since the new team came on board have exceeded our own expectations by far, and part of the reason for this is no doubt management’s impressive commitment, even amidst challenging market conditions. So far, SAFHolland still has no controlling shareholder. However we encourage board members to take out a personal equity interest in the company. Following our remarks, in last year’s general assembly, the supervising board just announced its members will have to invest the equivalent of one year of their remuneration in the company’s shares, which is definitely a step towards a better alignment with shareholders.

In light of the above, governance best practicies surprisingly don’t insist much on directors be significantly investing in the equity of companies whose shareholders they are meant to represent. When comes the time to approve a major deal, the perspective is certainly not the same when a director is heavily invested in the company’s equity. Just as good governance stresses the portion of independent directors on the board, we feel it is just as healthy for other directors to be significant shareholders so that they are aligned with the interests of those whom they represent. We believe such balance matters. Just as we speak up at general meetings for a minimum proportion of independent directors, who provide external insight, we also insist that other directors be significantly invested in the company’s equity.

It is not always easy to define the ideal governance structure, but Warren Buffett gave us some clues in 1993 in his shareholder’s annual letter. He believed that the presence of a large shareholder who is not involved in managing the company is best for the company. Here is an excerpt: « The third governance case occurs when there is a controlling owner who is not involved in management […] This puts the outside directors in a potentially useful position. If they become unhappy with either the competence or integrity of the manager, they can go directly to the owner (who may also be on the board) and report their dissatisfaction. This situation is ideal for an outside director, since he need make his case only to a single, presumably interested owner, who can forthwith effect change if the argument is persuasive. […] Logically, this type of governance should be the most effective in insuring first-class management.»

"We feel healthy that members of boards to be significant shareholders so that they are aligned with the interests of those whom they represent."

Proper understanding of the alignment of interrests is an essential component of our research as it is critical to a company’s economic performance. Having a controlling shareholder on board seems to be, by far, the best guarantee of such an alignment. When this is not the case, the compensation of managers, as well as employees, must be extremely well structured and must be a priority of boards of directors. Compensation can then mitigate some of the weaknesses of an excessively fragmented shareholder structure. At Amiral Gestion and in all our Sextant funds, as minority shareholders, taking the long view, we wish to be invested in most cases alongside controlling shareholders who share the same perspective.