Business groups owned by families have long made sense in underdeveloped economies. A wide-ranging diversified portfolio could take advantage of the family business’ strengths in brand reputation, social goodwill and government relations. It could also have better access to the country‘s limited capital that was allocated with political intentions. And when capital was really scarce or times were tough, the “group” could cross-subsidize the businesses in need. Family “groups” dominate the private economies in Latin America, Asia and the Middle East.
In developed economies these advantages and needs have less, if any, application. In fact, financial and strategic theory suggests that businesses should be focused, not diversified, and concentrate on one or a few tangible core competencies.
But study of long-lasting family firms in the highly developed markets of Western Europe and North America also shows a portfolio strategy works for them too – despite conventional wisdom. Why? What are the advantages special to family firms? And how do family firms mitigate the avowed disadvantages of diversification?
Stable, Content Capital
The primary advantage of family business diversification is that it helps assure ownership’s long-term commitment to the business. Diversified family owners feel more secure than when most of their personal wealth is committed to one business. Diversification helps guarantee that family dividends can continue during business cycles.
- A diversified company’s stock price doesn’t gyrate as much -- lessening speculative temptations to sell.
- A diversified company can sell one unit when there’s need for the redemption of an exiting shareholder or liquidity to meet death taxes, without escalating debt or selling shares to others.
- Death taxes will probably be less and gifting shares easier as an official “valuation” of a diversified business will likely be less than the sum of the individual businesses’ values.
For all these reasons, family shareholders can have a more long-term view, a special advantage for family-controlled firms.
Focus on Culture and Opportunism
The other special competitive advantages for a family business are its culture and ability to opportunistically pursue unfashionable strategies. The culture of a family business typically emphasizes integrity, trust and care for people. Those attributes are especially valuable in a diversified business where it’s most important to let each operator have managerial autonomy. Otherwise, top management is too diffused and too involved to make a portfolio strategy work.
In addition, a diversified business facilitates more strategic opportunism in new areas. And when the risk is hedged and the financing can be internal by the other businesses in the portfolio the strategic moves can be taken before the marketplace recognizes the opportunities.
Nose In, Fingers Out Ownership Theory suggests that the managers of diversified units will pursue their own interests. To avoid that, governance systems must be developed as a check and balance. The distribution and costs of that oversight weaken business performance. But in a family-owned company, top management owners can be personally involved in working with the business unit managers. Their relationship keeps oversight costs to a minimum. A major disadvantage of diversification is uniquely overcome through family governance.
The other disadvantage of diversification is that one management team can’t focus on too many core competencies. If family ownership entrusts unit management to manage, then each business’ core competence can be developed with intense, full-time vigor.
Right Sized, Right Mix
All this works so long as the family has the right number and mix of businesses of the right size each. If the businesses are too small to be able to compete effectively on economies of scale, then diversification seriously compromises performance. Successful families overcome this issue by being in niche businesses where scale is confined to a specific geography that they can dominate by being in fragmented industries where scale isn’t very important.
The portfolio must also be diverse enough to achieve the advantages sought, yet not so broad and diversified that ownership oversight is too remote. The different businesses also must have different cycles and risks (i.e., uncorrelated risk) when one is down, another is up.
A portfolio strategy for a family business is another example of how family ownership permits unusual strategies that can work uniquely well for family owners. Challenging the conventional wisdom can provide interesting possibilities.