Financing family firms a systemic view

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1 Financing family firms a systemic view TUM Technische Universität München, Lehrstuhl für Entrepreneurial Finance Seminar in Finance and Management Accounting WP StB Michael Kozikowski München, den 11. Juli 2013

2 Agenda Family businesses: characteristics and rules of the game Financing of family firms: a systemic view Facts and circumstances private vs. listed family firms debt-financing stages for privately held family firms review of key financial figures in the lapse of time anomaly of current market conditions selected characteristics (esp. shareholder loans, Betriebsaufspaltung ) Social relations autonomy of family businesses: How much leverage the family wants to afford? adhesion of family businesses: equity financing vs. debt-financing self monitoring: business judgement rules vs. reporting and covenants Time dimension short-term financing vs. long term financial planning plain vanilla financing vs. structured financing Are we asking the right questions about private family businesses? 2

3 Family businesses: characteristics and rules of the game In general, family businesses are described by the two, three or four circles model, respectively. Paradoxes are fundamental building blocks of family businesses: one is the paradox of financing: - A number of other mostly non financial - factors have been shown to influence financing decisions including: culture; entrepreneurial characteristics; entrepreneurs' prior experiences in capital structure; business goals; business lifecycle issues; preferred ownership structures; views regarding control, debt equity ratios, and short- vs. long-term debt; age and size of the firm; sources of funding for growth; attitudes toward debt financing; issues relating to independence and control; perceived risk and attitudes toward personal risk; etc. à financing / financial behaviour of family firms cannot be explained by facts and circumstances alone. The systemic view therefore follows the idea that the elements / circles are related in a special kind of way and that the interaction between the elements creates a new quality of the whole, which couldn t be explained by the properties of the elements themselves. Source: Tagiuri/Davis (1982), Gersick et. al (1997) 3

4 Agenda Family businesses: characteristics and rules of the game Financing of family firms: a systemic view Facts and circumstances private vs. listed family firms debt-financing stages for privately held family firms review of key financial figures in the lapse of time anomaly of current market conditions selected characteristics (esp. shareholder loans, Betriebsaufspaltung ) Social relations autonomy of family businesses: How much leverage the family wants to afford? adhesion of family businesses: equity financing vs. debt-financing self monitoring: business judgement rules vs. reporting and covenants Time dimension short-term financing vs. long term financial planning plain vanilla financing vs. structured financing Are we asking the right questions about private family businesses? 4

5 Private vs. listed family firms Half of all listed companies (excluding financial institutions) in Germany are family businesses. They represent about a third of the market capitalization. Non-family businesses significantly differ from family businesses in terms of their capital structure: They are far less indebted and have a much higher equity ratio (50%) than nonfamily businesses (36%). Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a last resort. The description of listed family firms however tends to be a bit more classical: investment and financing policies seem to be more independent. Finally, quoted family-owned businesses do not seem to suffer from lack of capital. Consequently one should observe rather lower equity ratios for listed family firms which is empirically not the case. So differences in capital structure seem to be more driven by other factors than one should expect from a pure capital market perspective. Generally the equity ratio of listed family businesses is higher than of other family businesses (see below). 5

6 Business stages and (debt-)financing Observed capital structures suggest that US-SMEs*) broadly following a financial growth life cycle model. Internal equity becomes the most important source of financing over time, as firms increasingly employ retained profits. This source is augmented by short-term debt, which is employed progressively more as age profiles increase. A small number of SMEs source equity from venture capitalists, business angels, private investors, and government grants. Results suggest that these sources of external equity are generally employed by firms in specific sectors with a defined profile, and are most important for firms in the youngest age groups. firm succession and control are fundamental aspects for family-owned firms to delineate their financing strategies. Family-owned firms prefer retained profits to any source of external finance. However, when internal finance is insufficient, family-owned firms prefer debt to external equity. Source: Mac an Bhaird, 2010 *) no specific data for family businesses available 6

7 Review of key financial figures Increasing equity base particularly among small SMEs*) SMEs improved their average equity ratio by 0.3 percentage points to 26.9 %. As in the previous year, small enterprises realised the highest growth rate, which again markedly increased their equity ratio (23.5 %). Large SMEs saw a fall in their equity ratios of 0.5 percentage points to 28.1 %. This might be a sign of easier access to, and more attractive terms for, debt financing. *) no specific data for family businesses available Source: KfW SME panel Declining demand for loans as a result of increasing equity financing capacity SMEs have the capacity to finance many of their investments with their equity. The planned credit requirements for investment financing fell for the third year in a row and totals EUR 100 billion (-5.7 %) with an increase in investment expenditure of EUR 18 billion in Equity thus remains by far the most important source of SME investment financing. 7

8 Review of key financial figures cont d Up to 70%-75 of debt-financing is bank financing (both for operating loans and for investment financing) Financing envivironment more positive than ever (2001) Only 1/3 of SMEs obeserve difficulties in debt financing 40% rating upgrade 40% of the firms have higher equity ratios But still difficult conditions for small businesses (46% of those companies see worsening their refinancing conditions) Equity ratio achieved all time high in Germany Compared to EU still low Not only driven by retained earning, working capital management is seen more relevant by family firms Mezzanine capital came to a standstill Mittelstandsanleihen Initial Bond Offerings (IBO s) seem already to decline Still reluctance against private equity, mainly because of controlling and voting rights 8

9 Anomaly of current market conditions SMEs rely to a larger extent on domesticallyprovided credit than larger or multinational firms. Against the background of high corporate indebtedness, heightened risk aversion of banks especially with respect to less creditworthy borrowers, and subdued demand for credit, SMEs in Germany contributed most to the deleveraging in the period from October 2012 to March Sources: ECB Survey on the access to finance on small and medium- sized enterprises in the euro area April SMEs in most euro area countries reported a further decrease in their debt-to-assets ratio. SMEs in Germany and Austria reported a decline in net interest expenses. SMEs in Germany reported, on balance, a decrease in the need for bank loans and a basically unchanged need for bank overdrafts in the period from October 2012 to March

10 Selected characteristics International comparisons between financing structures have to take into account different legal systems as well as institutional and regulatory settings One of the major reasons for the small share of equity financing in the German Mittelstand are accounting standards that favour the building of hidden reserves instead of equity in German firms balance sheets. The low equity ratio for small firms is at least partially explained by the possibility of asset-shifting from firm to private accounts, mirrored by the possibility of shifting liabilities from private to firm accounts; both of which is favorable for tax reasons. In these cases, German accounting standards produce lower equity ratios than others. Up until 2000, however, there has been also a tax disadvantage for retaining earnings, thus lowering the incentive to increase equity within firms. a company split for tax purposes including its close factual and personnel inter-company dependence is also (still) common practice in small-and medium-sized enterprises. German insolvency laws strongly favors lenders, making loans to firms less risky than in other countries. Also, the German Hausbank -system and strong competition in the banking sector increase access to finance for German firms. Mutual Guarantee Schemes in Germany (Bürgschaftsbanken). Small family businesses and owners who do not have formal planning processes in place tend to rely on family loans. However, family businesses in the service industry (e.g., retailers and wholesalers) are less likely to use family loans as are those owners who are planning to achieve growth through new products or process development. 10

11 Agenda Family businesses: characteristics and rules of the game Financing of family firms: a systemic view Facts and circumstances private vs. listed family firms debt-financing stages for privately held family firms review of key financial figures in the lapse of time anomaly of current market conditions selected characteristics (esp. shareholder loans, Betriebsaufspaltung ) Social relations autonomy of family businesses: How much leverage the family wants to afford? adhesion of family businesses: equity financing vs. debt-financing self monitoring: business judgement rules vs. reporting and covenants Time dimension short-term financing vs. long term financial planning plain vanilla financing vs. structured financing Are we asking the right questions about private family businesses? 11

12 Social relations From a familiy s perspective social, political and cultural contexts and individual and cultural value judgments determine the familiy members responses to the risks around them. So financing of a family business occurs always in the context of this social system and therefore is very much driven by social relations. Every family is a unique social system with a specific entrepreneurial orientation (e.g. degree of autonomy, risk-taking, innovativeness and pro-activeness) which changes over time ( long lived families ). So when analyzing family relationsships the entrepreneurial behaviour pattern needs to be complemented by the level of adhesion and extent of self-monitoring. Somestimes even if corporate entrepreneurship in family firms is moderate or low these firms have been very successful over time. à financing a family firm is no only driven by pure economical or ra6onale criteria but to a large extent by behaviourial aspects and industry rules. 12

13 Social relations cont d financing bevaviour of family firms from a social perspective dimensions orientation socially accepted level of leverage financing behaviour degree of autonomy generally high low leverage skepticism against financial institutions risk-taking even if family firms do take risks while engaged in entrepreneurial activities, they take risk to a lesser extent than nonfamily firms moderate leverage to be on the safe side, see also time perspective innovativeness moderate moderate leverage prefence for bank loans / overdraus pro-activeness moderate / high moderate / high leverage gambling with financial instruments, even if not really understood level of adhesion high low leverage how much leverage the financially poorest family member can afford extent of self-monitoring very high No leverage low/(er) transparency for lenders Source: fiducon 13

14 Social relations cont d... and may give somewhat different answers on the pure ecomonic analysis of financing famliy firms: e.g. autonomy of family businesses: How much leverage the family wants to afford? Esp. as a reaction of the financial crisis, many families reduced the leverage of their businesses significantly (mainly through retained earnings). One of the lessons learnt from the financial crisis was to stabilize the business early enough. e.g.: adhesion of family businesses: equity-financing vs. debt-financing? Maintaining an optimal capital structure to reduce the cost of capital is not an argument for most of the families. The family firm is in many ways the epitome of patient capital families are willing to invest for the long term, and do not suffer from the constraints imposed on their listed competitors by the quarterly reporting cycle and the need for quick returns. e.g. self monitoring: business judgement rules vs. reporting and covenants? Family firms prefer opacity and enjoy control benefits at the cost of over-reliance on monitored finance, while other firms, especially the large family firms, prefer transparency and the lower cost of external finance. Rapidly changing regulation (Basel II, III) requires transparency not only about financial statements but also about financial covenants and financial planning. But: family firms adopt new rules more quickly than expected. Corporate Governance (Internal controls, risk-management, compliance management) as a pre-requistite for PE / Mezzanine capital is gaining momentum ( family governance codex ) but still not wideley accepted. 14

15 Agenda Family businesses: characteristics and rules of the game Financing of family firms: a systemic view Facts and circumstances private vs. listed family firms debt-financing stages for privately held family firms review of key financial figures in the lapse of time anomaly of current market conditions selected characteristics (esp. shareholder loans, Betriebsaufspaltung ) Social relations autonomy of family businesses: How much leverage the family wants to afford? adhesion of family businesses: equity financing vs. debt-financing self monitoring: business judgement rules vs. reporting and covenants Time dimension short-term financing vs. long term financial planning plain vanilla financing vs. structured financing Are we asking the right questions about private family businesses? 15

16 Time dimension financing bevaviour of family firms from a timing perspective dimensions orientation timely accepted level of leverage financing behaviour degree of autonomy generally high short term virtually debt-free as quick as possible. risk-taking even if family firms do take risks while engaged in entrepreneurial activities, they take risk to a lesser extent than nonfamily firms has to match the pay-out period of the investment. no portfolio financing. Sometimes even cash-pooling hard to argue. innovativeness moderate more backwards orientated, based on experiences reluctance towards structured finance. pro-activeness moderate / high short-term financing and investment decisions are always linked. level of adhesion high declines with the remaining time-horizon of the entrepreneur. my succesor should be debtfree. extent of self-monitoring very high mid-term avoiding quartely banking / financial reporting Source: fiducon 16

17 Time dimension cont d... and may also give again somewhat different answers on the pure ecomonic analysis of financing famliy firms: e.g. short-term financing vs. long term financial planning Focus on long-term and balanced growth instead of short term profit maximization. But: truthworthiness of own (mid- and long-term) financial planning is often regarded as low and credit default is not an option. à short term financing (bank overdrafts!) is generally preferred, long-term financing only if linked to long-term investments. e.g. plain vanilla financing vs. structured financing Families don t forget: Sometimes admittedly poor track record of structured financing (LBOs; MBOs, IBOs...) is hard to overcome. Experiences with alternative financing is biased since the financial crisis, Mezzazine is sharply declining. Bonds may have seen their all-time high. Structured financing and financial engineering is more seen as gambling, which could be afforded only on low levels of leverage. Comprehensive financial planning, which should become more and more of an issue among SMEs, partly due to the change on the financial markets, is often regarded as not creating value and paradoxically shortterm driven. 17

18 Are we asking the right questions? I have a simple explanation [for the first Modigliani-Miller proposition]. It's after the ball game, and the pizza man comes up to Yogi Berra and he says, 'Yogi, how do you want me to cut this pizza, into quarters?' Yogi says, 'No, cut it into eight pieces, I'm feeling hungry tonight.' Now when I tell that story the usual reaction is, 'And you mean to say that they gave you a [Nobel] prize for that?' --Merton H. Miller, from his testimony in Glendale Federal Bank's lawsuit against the U.S. government, December 1997 May be family firms came (intuitively!!) somewhat earlier to this conclusion... 18

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