THE GOVERNANCE OF FAMILY FIRMS 1

THE GOVERNANCE OF FAMILY FIRMS 1 MORTEN BENNEDSEN, André and Rosalie Hoffmann Chaired Professor in Family Enterprise, INSEAD FRANCISCO PÉREZ-GONZÁLEZ, Assistant Professor of Finance, Stanford University and Faculty Research Fellow, National Bureau of Economic Research (NBER) DANIEL WOLFENZON, Stefan H. Robock Professor of Finance and Economics, Columbia University and Faculty Research Fellow, National Bureau of Economic Research (NBER) ABSTRACT In the last decade, corporate governance research has documented that families control most publicly-traded firms around the world. This finding has triggered a considerable body of research that seeks to understand the governance of family firms and their impact on firm performance. This chapter critically examines this literature. The chapter highlights that the main governance issue facing family firms is balancing the benefits associated to having a controlling family with the challenges this structure imposes on minority shareholders. Common governance mechanisms are less likely to be effective whenever control and decision-rights are concentrated around a family. The chapter emphasizes the crucial role of family governance on the allocation of resources and reviews recent studies that seek to understand the impact of family characteristics on firm decisions and performance. The chapter also discusses some of the most important topics for future research. 1 Forthcoming, R. Anderson and K. Baker (Eds), Corporate Governance, (John Wiley & Sons) (forthcoming, 2010). 1

INTRODUCTION Corporate governance deals with collective action problems facing a firm s alternative stakeholders. To address these conflicts, firms often rely on large shareholders, who combine substantial ownership and control rights to affect decisions. Around the world, the most common large shareholders are families (La Porta, Lopez-de-Silanes, and Shleifer, 1999; Morck, Stangeland, and Yeung, 2000; Claessens, Fan, and Lang, 2000; Faccio and Lang, 2002; Anderson and Reeb, 2003a; Villalonga and Amit, 2006). The prevalence of family firms has sparked a growing body of research that focuses on the governance of these firms. This chapter attempts to summarize the main issues in this literature and to highlight its future potential. The chapter emphasizes four main issues. First, family firms are a promising area of research. Family businesses play a prominent role in the allocation of resources that is still understudied by a literature that historically views such businesses as an anomaly. Family firms are widespread around the world and are also correlated with significantly more variation than other firms in measures of economic output. The literature does not currently provide a comprehensive understanding of the governance mechanisms that drive these extreme outcomes or that explain why family firms are the dominant form of organization in the world. Second, an important challenge in the advancement of this area of research is the lack of a clear definition of a family firm. Different researchers define family firms in various ways, but the definition used is crucial to (1) understand the many seemingly unrelated stylized facts documented in the literature, and (2) flesh out the specific governance challenges facing these firms. This chapter provides a narrow definition of family firms and then uses it to make an array of empirical predictions that distinguish family from other firms. Third, in terms of corporate governance, a major challenge has been to identify the distinguishing characteristics of family firms relative to other firms. Family businesses, like other corporations with ownership concentration, typically have a dominant shareholder. As a result, 2

the common agency conflict that plagues widely-held firms is often superseded by the conflict of interests between controlling and non-controlling shareholders. So why are family firms different? Family firms are unique because a family is at the apex of the firms governance institutions. The most important voice in governance is, in consequence, not necessarily exercised by an individual, but rather, by a group of people who are linked to each other by blood or marriage relations. As a result, the allocation of power within the family, the family governance institutions, the interaction between family members and other stakeholders, as well as family characteristics (such as size, age, and talent) are likely to have a determining impact on firms outcomes. The arguments for the overlap of family and business structures often rely on market imperfections that make arms-length contracts unattractive or on private benefits that reduce family participation costs. In terms of market frictions, within family labor or capital provision may be less exposed to information asymmetry or opportunistic behavior. Multiple family interactions may facilitate screening and enforcement of contracts, firm-specific investments, and reputation building. The joint maximization of family and business objectives, however, may also entail significant distortions to firms. The central objective of family-firm governance research is, therefore, to understand how family firms balance the protection that the controlling family brings to the firm with the challenges this structure imposes on minority shareholders. The existing literature provides few clues into the specific ways in which family firms use their characteristics or structure to affect value. Direct tests on the effect of family characteristics on performance are rare in the literature. Yet, they provide the distinguishing mark and the future of this area of research. Fourth, family firms can provide an attractive laboratory for addressing several research questions of general interest. Empirical work in corporate governance is plagued with endogeneity and omitted variables concerns. Causal relationships are difficult to establish. Nevertheless, variation in family firm decision making may result from family, not firm, 3

characteristics. These traits can potentially be exogenous to firms prospects. As a result, family firm research can be a fruitful avenue to addressing central questions in financial economics. In sum, the future of family firm governance research seems intrinsically linked to family governance. To this end, detailed datasets are increasingly been put together by researchers all over the world including datasets from the United States (Pérez-González, 2006; Villalonga and Amit, 2006, 2009; Miller, Le Breton-Miller, Lester, and Cannella, 2007); Denmark (Bennedsen, Nielsen, Pérez-González, and Wolfenzon, 2007; Bennedsen, Pérez-González, and Wolfenzon, 2009); Italy (Cucculelli and Micucci, 2008); Japan (Mehrotra, Morck, Shim, and Wiwattanakantang. 2009); Thailand (Bunkanwanicha, Fan, and Wiwattanakantang, 2008; Bertrand, Johnson, Samphantharak, and Schoar, 2008); and Singapore, Hong Kong, and Taiwan (Fan, Jian, Jin, and Yeh, 2009). This trend is likely to continue in the future. A cautionary caveat applies. The format and size restrictions of this chapter limit the scope and scale of analysis. The chapter focuses on the empirical governance literature and emphasizes governance problems facing minority shareholders. It stresses firm-level governance mechanisms and devotes substantial attention to identification problems that affect applied research. The chapter is, therefore, not a review on the vast family firm literature. Particular papers are only introduced in so far they enter the discussion of what the authors consider are the main issues and the most prominent topics for future research. As a result, the chapter does not make due consideration to all the excellent papers written on this topic. The remainder of the chapter is organized as follows. The next section provides the motivation for focusing on family firms. Following that, a definition of family firms is presented. The chapter then analyzes the ownership and control characteristics of family firms, and their governance challenges in two separate sections. The chapter also includes a methodology section that highlights common empirical challenges in corporate governance research and why family firms can provide a solution to inference problems. The final section concludes. 4

WHY FAMILY FIRMS? This section summarizes the main arguments that make the governance of family firms a promising area of research. They include their prevalence, wide dispersion in performance measures, current intergenerational challenges, and potential macroeconomic effects. Prevalence, Data and Persistence Family firms have historically been underrepresented in the literature for at least three reasons. First, research has traditionally focused on the widely-held paradigm of firms (Berle and Means, 1932). Second, data on family firms are generally harder to obtain because they are disproportionately private, smaller in size, and prevalent in developing economies. Third, family firms are often perceived as an anachronism in modern market economies. Recent studies are overcoming these barriers and challenging such conventional wisdom about family firms. As argued above, recent papers have shown that the majority of firms around the world have as a large shareholder, a founder or the founder s family. La Porta et al. (1999) document that families control over 53 percent of publicly-traded firms with at least $500 million in market capitalization in 27 countries. Additional evidence of the prominent role of families in large firms has been provided by Anderson and Reeb (2003a) and Villalonga and Amit (2006) for the United States; Morck et al. (2000) for Canada; Faccio and Lang (2002) for Europe; Claessens, Djankov, Fan, and Lang, 2002) for East Asian countries; and many others. Also, detailed datasets on governance and family characteristics are increasingly being developed all over the world. The availability of private firm data and of ownership and family characteristics is often superior outside the United States, particularly in Europe, the East, and South East Asia. These datasets provide fertile ground for original and potentially influential research. Finally, recent work by Franks, Mayer, and Rossi (2009) and Mehrotra et al. (2009) challenge the perception that family firms are destined to disappear in developed economies. These studies show that other than in the United Kingdom, family firms are persistent over time. 5

Dispersion in Performance The rise to prominence of corporate governance research is heavily influenced by the observation and strong empirical case of the idea that governance is vital in explaining dispersion in measures of economic output. Within this literature, family firms have been shown to be particularly prevalent at the extremes of the performance distribution. For example, Anderson and Reeb (2003a), Villalonga and Amit (2006), and Sraer and Thesmar (2007), document their superiority in terms of market-to-book valuations and profitability. In contrast, Morck et al. (2000), Pérez-González (2006), and Bennedsen et al. (2007) provide evidence of underperformance. Specifically, they find that firms managed by family chief executive officers (CEOs) significantly underperform. Similarly, Bloom and Van Reenen (2007) document that family-managed firms are among the least productive firms in Western Europe and that these firms may help to explain the observed productivity gap between this region and the United States. Why do such disparate outcomes exist? The evidence suggests that the definition of family firm used and sample selection play an important role in explaining these estimated results. For example, the positive effect of family firms has been largely explained by large founder-led firms. Random sub-sets of family firms do not over-perform (Miller et al., 2007). Yet, Bennedsen et al. (2007) establish a significant family-ceo underperformance result that is unlikely to be driven by sample selection. They find an arguably causal link between family- CEOs and lower performance. Overall, governance and firms outcomes of family and other firms may differ for many reasons. The biggest challenge is, therefore, establishing direct causal links between family governance characteristics and firm outcomes. Overcoming these obstacles provides ample opportunities for future research. 6

Generational Transfers An added rationale for focusing on family firms is the massive inter-generational transfer of assets that is currently under way around the world. Aging demographic statistics imply that a large fraction of these firms will be subject to leadership and wealth transfer challenges. Survey data from the United States, for example, indicates that 40 percent of the business owners expect to retire within a decade and the majority of them expect control to remain within the family (MassMutual, 2007). Family firms may be particularly vulnerable around succession events because governance institutions are often under-developed or centralized. Further work is needed to understand the challenges facing these firms and the potential consequences for resource allocation. Yet, recent evidence by Ellul, Pagano, and Panunzi (2009) and Tsoutsoura (2009) suggests that, for example, inheritance regulations can significantly affect firm investment and performance. Macroeconomic Implications and Political Connections Another strand of the literature has explored the macroeconomic consequences of having a corporate sector dominated by family firms. These firms have been argued to be second-best solutions that arise due to the underdevelopment of market institutions (Khanna and Yafeh, 2007). On an aggregate level, these non-market institutions have been alleged to hinder growth prospects due to distortions in the allocation of human capital (Caselli and Gennaioli, 2003) and financing efficiency (Almeida and Wolfenzon, 2006). A related line of research analyzes the consequences of political connections on firms (Fisman, 2001; Faccio, 2006). While these papers do not focus on family firms per se, they do document that connections tend to be particularly stronger for these firms (Faccio and Parsley, 2009). Various scholars argue that these connections retard growth through their impact on the development of market institutions (Morck et al., 2000; Morck, Wolfenzon, and Yeung, 2005). 7

Cross-country evidence is suggestive that some of these forces may be at work (Morck et al., 2000; Bertrand and Schoar, 2006). Yet, countries differ in many dimensions and, as a result, interpreting these results as causal is difficult. WHAT IS A FAMILY FIRM? As previously argued, researchers have used several and often broad definitions of family firms. This section develops a narrow definition of family firms, which serves as the basis for discussing the main characteristics and governance challenges facing these firms. Following this narrow approach seems a fruitful avenue to advance this area of research. A family firm is herein defined as an organization that shares four common traits: 1. Family. Two or more members of the same family (blood or marriage) are direct participants in the firm s formal governance institutions such as management and the board of directors. 2. Ownership. The family owns a significant fraction of the shares in the firm. Using classic portfolio theory as a benchmark, a significant threshold is defined as an investment exceeding the firms share in the overall market portfolio. In other words, this threshold is not necessarily related to a fraction of shares held. 3. Control rights. Members of the family exert significant control rights in the firm, where the control threshold is at least as large as the fraction of ownership rights held. 4. Preference for within firm inter-generational transfers. Families attach value to retaining their ownership and control rights within the family firm across generations. Defining family firms as those organizations that meet these four traits necessarily implies that many firms that other researchers, practitioners, or owners describe as family firms would not be considered as such. In particular, entrepreneurial firms such as Microsoft are often classified as family firms even if the crucial family component is missing. The definition above, however, captures the main traits that most family firms share. 8

OWNERSHIP AND CONTROL: FAMILY AND NON-FAMILY BLOCKHOLDERS This section stresses the role of ownership and control concentration in family firms and compares the resulting issues to the ownership concentration literature at large. It highlights the common ingredients between these two literatures and the empirical challenges in establishing causal ownership and control effects on performance. Ownership From the point of view of diversification, concentrated portfolio exposures are puzzling, particularly when individual human capital is also exposed to a firm. Why hold such exposures? Rationality implies that such exposures result from the existence of counterbalancing benefits. Private benefits of control may be one such benefit. In consequence, family firms tend to be more prevalent in settings with large private benefits or large amenity values, such as in sport firms (Demsetz and Lehn, 1985). Some of these benefits, such as the value of running a newspaper founded by one s grandfather, are unlikely to be valued by other market participants. Other benefits such as the prestige attached to ownership may be marketable. Standard portfolio logic implies, however, that family firms survival rates would tend to be lower when exposed to significant diversifiable shocks. Total risk exposure would put owners at a disadvantage. Similarly, family firms would be induced to engage in diversification, leading to, for example, business group creation. Consistent with these ideas, Faccio, Marchica, and Mura (2009) show that shareholders diversification affects firms risk-taking behavior. Anderson and Reeb (2003b), however, do not find evidence for this notion in S&P 500 U.S. firms. An alternative route for keeping private benefits while minimizing portfolio costs is separating ownership and control rights. Not surprisingly, family firms have been found to control firms using dual-class shares with differential voting rights (Villalonga and Amit, 2009) and pyramidal ownership structures (Morck et al., 2005). 9

In terms of governance, ownership concentration may alleviate the agency problems from dispersed shareholdings. The challenge is that families may steer firms towards decisions that favor them at the expense of minority shareholders. This large shareholder risk has been previously examined in the literature and it is therefore not unique to family firms (Shleifer and Vishny, 1986, 1997; Becht, Bolton, and Roell, 2003). The empirical record linking family ownership and firm value is mixed. Most studies that focus on large firms document a positive correlation between family ownership and performance (Anderson and Reeb, 2003a; Villalonga and Amit, 2006). This evidence is, however, difficult to interpret as results may be driven by selection. Consistent with this concern, random samples do not exhibit such an over-performance result (Miller et al., 2007.) Selection is hardly surprising because families determine when they sell their ownership stakes. Average performance may be insufficient to warrant concentrated ownership positions. Families may, as a result, prefer to diversify their positions. The resulting samples would indicate that family ownership is positively correlated with performance even when the relevant counterfactuals (i.e., the performance of the family firm without family ownership or the performance of non-family firms with family owners) would be difficult to predict. More generally, the family ownership literature faces the same inference challenges as the older ownership concentration studies. As highlighted by Himmelberg, Hubbard, and Palia (1999), ownership is endogenous. As a result, establishing the direct ownership effects on performance is difficult. Overall, while ownership concentration provides important insights on the characteristics and challenges facing family firms, it does not, by itself, provide a compelling case for an independent literature on family businesses. Control In terms of control rights, the literature has emphasized that control matters in settings of contract incompleteness (Williamson, 1985). In these settings, stakeholders may not ex-ante 10

invest in efficient tasks (Grossman and Hart, 1986; Hart and Moore, 1990) or would strategically invest in value destroying projects (Shleifer and Vishny, 1989). Similarly, ex-post bargaining may be affected by, for example, free-rider problems (Grossman and Hart, 1980) or wealth constraints (Aghion and Bolton, 1992). In terms of optimal organizational design, the literature is interested in understanding the circumstances under which family control is efficient. Firm control, for example, would tend to reside on the family whenever family firmspecific, non-contractible investments are important. The exact nature of these investments in industries as disparate as construction or malt beverage manufacturing, where family firms prevail, are difficult to spell out and are a source of debate in the literature. Following this logic, family control may be inefficient in rapidly evolving industries where strategic investments are difficult to predict. Tight family control would discourage other stakeholders investments (Burkart, Gromb, and Panunzi, 1997). Consistent with this idea, family control is rare in research and development intensive industries (Pérez-González, 2006; Villalonga and Amit, 2008). The focus on family control may lead families to separate cash flows and voting rights to achieve diversification or to fund large scale projects. Such separation tends to be priced: investors would pay less for limited control rights. An empirical challenge of this observation is that family excess control would occur only in firms where the distortions generated by control dilution are outweighed by their perceived benefits, at least from the perspective of the family. In practice, establishing causal control (not ownership) effects on firm performance or valuation has been difficult in the governance literature at large. Despite this fact, the family firm literature has examined the specific mechanisms used to retain family control and the mostly cross-sectional differences between family control and firm value. La Porta et al. (1999) and Morck et al. (2005) show international evidence that family firms exert disproportionate control relative to cash-flow rights through the use of pyramids and active participation in management positions. Villalonga and Amit (2009) document that families in the United States retain control through dual-class shares, excess board representation, and 11

voting agreements. Pyramids are rare in the United States. Similarly, Bennedsen and Nielsen (2009) show a widespread use of dual-class shares in Western Europe. An alternative way to document family control is to compare the probability of takeovers for family and other firms. Morck, Shleifer, and Vishny (1989) document that hostile takeovers are more infrequent for firms run by a member of the founding family, and Slovin and Sushka (1993) show founders deaths lead to increases in the probability of control contests. Studies that have examined the effect of family control on firm value have documented a strong positive correlation (McConaughy, Walker, Henderson, and Mishra, 1998; Villalonga and Amit, 2006). These results suggest that family control may increase efficiency. Yet, these findings are also subject to the selection concerns that plague ownership studies. Recent studies that estimate the value of control document significant premiums for insiders, particularly in settings of poor investor protection (Nenova, 2003; Dyck and Zingales, 2004). As a result, the verdict is still out in terms of the net effect of family control concentration and minority shareholder value. Family firms are similar to other firms with concentrated ownership because decision making is often concentrated in a few hands. Large shareholders and CEOs are often the same person. As a result, changes in common governance mechanisms often fail to bring about substantial effects on outcomes. A board of directors, for example, even if nominally independent may not discipline management when the largest owner is the manager herself. Such an independent board de jure may not be de facto independent. Similarly, the market for corporate control may not discipline managers when they themselves are the large owners. In consequence, changes in governance mechanisms may still matter, as Anderson and Reeb (2004), Anderson, Duru, and Reeb (2009), and others have shown, but the scope for intervention may be limited relative to other settings. 12

So what distinguishes family firms from other firms with concentrated ownership? The family is the sine qua non or indispensible condition of any study in this area of research. Surprisingly, family analysis is often underemphasized in empirical tests. Families are not distinguished from other groups of individuals or they are frequently assumed to be monolithic entities. The next section examines these key distinguishing traits. INSIDE THE FAMILY FIRM: FAMILY INFLUENCE AND INTERGENERATIONAL ISSUES Building on the idea that even small changes in family governance can bring about large effects for firm outcomes, this section emphasizes the role of the family behind the family firm. Mixing Family and Business Starting with the seminal work of Becker (1981), economists have viewed families as entities that produce and organize multiple activities. Families take decisions that maximize the welfare of the family. But the joint maximization of family and business objectives often entails gains in one sphere at the expense of the other. Given these distortions, finding that most firms around the world are exposed to such problems is surprising. Not surprising, however, is that these distortions are typically accompanied by benefits favoring the family firm organizational form. The arguments for mixing family with business transactions often rely on market imperfections that make arms-length contracts expensive. For example, within family labor or capital provision may be less exposed to information asymmetry or opportunistic behavior than hired inputs. Multiple family interactions facilitate screening and contract enforcement, leading to higher levels of trust. Advantageous features also include similarity in preferences. Ex-post inefficiencies, for example, may be reduced if the preferences of relatives are closer to each other than the preferences of non-family members. Hansmann (1996) provides compelling evidence that agents with disparate preferences rarely share control. 13

Similarly, if family ties are stronger than non-relatives links ( blood is thicker than water ), higher separation costs for relatives may lead to greater commitment, higher ex-ante investments, and longer maturity in investments. These investments may be crucial in firms that thrive on firm-specific knowledge. The apprentice system, where younger generations learn the intricacies of business from their elders, is easier to sustain in such conditions. Private benefits associated with working for a business that carries one s name or that was founded by an ancestor may lead to lower participation costs for relatives. Similar private benefits may be derived from working with relatives. In some cases, these forces are so strong that the firm may be an extension of the family and an integral part of the family identity. The superiority of family firms may also result from their culture or reputation. The family may provide a focal point for a corporate culture that minimizes transaction costs (Kreps, 1990). Families have the reputation to establish a credible commitment that authority will be consistently used. For example, if a family enjoys a reputation for integrity, other stakeholders may expect the firm to follow that principle. Strong reputations can smooth transactions in most market interactions. They also facilitate social network development and political connections. Joint family and firm optimization, however, may result in substantial costs. The potential inconsistency of family norms with business rationale may lead to epic and emotional rivalries. Families tend to favor equality among members, while productive organizations base rewards on productivity. Hiring based on blood and not on merit considerations hinders efficiency. Needless to say, firing and comforting one s child may be difficult. Furthermore, some of the attractive features of family firms require undisputed family control. As a result, family firms may also be at a disadvantage when financing large projects or at hiring talented employees. The discussion above suggests that family characteristics, such as family size and talent, and resources can have an important impact on firms outcomes. If, for example, costly external financing is a crucial friction in the marketplace, the ability of the firm to overcome this friction may depend on the depth of the family s pockets. 14

The analysis provides an array of predictions in terms of the settings where family firms would be expected to flourish including countries where market institutions are poorly developed (Burkart, Panunzi, and Shleifer, 2003) or where family trust relative to non-family trust is disproportionate (Banfield, 1958). Other settings involve industries where implicit contracts are important or firms whose products or corporate culture are intricately linked to the reputation of a family. The arguments also provide a benchmark for a critical assessment of the family firm. The path of least resistance is, in many firms, preserving the status quo, where family labor and financial resources are by default allocated to the firm. Such practices do not need to maximize family or firm value. Unleashing family resources, through family offices or by inducing relatives to find productive matches for their talent, could potentially add value even for non-family investors. An extreme version of this analysis may lead to the decision to exit the business. Succession Succession is perhaps the most visible test on the quality of firms ongoing governance institutions. Succession is a crucial concern for family members, practitioners, and family firm researchers. Succession may take many forms, such as family, ownership, board, management, and wealth succession. Succession is a powerful force that seems to preserve an instinctual drive. Family firms typically have strong preferences for family continuity. Such preferences may be the result of private benefits derived from having close relatives influencing decisions. If children are the closest relatives, then the family would tend to focus on the future. Alternatively, family members often view themselves as the stewards of their firms (Davis, Schoorman, and Donaldson, 1997). Within family-specific stewardship leads to similar predictions with regard to the future. Empirically, separating between these arguments is difficult. 15

Intergenerational preferences also imply large tradeoffs for family firms. Dynastic motives may facilitate long-term investments, help overcoming asset substitution conflicts (Jensen and Meckling, 1976), or provide incentives to develop a family reputation. The family willingness to invest for the long run may explain family firm prevalence in reputation intensive industries such as in media outlets. It may also translate into stronger labor relations (Sraer and Thesmar, 2007) or lower financing costs (Anderson, Mansi, and Reeb, 2003). Within-family intergenerational preferences may, in contrast, lead to nepotism in management or board representation; to an inability to hire or retain non-family talent; to inefficient strategic investments that reinforce the likelihood of a family succession or to political activism to block growth enhancing reforms. Family Governance: Open Issues and Recent Evidence In terms of governance, the above described arguments indicate that the family organization can play a crucial role in decision making. At the most general level, family governance determines the type of interactions between the family and the firm (such as ownership, board of directors, and management) and the rules that guide those interactions. On a broad sense, few systematic studies provide direct tests on the specific channels through which family structure affects value. There is hardly any evidence on family, not firm, board (family council) effects; the effect of its composition and size on decisions and outcomes. Little is known about the selection processes or incentive contracts to induce family member participation, or about family rules that guide participation. How do families make decisions? How do families with complicated family trees reduce or manage the level of complexity? How do families prevent inefficient participation from unqualified relatives? How does the family isolate the business from unexpected family shocks? How does the family protect the relatives standard of living from drastic changes in firm profitability? Should family governance institutions be concerned about these otherwise personal issues? Under what circumstances does family 16

governance become active and contentious? What is the interaction between liquidity (ex dividend) policies and family governance? What family arrangements induce relatives to exit the business? When does the family exit the business? The empirical governance literature has, to date, only scratched the surface of the family characteristics that may provide answers to these questions. It has thus far mostly focused on family effects with regard to management and investment. The focus on these issues is partly data driven but as detailed datasets become available, the room for sharper analyses and more ambitious tests grows. With regard to managerial succession, Pérez-González (2006) shows that a proxy for managerial talent of family heirs (the selectivity of the college attended) can have a large and significant effect on firm performance. Within the pool of incoming family CEOs, the differential performance gap between talented and less talented family CEOs is at least 15 percent of firm value. He finds no such difference for incoming non-family CEOs. Bennedsen et al. (2007) provide stark evidence that the characteristics of the family behind the firm can affect succession decisions and performance. Using data from Denmark they show that the gender of the first child of a family CEO affects the probability of observing a family CEO (if male, higher than if female) and that succession decisions affect profitability (family CEOs lead to lower profitability). As discussed in the next section, this evidence provides perhaps the cleanest evidence to date that family characteristics affect performance. The random assignment of gender to firms provides a compelling argument for a causal negative family-ceo effect on performance. Two related studies are Bloom and Van Reenen (2007) and Mehrotra et al. (2009). Bloom and Van Reenen show that Western European firms that select CEOs based on primogeniture rules exhibit lower levels of managerial practices and productivity than other firms. Mehrotra et al. show that small changes in the quality of the family talent pool of Japanese firms can have positive effects on performance. In-laws or other adopted sons, who 17

are often selected based on managerial talent, outperform blood relatives. The implication of this result is that giving priority to firm considerations when evaluating prospective partners in arranged marriages settings can significantly affect firm performance. The results of these papers cast doubt on the benefits of succession policies that select CEOs at birth (e.g., primogeniture) and suggest that an important subsample of family firms around the world may benefit from limiting the family interaction to ownership and board representation. Whether family firms can retain their effectiveness without the top management positions (i.e., without the negative costs on management) is an open research question. In terms of investment, Bertrand et al. (2008) use data from Thailand to show that the number of founder s sons affects how assets are divided within the family. They also show that the number of sons is negatively related to business groups recovery from the financial crisis of the late nineties. Bunkanwanicha et al. (2008) show that marriages in Thailand are a common way to establishing business networks and that these marriages can affect firm valuation. Ellul et al. (2009) and Tsoutsoura (2009) demonstrate that family inheritance regulations and taxes can negatively affect investment. Ellul et al. find that countries that tend to force equal inheritances have lower investment rates after succession. Tsoutsoura studies the effect of personal wealth transfer taxes on the investment decisions of Greek family firms. Using a tax reform as a laboratory for analysis and the first-born approach of Bennedsen et al. (2007), she finds that wealth transfer taxes affect the probability of observing family successions and investment decisions. These two papers show that the separation between firms decisions and personal characteristics predicted by Fisher (1930) does not hold empirically. In sum, this section has emphasized the importance of family governance as the key determining factor in the governance of the family firm. It described the main arguments that favor the development of family firms and the conditions that challenge their existence. The discussion highlighted the role of succession as a crucial governance event. Lastly, this section 18

stressed that the empirical literature currently provides few answers regarding the effectiveness of the family as the main governance institutions of the family firm. FAMILY FIRMS AND RESEARCH DESIGN This section emphasizes that family firms may generate variation in firm decision making that can potentially be used to establish causal relationships. The discussion is organized around the challenges faced when assessing a specific research question the impact of family-ceos on firm performance Research Design: from Randomization to Family Firms Researchers are ultimately interested in establishing causal links. With this objective in mind, randomized experiments are the natural approach to establishing cause-and-effect relationships. Yet, randomized experiments are rarely an option in corporate governance research. Furthermore, because firms do not randomly make decisions, empirical corporate governance research tends to be plagued with endogeneity and omitted variables concerns. In general terms, endogeneity challenges imply that demonstrating whether a governance variable causes the observed effect on performance, or alternatively, whether performance drives governance outcomes is difficult. Concerns with omitted variables arise when a variable of interest, often unobserved, is omitted from the analysis, and other variables that are included as controls capture the variation of this omitted control. As a result, establishing a direct effect from the control variables reported is challenging. Adding more covariates may be counter-productive in these settings if these variables are themselves outcome variables of the problem under examination. For example, the size or composition of the board may vary in preparation for the appointment of a family CEO. Consequently, board characteristics should not be assumed to be exogenous and should not be included as controls. 19

How can governance researchers overcome these empirical challenges? Instrumental variables provide one potential solution to endogeneity and omitted variables concerns (Angrist and Pischke, 2009). A valid instrumental variable (IV) must be correlated with the key control variable (family CEOs) but it cannot be correlated with the error term in the variable of interest (performance equation). Such IV generates variation in the key control variable (family CEO) that is likely to be exogenous, overcoming inference problems. This clean source can potentially allow researchers to estimate the causal effect of the control variable (family CEOs) on the outcome variable (performance). In practice, however, finding instruments that meet these two basic criteria is difficult. This section illustrates how a family characteristic, such as the gender of the first child of a founder, can potentially be used as a valid instrumental variable. Instrumental Variables: An Example Suppose that firm performance is given by Q + I, where Q is a firm characteristic that affects performance such as the quality of the firm s new projects, and I is related to the identity of a CEO. Assume that CEOs can be of two types: family or unrelated. Let I = f when the incoming CEO is related to the outgoing CEO and I = u when the incoming CEO is unrelated or non-family. In terms of inference, researchers are interested in estimating f u, the direct effect of family CEOs. Suppose there is heterogeneity in the quality of firms new projects around succession decisions that the econometrician cannot observe or control. Specifically, the quality of a firm s new projects can be high (q H ), medium (q M ), or low (q L ) each with a probability of one third. A standard ordinary least-squared specification would yield f - u directly if family and unrelated CEOs were randomly assigned to firms. However, firms are unlikely to follow random assignment of CEO positions. In fact, Pérez-González (2006) and Bennedsen et al. (2007) document that firms that select family and non-family CEOs differ along several observable and 20

likely unobservable characteristics. In other words, they highlight that the assumption that CEO promotions are random is strong. To stress the effect of non-random assignment, and in the spirit of Hermalin and Weisbach (1998), suppose that the higher the quality of the firm s prospects, the more powerful the departing CEO and the more likely he selects a family CEO. Also, suppose that for non-firm related reasons (e.g., family tradition) the likelihood of a family succession is higher when the CEO s first-born child is male. Table 19.1 shows a decision rule that satisfies these conditions. (Insert Table 19.1 about here) Standard least-squares estimates compare firms according to the observed outcomes: family versus unrelated succession. If male and a female first-born children occur with equal probability, the difference in performance in these two groups is 1/3(q H - q L ) + 1/2(f - u). Clearly, the standard least-squares estimated coefficients would reflect not only the true effect of family CEOs but also a selection bias, which would then be incorrectly attributed to CEO characteristics. In consequence, the estimate would have an upward bias. In other words, family CEOs would look better than unrelated CEOs because family CEOs receive the best firms. Instrumental variables, in contrast, starts by using information on all CEO successions conditional on the gender of the first-born child and then compares the outcome of CEO successions as a function of the IV. Intuitively, this is equivalent to comparing the outcomes of all CEO transitions in Table 19.1 and calculating the difference in performance across columns. Mathematically, this difference is 1/3(f - u). The IV estimator uses only the information of the group with medium investment prospects, which is the variation that is not contaminated by differences in investment opportunities. Other than the fact that family transitions are more common in male first-born firms, firms falling in each of the two columns are likely to have similar characteristics. The effect of unobserved variables on performance then cancels out when the difference across groups is taken. Indeed, Bennedsen et al. (2007) show that when firms are classified by the gender of the 21

first-born child of the CEO, their characteristics are remarkably similar suggesting the gender of a first-born child is randomly distributed across firms. Lessons of General Interest Given that family firms are subject to variation in family characteristics, some of which are determined by nature, and as a result exogenous to firm investment opportunities, research based on these firms can potentially shed light on important questions in financial economics. As previously discussed, Bennedsen et al. (2007) use the gender of the first child born of a departing CEO to establish that family CEOs negatively affect performance. This result, however, also highlights that non-family CEOs provide valuable services to the organizations they head. This direct test is important because finding convincing evidence that CEOs add value in organizations has historically been difficult. In a more recent paper, Bennedsen et al. (2009) test for the importance of CEO focus for performance. Using variation in CEO attention that results from deaths in his immediate family (such as spouse, children, and parents), they show that CEOs significantly affect firm outcomes. This result has broad implications in corporate governance research because it provides direct evidence that CEO actions can have a meaningful impact on performance. In sum, family businesses are a fruitful area of research. Family firms are relevant and understudied in the literature. Furthermore, they can also provide an attractive laboratory for addressing central questions of general interest in financial economics. 22

SUMMARY AND CONCLUSIONS The focus on family firm research is relatively new in the financial economics literature. The interest in understanding the governance institutions of family firms is motivated by recent evidence documenting that the majority of firms around the world are owned by members of the founding family of the corporation. This chapter studies the governance mechanisms of family firms; it examines the main issues and challenges in the existing literature and then highlights a number of promising lines of research. The analysis emphasizes four broad issues. First, family-firm research provides a fertile ground for corporate governance research. Family businesses are prevalent around the world and they are also correlated with significantly more dispersion in measures of economic output than other firms. The corporate governance mechanisms that allow for such extreme outcomes in performance are currently only partially understood. More data will be needed to investigate these issues. Recent research, however, shows that detailed datasets can be constructed to provide novel answers to these questions. Second, moving this research agenda forward requires sharper definitions of family firms. This chapter provides one such definition and then stresses its main governance implications. A large number of stylized facts that have been found in the literature are direct implications of a simple characterization of these firms. For empirical researchers, such observation implies that arguing that governance, investment, financial or succession decisions are exogenous with regard to other characteristics is difficult. Third, family firms are unique because the governance of these firms is largely determined by the governance of the family behind the family firm. Market imperfections often introduce a wedge between family and arms-length transactions, favoring the within family allocation of resources. As a result, the collective action problems that characterize family decision making and family relationships relative to non-relative relationships may differ in 23

systematic ways. Understanding these relationships is crucial for the development of this area of research. Fourth, family firms may provide an attractive laboratory for addressing important research questions in financial economics. Family-firm decisions that result from family, not firm, characteristics provide researchers with the opportunity to overcome endogeneity and omitted variables concerns that plague corporate governance research. Further work is needed to understand how family firms balance the protection that the controlling family brings to the firm with the challenges this structure imposes on minority shareholders. 24

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Table 19.1 Relationship between Investment Opportunities and CEO Selection Decisions This table describes a decision rule that leads to the appointment of a family (unrelated) chief executive officer (CEO) as a function of the firms unobserved investment opportunities to illustrate the potential advantage of using an exogenous family characteristic for overcoming omitted variables and endogeneity concerns. Specifically, the table indicates that whenever investment opportunities are above (below) average or high ( low ), family firms would appoint family CEOs (unrelated CEOs). When investment opportunities are moderate ( medium ), firms tend to select a family CEO if the first child of the founder is male but an unrelated CEO if the first child is female. Assuming the variation from the gender of the first child is random, researchers may use this variation to test for the impact of family CEOs on firm performance. Gender of First Child Investment Opportunities Male Female High Family CEO Family CEO ( q H + f ) ( q H + f ) Medium Family CEO Unrelated CEO ( q M + f ) ( q M + u ) Low Unrelated CEO Unrelated CEO ( q L + u ) ( q L + u ) 31