(a) The family-owned company

By “family-owned” we mean that the shareholders have been made up of members of the same family for several generations and, often through a holding company, exert significant influence over management. This is still the dominant model in Europe. The following table shows the shareholder base of the 50 largest companies by market capitalisation in several countries (2016):

However, this type of shareholder structure is on the decline for several reasons:

• some new or capital-intensive industries, such as telecoms, energy/utilities and banks require so much capital that a family-owned structure is not viable over the long term. Indeed, family ownership is more suited to consumer goods, retailing, services, processing, etc.;
• financial markets have matured and financial savings are now properly rewarded, so that, with rare exceptions, diversification is a better investment strategy than concentration on a specific risk (see Section II of this book);
• increasingly, family-owned companies are being managed on the basis of financial criteria, prompting the family group either to exit the capital or to dilute the family’s interests in a larger pool of investors that it no longer controls.

Some research has demonstrated that family-owned companies register on average better performance than non-family-owned companies. Having most of your wealth in one single company or group is a strong incentive to properly monitor its managers or to act responsibly as its manager.

(b) Business angels

See Chapter 40.

(c) Private equity funds

Private equity funds, financed by insurance companies, pension funds or wealthy investors, play a major role. In most cases these funds specialise in a certain type of investment: venture capital, development capital, LBOs (see Chapter 46) or turnaround capital, which correspond to a company’s different stages of maturity.

Venture capital funds focus on bringing seed capital, i.e. equity, to start-ups to finance their early developments, or to struggling companies, buying their debts to take them over and restructure them.

Development capital funds give an acquisitive company in a consolidating market the financial resources it needs to achieve its goals.

LBO funds invest in companies put up for sale by a group looking to refocus on its core business or by a family-held group faced with succession problems, or help a company whose shares are depressed (in the opinion of the management) to delist itself in a public-to-private (P-to-P) transaction. LBO funds are keen to get full control over a company in order to reap all of the rewards and also to make it possible to restructure the company as they think best, without having to worry about the interests of minority shareholders. Therefore, they usually prefer the target companies not to be listed (or to be delisted if the target was public), but the fund itself can be listed.

Turnaround funds work with distressed companies, helping them to turn themselves around.

Managed by teams of investment professionals whose compensation is linked to performance, these funds have a limited lifespan (no more than 10 years). Before the fund is closed, the companies that the fund has acquired are resold, floated on the stock exchange or the fund’s investments are taken over by another fund.

Some private equity funds take a minority stake in listed companies, a PIPE (private investment in public equity), helping the management to revitalise the company so as to make a capital gain.

Private equity funds play an important role in the economy and are a real alternative to a listing on the stock exchange. They solve agency problems by putting in place strict reporting from the management, which is incentivised through management packages and the pressure of debt¹ (LBO funds).

They also bring a cash culture to optimise working capital management and limit capital expenditure to reasonably value-creating investments. Private equity funds are ready to bring additional equity to finance acquisitions with an industrial logic. They also bring to management a capacity to listen, to advise and to exchange, which is far greater than that provided by most institutional investors. They are professional shareholders who have only one aim – to create value – and they do not hesitate to align the management of companies they invest in with that objective.

(d) Institutional investors

Institutional investors are banks, insurance companies, pension funds and unit trusts that manage money on behalf of private individuals. Most of the time they individually own minor stakes (less than 10%), but they play a much bigger role as they define the stock market price of companies in which they collectively represent the major part of their floating capital.

Because of new regulations on corporate governance (see Chapter 43), they vote at AGMs more frequently, especially to defeat resolutions they do not like (share issues without pre-emption rights, voting limits, stock option plans that are too generous, excessive compensation, etc.).

Some of them have started to play a far more active role and are called activist funds. They publicly put pressure on underperforming management teams, suggesting corrective measures to improve value creation. In 2016, one of them, Muddy Waters, pushed Casino to sell its Asian assets to reduce its debt load.

(e) Financial holding companies

Large European financial holding companies such as Deutsche Bank, Paribas, ­Mediobanca, Société Générale de Belgique, etc. played a major role in creating and financing large groups. In a sense, they played the role of the (then-deficient) capital markets. Their gradual disappearance or mutation has led to the breakup of core shareholder groups and cross-shareholdings. Today, in emerging countries (Korea, India, Colombia), large industrial and financial conglomerates play their role (Samsung, Tata, Votorantim, etc.).

(f) Employee-shareholders

Many companies have invited their employees to become shareholders. In most of these cases, employees hold a small proportion of the shares, although in a few cases the majority of the shares. This shareholder group, loyal and non-volatile, lends a degree of stability to the capital and, in general, strengthens the position of the majority shareholder, if any, and of the management.

The main schemes to incentivise employees are:

• Direct ownership. Employees and management can invest directly in the shares of the company. In LBOs, private equity sponsors bring the management into the shareholding structure to minimise agency costs.
• Employee stock ownership programmes (ESOPs). ESOPs consist in granting shares to employees as a form of compensation. Alternatively, the shares are acquired by shareholders but the firm will offer free shares so as to encourage employees to invest in the shares of the company. The shares will be held by a trust (or employee savings plan) for the employees. Such programmes can include lock-up clauses to maintain the incentive aspect and limit flowback (see Chapter 25). In this way, the shares allocated to each employee will vest (i.e. become available) gradually over time.
• Stock options. Stock options are a right to subscribe to new shares or new shares held by the company as treasury stocks at a certain point in time.

For service companies and fast-growing companies, it is key to incentivise employees and management with shares or stock options, as the key assets of such companies are their people. For other companies, offering stock to employees can be part of a broader effort to improve employee relations (all types of companies) and promote the company’s image internally. The success of such a policy largely depends on the overall corporate mood. In large companies, employees can hold up to 10% (Orange, 4.9%). Lehman, the US investment bank, was one of the listed companies with the largest employee shareholdings (c. 25%) when it went into meltdown in 2008.

Regardless of the type of company and its motivation for making employees shareholders, you should keep in mind that the special relationship between the company and the employee-shareholder cannot last forever. Prudent investment principles dictate that the employee should not invest too heavily in the shares of the company that pays their salaries, because in so doing they, in fact, compound the “everyday life” risks they are running.²

Basically, the company should be particularly fast-growing and safe before the employee agrees to a long-term participation in the fruits of its expansion. Most often, this condition is not met. Moreover, just because employees hold stock options does not mean they will be loyal or long-term shareholders. The LBO models we will study in Chapter 46 become dangerous when they make a majority of the employees shareholders. In a crisis, the employees may be keener to protect their jobs than to vote for a painful restructuring. When limited to a small number of employees, however, LBOs create a stable, internal group of shareholders.

(g) Governments

In Europe and the USA, governments’ role as the major shareholders of listed groups is fading, even if they are still majority shareholders of large industry players (Deutsche Bahn, EDF, Enel) or playing a key role in some groups like Deutsche Telekom, Airbus or Eni. State ownership had a period of revival thanks to the economic crisis, as some groups were taken over to avoid collapse (General Motors, RBS) or funds were injected through equity issues to reinforce financial institutions (Citi, ING, etc.).

At the same time, sovereign wealth funds, mostly created by emerging countries and financed thanks to reserves from staples, are gaining importance as long-term shareholders. They are normally very financially minded, but their opacity, their size (often above €50bn or €100bn) and their strong connections with mostly undemocratic states are worrying to some. As of mid-2016, they had c. $7250bn under management. The most well known include the Government Pension Fund of Norway ($848bn), Abu Dhabi Investment Authority (ADIA, $792bn), China Investment Company (CIC, $747bn), Saudi Arabian Monetary Agency (SAMA, $598bn), Kuwait Investment Authority (KIA, $592bn), Government of Singapore Investment Corporation (GIC) and Temasek in Singapore ($538bn), SAFE Investment Company ($474bn) from China, etc. They are majority shareholders of a number of firms (Travelodge, Tussauds, Aston Martin, P&O, etc.) and minority shareholders in some listed firms such as the London Stock Exchange, KKR, Carlyle, Daimler, etc.

5. Joint ventures

Most technological or industrial alliances take place through joint ventures, often held 50/50, or through joint partnerships that perform services at cost for the benefit of their shareholders. In some countries (China, India) and in some sectors, association with a local partner is the only way to enter a market.

These often-ephemeral companies can easily fall victim to boardroom paralysis. When business is booming, one or both of the partners may want to take it over entirely. Conversely, when the joint venture’s fortunes are fading, both partners may be looking for the exit.

Preparing the potential future exit of one partner is key when creating a joint venture. Joint venture agreements often have exit clauses intended to resolve conflicts. Some examples are:

• a buy–sell provision, also called a Dutch clause or a shotgun clause. For example, shareholder A offers to sell his shares at price X to shareholder B. Either B agrees to buy the shares at price X or, if he refuses, he must offer his stake to A at the same price X. Another form calls for a simple auction among shareholders;
• an appraisal clause, which states that the price of a transaction between shareholders shall be determined by independent appraisal.

In summary, the joint venture company – like any company – must have a coherent strategy and set of objectives. A 50/50 sharing arrangement injects numerous difficult-to-resolve problems into the management equation.

1. Separating management control from financial control

2. Controlling shareholder changes

3. Strengthening the position of loyal shareholders

4. Legal and regulatory protection

1. Listing subsidiaries

Listing certain subsidiaries brings in minority shareholders and increases the capital available to the group while offering investors a slice of the assets that interest them the most. The same reasoning holds for bringing financial investors into the capital of the subsidiaries.

The company gains access to equity financing without fundamentally changing the capital structure of the group.

It is easier to incentivise subsidiaries’ managers on the basis of the results of the company they are managing rather than the group’s results where their influence is necessarily weaker. In the same way, it will be easier to make investors understand an outstanding subsidiary if it is listed, rather than invisible, among one of the divisions of the group.

We note, however, that in certain sectors of the economy, legislation requires the presence of a financial partner or a public listing. In Luxembourg, for example, a shareholder may not hold more than 25% of the capital of a radio station; in France, no one may own more than 49% of a free-to-air TV channel. Researchers have shown that the share price performance of the subsidiary improves when the parent company’s stake falls below 50%! A company that creates a new subsidiary and sells a stake on the stock exchange is said to perform a carve-out.

Carried too far, however, the parent company becomes a financial holding company with the problem of the holding company discount (see next section). In addition, tax consolidation (offsetting the positive results of some subsidiaries with the negative results of others to lower the global amount of corporate income tax payable) may no longer be possible as a minimum threshold is required (75% in the UK, 95% in the Netherlands and in France). Lastly, the group must set up strict corporate governance rules to protect minority interests, which are cumbersome and costly.

Depending on market conditions, valuations and strategies, sometimes it will be advantageous to list subsidiaries and bring in minority shareholders and sometimes it will be better to do the opposite and delist a subsidiary. Many companies – Enel and Iberdrola, to name just two – listed their wind power or similar subsidiaries in 2007. This was to take advantage of the high multiples the market was ascribing to the sector in the hope of paying for future acquisitions with the shares of their newly listed subsidiaries rather than with cash. This strategy works well when valuations are high because when acquisitions are paid in paper, the question of price becomes one of parity. At the same time, many more mature companies – Generali, Allianz and Lafarge stand out as examples – bought out minority shareholders in their listed subsidiaries. Moral: nothing is irreversible.

2. Cascade structure

As a newly minted CEO, you may be tempted to structure your group as a Russian ­Matryoshka doll, like Groupe Arnault and LVMH or like the current Albert Frère group:

At each level, it makes sense to create a new company only if it will house different businesses. The most profitable activities must be as close as possible to the controlling holding company. Otherwise, if it is the company at the bottom of the “cascade”, cash flow will have trouble reaching the controlling holding company and shareholders will have the impression their money is working for free!

What are the advantages and disadvantages of such a cascade structure?

The multiplier effect is maximised. With capital of 100, you can control a set of businesses with a capital of 2500! Even more leverage can be obtained if intermediate structures borrow, but we strongly recommend against this practice. As they do not hold the operating assets directly and depend solely on dividends for their livelihood, borrowing would make the intermediate structures even more fragile. Remember that a chain is only as strong as its weakest link.

These cascade companies generally trade at a deep discount (between 20% and 50%). If a parent company wants to participate in its subsidiary’s capital increase in order to maintain control over it, it must, in turn, carry out a capital increase. But because of the holding company discount, the new shares of the holding company will be issued at a heavy discount, increasing its cost of capital. In effect, the cost of capital for a parent holding company which has stock that trades at a 50% discount is twice the cost of capital of the operating subsidiary.

1. Holding company discounts

A holding company owns minority or majority investments in listed or unlisted companies either for purely financial reasons or for the purpose of control.

A holding company trades at a discount when its market capitalisation is less than the sum of the investments it holds. This is usually the case. For example, the holding company holds assets worth 100, but the stock market values the holding company at only 80. Consequently, the investor who buys the holding company’s stock will think he is buying something “at a discount”, because he is paying 80 for something that is worth 100. The market value of the holding company will never reach 100 unless something happens to eliminate the discount, such as a merger between the holding company and its operating subsidiary.

The size of the discount varies with prevailing stock market conditions. In bull markets, holding company discounts tend to contract, while in bear markets they can widen to more than 30%.

Here are four reasons for this phenomenon:

• the portfolio of assets of the holding company is imposed on investors who cannot choose it;
• the free float of the holding company is usually smaller than that of the companies in which it is invested, making the holding’s shares less liquid;
• tax inefficiencies: capital gains on the shares held by the holding company may be taxed twice – first at the holding company level, then at the level of the shareholders. Moreover, it takes time for the flow of dividends to come from the operating company up to the ultimate holding company;
• administrative inefficiencies: the holding company has its own administrative costs which, discounted over a long period, constitute a liability to be subtracted from the value of the investments it holds. Imagine a holding company valued at €2bn with administrative costs of €10m p.a. If those costs are projected to infinity and discounted at 8% p.a., their present value is €125m before tax, or 6.25% of the value of the holding company.

These factors can generally explain a statistical discount up to the 15–25% range. Beyond that, the discount is probably more indicative of a power struggle between investors and holding companies. The former want to get rid of the latter and finance the operating assets directly.

2. Conglomerate discounts

A conglomerate is a group active in several, diverse businesses. Whether the group combines water and telephones or missiles and magazines, the market value of the conglomerate is usually less than the sum of the values of the assets the conglomerate holds. The difference, the conglomerate discount, generally reflects investors’ fears that resources will be poorly allocated. In other words, the group might reduce emphasis on profitable investments in order to support ailing divisions in which the profitability is mediocre or below their cost of capital.

Moreover, investors now want “pure play” stocks and prefer to diversify their holdings themselves. In a conglomerate, investors cannot select the company’s portfolio of assets; they are, in fact, stuck with the holding company’s choice. As in the case of holding companies, head office costs absorb some of the value of the conglomerate.

A persistent conglomerate discount usually leads to a spin-off³ or a hostile takeover bid.⁴

Some conglomerates are valued without a discount (General Electric, Berkshire Hathaway) because investors are convinced that they are efficiently managed.