Book Review: Critical Generations – Out of the Succession Dilemma of Chinese Family Businesses (关键世代：走出华人家族企业传承之困) by Prof. Joseph P. H. Fan

In my research and investing I stress three things: people, structure and value.  I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below intrinsic levels if not outright cheap.

Academia is one of my favorite sources for information on corporate leaders and business structures.  There are a handful of academics in various business sub-disciplines that look at corporate structure, and objectively research leaders' backgrounds and relationships.  While most write for entrepreneurs and a public policy audience, many times their studies contain helpful information for investors.

Professor Joseph Fan who works at the Chinese University of Hong Kong is one such expert.  Individually and with others he has authored and published many studies and articles on what works and does not for family owned businesses in Hong Kong, Taiwan, Mainland China and other Asian countries. (Prof. Fan's research and personal homepage is here).

This book – like many of his other studies – is geared more toward helping entrepreneurs and wealthy families structure with their succession plans.  Intergenerational gaps many times lead to failing businesses, broken extended families and sometimes both.

While investors are not the target audience Critical Generations does contain some interesting observations:

• Many companies listed in greater China are still led by the founder. In many instances the founder is quite old and close to retirement age. The next ten years will see a lot of changes in corporate leadership as their founders and key builders step down (at least the ten years after the book’s 2012 publish date).

• Share prices decrease in anticipation of the founder leaving the company.  In a study that looked at 250 family-owned companies listed betweeen 1980 to 2000 in Hong Kong, Taiwan and Singapore, Prof. Fan found that share prices decreased over 50% in the five years before the founder retired.

• The transition does not mark the end of share price fall.  In the five years before and three years after the succession, the market value of 200 family owned listcos in Hong Kong, Singapore and Taiwan went down by 60% on average. In other words, if an investor bought shares valued at $100 five years before the succession, the value of their shares would be reduced to an average of $40 three years after the succession.  Hong Kong companies dropped the most losing some 80% on average with Taiwan and Singapore family owned companies falling about 40% and 20% respectively.

• Founders bring intangible benefits. Owing to their personal attributes such as creativity, leadership style, craftsmanship, and personal connections with company stakeholders, the founder is a major ‘intangible’ asset and many times the essential asset.  Think of Li Ka-Shing and Steve Jobs Prof. Fan writes.  The book goes on to note that rarely does the company do better under the second generation than it did under the founder.

• Market notices the passing of founder.  Not all successions result in a decline in market value. In some cases, the passing or a rumor circulating around the poor health of the leader leads to positive market response.  A year after the Hong Kong industrialist Lim Por Yen passed away in 2005, share price of his Lai Sun group companies increased by some 50%. (For a more recent example, Sincere’s shares increased by 40% after its founder’s death – see article here).

• Political connections hurt in China.  In another study Prof. Fan tracked the post-IPO performance of 630 state-owned Chinese enterprises.  He found that firms with politically connected CEOs (i.e. CEOs who are current or former government officials) on average exhibited a 40% loss on market-adjusted stock returns over the three-years subsequent to their IPOs, while those without politically connected CEOs deteriorated by just 10%.

• In contrast government connections can help in Thailand.  Prof. Fan’s study on prestigious Thai-Chinese families reveals that a marriage between the offspring of government officials and business leaders led to a 4% increase in the family firm’s market value. Contrastingly marriage to ordinary families contributed nothing to the share price.

• Trust-held companies trade at lower valuations. Fan’s research finds that among 216 family owned listcos in Hong Kong, one-third are controlled by trusts, but the performance of these companies is no better than those that are directly controlled by family members.  Financial performance of businesses that are controlled by trusts tend to be worse off when family members have a dispute.
• During the financial crisis the price-to-book value of businesses held directly by family members fell to 0.97 while for businesses controlled by trusts the ratio fell to 0.87.
• Companies controlled by trusts are more reluctant to invest on improving business efficiency, and have slower growth rate in the number of employees and sales.
• Family owned companies controlled by the trust structure tend to distribute more dividends. 

• More firms to use capital markets to spread wealth.  If greater China entrepreneurs take Professor Fan’s advice, there should be a lot more public companies. He wrote that a stock market listing is a good way to distribute ownership to family members. 

The above bullet points account for a small part of the book.  The bulk of it provides research, insights and tools families can use to improve their structure and, with luck and foresight, the firm’s transition to the next generation.

Note that the book was originally written in Chinese, although several of Prof. Fan’s studies have been published in English.  My very capable assistant JC Ho read and summarized the Chinese version from which this blog post is based.

Critical Generations can be ordered from the Chinese University of Hong Kong (link is here)

Prof. Fan’s new book The Family Business Map: Assets and Roadblocks in Long Term Planning is in English and is due to be published toward the end of October 2014 (link here).

Book Review - YK Pao, My Father

I was thrilled to get this book fresh from HK University Press.  I've heard about YK Pao for many
years and always had a favourable impression of him and the business empire he built.  But actually I knew very little about him, and his two largest companies - World Wide Shipping and Wharf/Wheelock  - as he was retiring about the same time I was starting as an analyst in Asia.

For those who don't know, YK Pao built the world's largest shipping company in twenty years from a single used ship he purchased in 1955.  By the mid-70s he was on the cover of Time magazine.  He later went on to acquire the Wharf/Wheelock group which was the first ethnic Chinese takeover of a British owned 'hong', or trading house.  His net worth when he passed away in 1990 was estimated at some US$11b.  Along the way he met and built relations with some of the world's most influential people including Deng Xiaoping, Margaret Thatcher, and Li Ka-shing, amongst many others.

My perception of him was that of an old-school, Ningbo-to-Shanghai-to-post-liberation-Hong Kong transplant doing do the right thing for himself, his family, as well as the greater community.   With the book being written by his daughter I suspect this image would be reinforced.

And it was.  His daughter is certainly filial and after putting the book down, it was hard to remember any faults, bad habits or annoying traits that her father possessed.  But then I doubt I would be very objective when writing about my own flesh-and-blood.  Despite the lack of objectivity, the book provides good insight into the history of a self-made man who through hard work, connections and good fortune made a lot of money - and did a lot of good.

Perhaps the most insightful section was about YK Pao and his family's relationship with Deng Xiaoping and his family.  Deng Xiaoping is a personal hero of of mine and this is insight I had not been aware of.

The book notes that YK Pao appears to have been one of the closest non-Mainland confidants to Deng Xiaoping.  This closeness and YK Pao's international experience, contacts and stature helped on several fronts.  This included building the first foreign funded hotel in China, setting up one of the first private-government joint-ventures (for the hotel), and smoothing China-British relations in negotiating Hong Kong's return to Mainland China.

There is also good insight into HK business circles of the 60s and 70s. Particularly how YK Pao's good relationship with senior HSBC bankers and Li Ka-shing  helped him to outbid Jardines in taking  control of Wharf/Wheelock.

The book also provides good insight into the Pao family and his four daughters.  They all married people from different backgrounds.  The author and oldest marrying an ethnic European, the second a Hong Kong raised Shanghainese, the third to an American of Japanese ancestry, and the youngest to a successful Hong Kong businessman.

Despite his initial objection to his eldest daughter not marrying an ethnic Chinese, once her decision was final and the marriage complete, YK Pao brought him into the business on equal footing as he did his three other son-in-laws.  I suspect this was very forward and open-minded from someone in the late 1960s.  Especially from a man who lived in 1930/40s Shanghai when ethnic Chinese were prohibited from entering 'public' parks located in the European concessions.

Keeping with the tradition of handing the business to his sons, YK split his businesses into four parts - one for each son-in-law. The largest and central business - shipping - went to the eldest son-in-law, despite his European heritage.  The second largest business, Wharf/Wheelock went to the second-eldest.

The book also highlights YK Pao's charitable works.  Like other successful entrepreneurs he never forgot his roots and he and his daughters have given generously to educational and other institutions in the family's hometown of Ningbo, as well as Shanghai, Hong Kong and other places.

The book is an easy read, a good insight into one of the wealthiest and more charitable families in Asia, and is highly recommended for readers who are interested in gaining insight into one of modern Asia's true builders. 

My biggest criticism is not the lack of objectivity, but lack of an index.  There is a great deal of valuable information that scholars and others would/should value but is hard to find to without an index.  This oversight is especially surprising as it given its academic linked publisher.

Asian Conglomerates As PE Replacements?

I've heard from several sources that returns from private equity (PE) funds investing in Asia, and their fund-of-funds equivalents, have had poor returns.

At the same time, many family owned and controlled conglomerates in Asia are criticized for 'asset-trading', which sounds like PE-type investment strategy.

My question is the following: what if one viewed, invested and valued Asian conglomerates like a PE alternative rather than an operating company?

This would involve not just looking at current business lines but also the conglomerate's investment track record.  Instead of evaluating the CEO/Chairman as an operator, perhaps look at the group's long-term investment returns and prospects, and how much of this is distributed to minority investors.  As compared with PE investments investors in listed companies have a timing advantage and an information advantage as the investor can buy when shares overshoot on the downside (late 1998/early 1999), and company insiders need to disclose when they buy and sell shares. 

Conglomerates retain optionality. A key advantage for conglomerates is retaining the option of when to sell. Unlike PE funds, conglomerates are not subject to exiting their investments in a predetermined time period, which is typically 7-10 years for PE funds.

Thus the PE fund is giving up the option to hold its investments past the life of the fund. To raise the next fund, there is a powerful incentive for managers to realize capital gains quickly rather than holding on for a higher value.  Forced, or pressured selling, is not a very good way to get top dollar.  (This is not my thinking but rather from reading a study on the subject as part of the CAIA program.  But logically this makes sense).

Asian markets tend to be more volatile than those in the US so putting a time-frame on selling could lead to additional diminished returns for Asian PE investors.

Options have value and PE fund managers are under pressure - internally and externally - to give up this option.

People like Li Ka-shing and his Cheung Kong Holdings, as well as many other family-run conglomerates, have done very well by retaining and acting on this 'option' at the right time.  (It has also been written that Li Ka-shing very rarely losses money when he buys shares in companies he controls.  I suspect, but don't know, that this is the case for similar insiders).   

Operating Knowledge.  Another advantage is inside operating knowledge.  Most Asian conglomerates focus on one or two key business lines with a healthy dose of property somewhere in the mix.  This likely means they have insiders' knowledge when investing in a competing or complimentary business. This may give them an advantage over a PE fund which are more than likely more interested in the financial returns only rather than strategic, longer-term returns.

This can be is different then Silicon Valley and the US where many funds are started by ex-entrepreneurs and/or businessmen.  In Asia, most PE funds are started and staffed by bankers and financial types, rather than operators.  This puts them at a disadvantage in many instances.  Conglomerates thus may have an edge in buying and building businesses.

There are a lot of risks to investing in Asia-based conglomerates.  Taking money out of the listco via negative transfer pricing; long-term operational pump-and-dumps; selling and buying assets from the parent; valuation difficulties from multiple business lines, lack of business line concentration, replication of fund manager's diversification, etc.

But at the same time, there could be several unrecognized - and therefore likely undervalued - embedded options in the conglomerate that investors can ultimately benefit from.