Tackling Family Business Investment Decisions in a Low-return Environment

Tackling family business investment decisions

This is the first in a series of article I will be doing for Smart Company. How will your family business fare in this low return environment? – David Harland, Managing Director of FINH

Family businesses should look to their inherent strengths to maximise asset productivity or finance growth.

Family businesses face unique investment challenges in the current low-return environment. Fortunately, families can rely on their natural advantages to maximise asset productivity and preserve future capital.

For the typical Australian, investment decisions centre around their retirement portfolio – superannuation, employer benefits, maybe some stocks or funds on the side. They may make adjustments once per quarter or once per year, otherwise relying on the business savvy of others to generate a return.

By contrast, those who own and operate their own family businesses make investment decisions every day. They drive nearly all of their investable assets into their business. Family business investors don’t just keep an eye to retirement or a family vacation; they must consider the future financing needs of their business. Investments made today will help replace or upgrade capital equipment, expand operations, or simply boost market value.

Family businesses have the comfort — and stress — of controlling the returns on their investments. They do this by generating profits and serving their customers. They keep a lid on expenses and strive for innovation. And, unlike other businesses, they can afford a longer-term perspective. Historically, family firms generate higher return on assets (ROA) and higher profit margins than non-family firms, especially over extended periods.

The low-return environment

Australia’s investors must manoeuvre and adapt to the Reserve Bank of Australia’s (RBA) interest rate adjustments, as well as political and economic fallout from foreign markets. We must, at least, consider the risk of Japan-style stagnation in a low-rate world.

Low interest rate policies reduce the risk premium on equity assets, which means investors of all stripes tend to realise lower returns. The interest on savings accounts and bonds fall as well, pushing more money into riskier asset classes. This causes valuations to rise, exacerbating the decline in returns. Unless future business growth justifies those higher asset prices, investors could be in for a sluggish and disappointing ride.

Australia’s market looks more optimistic than those in Europe, China, or Japan. Still, investment return prospects are lower than most are used to. For the family business owner, this may be time to double down on the promise of family investments.

Family investment governance is critical

The dual advantages of family business investments are 1) increased control over returns; and 2) higher ROAs and better margins on invested business capital. However, even though history tells us that family businesses generate stronger and more sustainable returns, family businesses need to work at maintaining their investment advantages. If low rates suppress investment returns, families need to recalibrate their capital decisions.

Family meetings are a crucial component of every aspect of family business success. Ideas need to be presented, communicated, and agreed upon before committing the business to a strategy. Families should discuss how profits are distributed, reinvested, or otherwise preserved. This is where a written family constitution and family council, as well as a trusted family business advisor, become important assets.

Sourcing families to invest in your family business

Most family businesses, Australian or otherwise, are far more likely to auto-finance capital for investment. They are more dependent on internally generated funds than private non-family firms.

This makes sense. The advantages enjoyed by family businesses are not accidents, after all. Successful families stick together. They maintain a strong sense of value and responsibility, and they impute those values to the next generation — future growth is rarely sacrificed for immediate gains. For this reason, family businesses rarely offer equity to others outside of their trusted circle.

A KPMG Global Family Business Survey revealed many family businesses shy away from external investors because they fear losing control or ownership. A strong 67% of respondents identified “possible loss of independence” as their most or second-most important barrier to an equity offering.

However, there is a third way that enterprising families might consider in a low-return market: sourcing other families to invest in your business.

Other families and family businesses make ideal, if atypical, investors in other family businesses. For example, a family business in Australia may source the knowledge, savvy, and resources of a successful family in the United States or United Kingdom. This can be done by selling down a minority stake in the Australian family’s business (say, 25%) in return for financial capital and other resources. This kind of investment relationship does not dilute the inherent strength of the family business structure, nor does it cede a controlling interest. Rather, the other investing family provides the necessary resources and relationships to boost returns.