Family enterprises show signs of healthier credit quality

Companies with family owners cover a diverse range of sizes, geographic footprints and industries, yet they share some revealing similarities. For these businesses, a longer-term outlook on business strategy is the norm, driven by a focus on stability.

Indeed, our analysis shows that credit ratings for family-owned businesses have proven more stable over the past five years than ratings belonging to businesses with more varied ownership structures. What’s more, family enterprises tend to have higher ratings in the first place (with a median of BB+ compared to the overall nonfinancial corporate median of BB) and stronger management and governance structures.

These are crucial strengths at a time when bank lending is becoming increasingly scarce due to capital constraints and regulation, and small-to-medium sized businesses – including many family enterprises – consider debt issuance for the first time.

A small but diverse group
Broadly, our definition of family ownership requires the majority of decision-making rights to be in the possession of the firm’s founder(s) or immediate family and direct heirs, and at least one representative of the family to be formally involved in the firm’s management. As such, listed companies meet the definition of family enterprise if the person who established or acquired the firm – or their families or descendants – possess 25% of the decision-making rights mandated by their share capital.

Applying this definition to the 784 companies we rate in EMEA – excluding utilities, project finance entities and financial services companies – only 92 fall within our definition of family ownership. Yet this small sub-set is a diverse group in terms of size, geographic footprint, and industry exposure. And contrary to the perception that family businesses must be small, almost 50% of the 92 companies are large multinational businesses with revenues of greater than €5 billion-equivalent and 36% have outstanding total debt of greater than €3 billion-equivalent.

Yet, despite the group’s diversity, there are several characteristics that its members share. For instance, family owned businesses often take a longer-term view because owner families want to bequeath the business to their children. This often translates into more defensive business strategies, and these firms tend not to respond to economic downturns with large-scale layoffs and drastic investment cutbacks. Similarly, during upswings in the business cycle these firms seldom initiate rapid expansion, expensive hires, and large capital outlays.

There have been various studies trying to understand the effect of this behaviour on performance. For our part, we’ve examined the stability of ratings by measuring rating transitions by family owned companies over the past five years and comparing this to our total rated nonfinancial corporate portfolio in EMEA. The results show that family owned companies were more stable in each rating category apart from those at the ‘BBB’ level.

Management and governance is a strength
In addition to more stable rating performance, our analysis indicates that family controlled businesses exhibit slightly stronger management & governance (M&G) scores as a group, with 18% assigned a “strong” score, versus 13.1% for our rated issuer base.
We define M&G as the broad range of oversight and direction conducted by the owners of an enterprise, covering board representatives, executives, and functional managers. We look at their strategic competence, operational effectiveness, and ability to manage risks, all of which shape a company’s competitiveness in the marketplace and credit profile.

While M&G is usually a strength for family enterprises, they are especially vulnerable to “key man” risk when there is dominant figure running the business. In that case, the presence of a clear succession plan is imperative. The loss of key personnel can significantly disrupt operations and cash flow; and tax burdens (in the form of death duties) can also arise when passing shares from one generation to another.

Financial policy a mixed bag
Financial policy is an area to which we attach great importance when conducting our financial risk assessment. Better, more sophisticated business managers have policies that recognize cash flow parameters and the interplay between business and financial risk.

Here, the family enterprises in our study are a mixed bag. For example, auto component supplier Robert Bosch GmbH has a very conservative financial policy according to our analysis. The group has a track record of low leverage, exceptional liquidity, and credible commitment to maintaining a conservative financial structure.

By contrast, other family owned companies have become more aggressive in their financial policies and as a consequence compromised their credit quality. This is evident in the large percentage of family-owned “fallen angels” – that is, companies downgraded to speculative grade (‘BB+’ or lower) from investment grade (BBB- or higher) – now in the ‘BB’ rating category, which includes French investment company Wendel and German holding company Franz Haniel & Cie GmbH.

New sources of finance
Yet even with these significant variations, 64% of family enterprises have financial policies we would class as moderate, conservative or very conservative – which speaks to the caution of most family enterprises. While we were unable to identify a systematic positive or negative bias in the ratings of family businesses, we understand that these businesses often represent a large concentration of a family’s wealth, leading the owners to be inherently more cautious than others.

This caution – and consequent stability – is an important strength following the financial crisis of 2008, as bank lending contracts and businesses throughout EMEA search for new sources of funding. More enterprising family owners will consider sources of finance outside of their traditional banking relationships – perhaps turning to the debt markets.

That said, growing outside of long-standing lending relationships can be a significant cultural shift, not least for companies too small for a formal credit rating. And many potential investors do not have the resources necessary to conduct in-house credit risk analyses of new, unfamiliar businesses. We believe that better access to timely financial information could go some way toward helping them diversify into this new asset class.

To this end, Standard & Poor’s launched its Mid-Market Evaluation (MME) in June this year. The MME aims to bridge the knowledge gap by providing mid-market companies – which we define as companies with revenues less than €1.5 billion and outstanding debt less than €500 million – with an independent, third-party assessment of creditworthiness. For family owned businesses too small to consider a formal, public credit rating, the MME represents a discreet but effective method of communicating their stability and investment potential to new backers