Accurately pricing a family business succession plan

With China’s first generation of entrepreneurs about to retire, many of the family businesses that currently dominate the country’s corporate landscape are facing a wave of successions.

But analysts at UBS are warning the real costs of what can often prove a volatile handover of power are too often overlooked, particularly the loss of what have become long-standing personal business relationships.

In the coming decade, they say in a new report, a significant portion of first-generation Chinese entrepreneurs and company leaders are likely to retire.

And that could mean a radical change in the management skills, corporate culture, or strategy within a typical family firm.

“Concerns can also grow over the levels of non-performing loans, for instance, or a company’s global ambitions, within any management transition,” said Yankun Hou, who led the UBS research team behind the study.

“We believe these risks are not being fully appreciated or priced in by the market, and they apply for both A-share listed and H-share listed companies.”

According to the State Administration for Industry & Commerce (SAIC), the number of private enterprises in China mushroomed from 2.6 million in 2002 to 16.5 million in 2015, representing a compound annual growth rate of 15 per cent.

The private sector’s share of all companies also surged, from 36 per cent in 2002 to 86 per cent in 2015.

“Given that most Chinese private enterprises are now family-run, these constitute an important part of the economy,” Hou said.

This great rise in the number of family firms was largely fuelled by the efforts of the country’s pioneering entrepreneurs, who emerged when the economic liberalisation process kicked off in the late 1970s.

“That first generation grasped the opportunities provided by market reform, and developed their businesses against a backdrop of a fast-growing Chinese economy,” Hou added.

However, according to a recent survey by the All-China Federation of Industry and Commerce (ACFIC), with about two-thirds of owners over 50 years old in 2012, many of these founding fathers and mothers are now approaching retirement age.

The next generation lined up to replace them might be better educated, but they certainly have a lot less experience than their parents, says UBS.

And many are about to realise, for the first time, that taking control of the family business can be a complex process, which presents a whole new set of challenges which are likely to have a material effect on the company’s financial performances.

One of the most crucial issues, the report warns, is any power transfer can cause the loss of personal business connections, knowledge and reputation, which are often the most vital assets for the survival of any family business.

“The more a firm depends on this type of specialised asset, the less likely it is that a new leader will be able to comprehend the business, or have comparable credibility with shareholders,” said UBS.

In particular, it says such “tacit connections”, or non-quantifiable information, are especially important to firms whose upstream value chains lack competition.

In those cases, as the transition happens suppliers can quickly gain the upper hand in the pricing process.

Long-established business connections play an especially important role, too, if a firm has a high number of downstream customers with whom the previous generation had taken years to build solid client relationships, and a deep understanding of their mutual needs.

UBS analysts cited companies in the healthcare and movie production sectors as offering strong examples.

Pharmaceutical companies do business with hospitals, while moviemakers compete for resources and bargain with distributors.

But in both cases, the networks of business connections were vital to the performance of all the companies involved in the chain, said UBS.

Consumer-driven companies, such as those in retail, apparel and home appliances, are listed as those most likely to maintain sustainable growth even after a succession, as their upstream customers are usually highly competitive, and their downstream users are always individual customers — far simpler supply chains altogether.

Besides the potential losses of these special assets, the transition phase can also cause a tightening of both the control rights and cash-flow rights within a business, as new family members generally like to take a firmer hold of a firm in the early stages of their control.

“With a further dilution of cash flow rights and possibly increased control rights during a succession, we believe deviation can worsen,” UBS analysts said in the report, noting they could also reduce overall transparency within a family firm.

Its research suggests private companies with a wider gap between control rights and cash flow rights tend to develop higher leverage, and loan ratios.

“And theoretically, higher leverage brings about higher interest expenses, which can hurt the value of a company,” they said.

For those company leaders who can increase leverage arbitrarily, “the liability burden can be heavier, leading to larger exposure to non-performing loans”, the analysts said.