Controlled companies generally underperformed non-controlled firms in terms of total shareholder returns, revenue growth, and return on equity, according to a new report, Controlled Companies in the Standard & Poor’s 1500: A Follow-up Review of Performance & Risk, commissioned by the Investor Responsibility Research Center Institute (IRRCi) and conducted by Institutional Shareholder Services Inc. (ISS).
The study also finds that average chief executive (CEO) pay is significantly higher at controlled companies with multi-class stock structures: three times higher than that at single-class stock controlled firms and more than 40% higher than average CEO pay at non-controlled firms. In addition, director tenure typically runs longer, board refreshment is generally slower, and boardrooms are less diverse at controlled companies.
Most U.S. companies are structured around “one share, one vote” provisions, so voting power is directly proportional to an investor’s capital at risk. However, some companies, especially in Silicon Valley, use of different share classes to allow insiders or founders to control board of director elections. At other companies, a single shareowner or group owns so much of the company’s single class of stock that it effectively controls the company. The study results challenge the often heard justification that controlled companies automatically benefit a company and its shareowners because this allows management to focus on the long term.
This new study follows up on a 2012 study that is available here.
Controlled companies: Comments From Sponsor and Author
While the findings are directional conclusions and there are exceptions, the results challenge claims by advocates of controlled firms that such structures ultimately benefit all shareholders by insulating management from market pressures. Some controlled companies do function as benevolent dictatorships, but for other controlled companies, the adage about the corrupting qualities of absolute power rings true. In these cases, self-dealing, poor strategic planning and ossified boards result in underperforming companies.
But the real issue is that when such behavior does occur, external shareowners have little recourse, particularly at controlled companies that feature multi-class governance. The upshot for outside investors in controlled companies is to understand both the structures of the company and the motivation and history of the controlling owner.
Edward Kamonjoh, study author and U.S. head of strategic research and analysis at ISS adds:
Given the diminished pervasiveness of poison pills and other traditional defenses for corporate control, unequal voting rights have been transformed from a seldom-seen defense to one of the most effective ways to cement control. The findings of our study show that while the prevalence of unequal voting structures has declined over the past three years, the impact of those structures on shareholders remains problematic.
Controlled firms featuring multiple classes of stock generally underperformed on a broad swath of financial metrics over the long term, are perceived as having more financial risk and offer fewer rights to unaffiliated shareholders than dispersedly owned firms. By contrast, firms in which the controlling party’s voting power and economic power are aligned outperform other controlled companies in some respects and offer unaffiliated shareholders comparatively more rights.
Controlled companies: Key Findings
- Controlled Company Prevalence Drops: The number of controlled firms in the S&P 1500 fell by approximately 8 percent from 2012 to 2015. Fewer firms
- Controlled Companies Concentrated in Three Sectors: Nearly 70 percent of all controlled companies cluster in three sectors: Consumer Discretionary (40 percent), Industrials (16.2 percent) and Consumer Staples (12.4 percent).
- Controlled Companies Generally Tend To Underperform on Metrics That Affect Un-affiliated Shareholders: Controlled companies underperformed non-controlled firms over all periods reviewed (one-, three-, five- and 10-year periods) with respect to total shareholder returns, revenue growth, return on equity, and dividend payout ratios. However, controlled firms outperformed non-controlled firms with respect to return on assets. Results for returns on invested capital were mixed: controlled companies outperformed marginally (by less than a percentage point) for most time periods, but underperformed over the 10-year period.
- Related Party Dealings at Controlled Companies Remain Elevated: The frequency of related-party transactions (RPTs) at controlled firms declined over the study period but continues to exceed the incidence at non-controlled firms.
- Director Tenure Runs Longer at Controlled Firms: The proportion of controlled firms where board members averaged at least 15 years of board service is more than 17 percentage points higher than at non-controlled firms. Almost 80 percent of controlled firms have no new nominees on their board – roughly 10 percentage points higher than at non-controlled companies.
- Controlled Firms’ Boardrooms Are Less Diverse: Women and minority directors are less common at controlled companies compared with non-controlled firms. The proportion of controlled firms with no female representation on their boards is almost 4 percentage points higher than at non-controlled firms, and the percentage of firms with two women on the board is almost 7 percentage points lower. The prevalence of controlled firms with no minority representation on the board is 20 percentage points higher than at non-controlled companies, and the proportion of firms with two minorities on the board is lower by almost 11 percentage points.
- Average CEO Pay Is Significantly Higher at Controlled Companies with Multi-class Stock Structures: Average CEO pay at multi-class controlled firms outstrips that at both non-controlled companies and controlled entities with a single class of stock. Average CEO pay at controlled companies with a multi-class capital structure is three times higher (by some $7.2 million) than that at single-class stock controlled firms and is more than 40 percent ($3.3 million) higher than average CEO pay at non-controlled firms.
- A lower proportion of board members have financial expertise at controlled companies compared with non–controlled firms.
- Controlled firmss generally offer more ‘rights’ to shareholders, like the right to call a special meeting or to act by written consent. However, this simply allows the controlling shareholders to take action without participation by non-controlling shareholders.
- Single class controlled companies have a limited shelf-life as controlled, versus multi-class stocks. Multi-class controlled companies grew from 5% of S&P 500 market cap to 10% in last 10 years.
- Some funds, such as T Rowe Price, are beginning to vote against members of board at dual-class controlled companies.
- Although there have been at least 35 proposals to phase out multi-class controlled firms, only one such proposal was embraced by the controlling shareholder and passed. That proposal was from Bulldog Investors at Stewart Information Services (STC).
The study examines firms in the S&P 1500 Composite Index as of July 31, 2015. Other portions of the study include a survey of institutional investors on questions germane to controlled entities and feedback from a number of institutional investors and investment banks to provide context for the study’s findings.
Conclusion of the Report
The findings of this study are consequential for both investors and board members at controlled firms. The findings show that control matters. This study also shows that not all controlled firms are created equal. At least in the United States, the control mechanism matters. Controlled companies featuring multiple classes of stock generally underperformed on a broad swath of financial metrics over the long term, are perceived as having more financial risk, and offer fewer rights to unaffiliated shareholders than dispersedly owned firms. By contrast, firms in which the controlling party’s voting power and economic power are aligned outperform other controlled companies in some respects while offering unaffiliated shareholders comparatively more rights. While these are directional conclusions and there are exceptions, these findings challenge claims by advocates of controlled firms that such structures ultimately benefit all shareholders. While insiders may favor the combination of public market liquidity with private market autonomy, it does not appear that external shareholders necessarily benefit from this tradeoff.
News and Related Coverage
- Companies with unequal voting rights underperform shareholder friendly ones, study finds by Francine McKenna.
- Controlled Companies Built for Comfort, Not for Performance by Jon Lukomnik
- U.S. investor group urges halt to dual-class structures in IPOs by Ross Kerber.
- Council of Institutional Investors calls for ‘one-share, one-vote’ structures by Hazel Bradford
- Tenure Voting and the U.S. Public Company by David J. Berger, Steven Davidoff Solomon, Aaron Jedidiah Benjamin.
- Recent Research in Corporate Governance: Part 3 by James McRitchie