Family-owned businesses (FOBs) are a large part of the global economy and a source of investment for private equity (PE) firms around the world. In this episode of Deal Volume, McKinsey’s podcast on private markets, host and McKinsey Partner Brian Vickery speaks to Senior Partner Acha Leke and Consultant Igor Carvalho, who recently published their research on FOBs in an article titled “The secrets of outperforming family-owned businesses: How they create value—and how you can become one.” Leke and Carvalho are members of McKinsey’s Family-Owned Business Special Initiative, which seeks to create lasting value and impact for family businesses around the world.
Together, Vickery, Leke, and Carvalho discuss the attributes that outperforming FOBs possess, the opportunities PE firms could have to invest in these companies, and how investors can balance their aspirations with a family’s long-term vision. An edited version of their conversation follows.
How FOBs rise to the top
Brian Vickery: Something we’ve noticed in our annual private markets report over the past few years is the growing influence of privately held businesses.1 Companies have been staying private longer and growing bigger, often through several funding cycles. While VC [venture capital] and growth equity fundraising are down substantially, the longer-term arc seems to be that an increasing number of larger, private companies are backed by sponsors. Today’s conversation intersects with that trend. Many FOBs become great candidates for sponsors at some point in their evolution. Acha, what trends did you find when researching FOBs?
Acha Leke: About a year ago, McKinsey relaunched its Family-Owned Business Special Initiative. As part of that work, we wanted to understand what it takes to outperform as a family business. We studied a large data set of family businesses, looking at 600 publicly listed family businesses and comparing their financial data and performance with that of 600 publicly listed nonfamily businesses. We then surveyed another 600 primarily private family businesses and interviewed about 30.
We found that family businesses outperformed nonfamily businesses—which has been well-known and documented—but we got to understand the underlying reasons for that outperformance. In terms of TSR, family businesses outperformed by about 14 percent because of their operational performance. That shows how resilient family businesses are, what their long-term perspectives are, and how operations affect their financial performance.
We also found that, while family businesses outperformed nonfamily businesses across every quintile, the best family businesses outperformed the best nonfamily businesses by three times in terms of the average delta of economic spread. We identified 120 companies from our sample that were in the top quintile. Igor, could you share some of the findings from the analysis?
Igor Carvalho: We confirmed that FOBs outperform non-FOBs in terms of TSR, but we wanted to understand the actions under the control of management that allowed FOBs to outperform. When we looked at economic profit—which includes accounting profit and opportunity cost—we saw that FOBs outperformed non-FOBs by 17 percent on average in the past five years. When we look at the economic spread—which is ROIC minus the weighted average cost of capital—the outperformance was even more significant, at about 33 percent over the past five years.
We not only saw nuances for growth, but we also got some insight into the inherent challenges that FOBs face. For example, FOBs tend to underinvest in research and development, which limits innovation and entrepreneurial risk-taking. They’re a little bit more cautious, and they grow slower than non-FOBs during postcrisis periods. Many also face governance challenges due to family ownership.
We synthesized our learnings on the 120 companies that make up the top quintile to develop a value creation formula: our “4+5 formula.” The 4+5 formula, broadly speaking, is based on four critical mindsets and five strategic actions. The four critical mindsets are traits or characteristics that were common to all FOBs but were expressed more clearly by some of the top-performing FOBs. The first one is a clear purpose that extends beyond the bottom line. The second is a clear long-term perspective or orientation with a willingness to invest in the future. The third is a cautious approach to finances; FOBs have a conservative approach to how they structure their growth that affords independence and resilience. And the fourth is an efficient decision-making process that is centralized and streamlined.
The five strategic actions are actions or best practices that set outperforming FOBs apart. First, they have diversified portfolios with a significant share of revenues coming from beyond their core business. Second, they allocate capital dynamically to high-growth areas. Third, they excel at both capital efficiency and operational excellence. Fourth, they focus relentlessly on talent—attracting, developing, and retaining top talent. And fifth, they have very strong governance processes, which is a key area of ventures for FOBs.
Acha Leke: To put some of these findings into context, in terms of diversified portfolios, for instance, 40 percent of outperformers had more than half of their revenues coming from noncore businesses. Non-outperformers have only 7 percent of their revenues coming from noncore businesses. In terms of capital allocation, about 60 percent of the outperformers had reallocated 30 percent of their capital to other regions or industries within the past five years. Only 20 percent of non-outperformers had dynamic capital allocation. Last, in terms of capital efficiency versus operational excellence, our research showed that young companies are better investors but become better operators as they grow. The best can do both at the same time: they maintain that investment edge as they become better operators.
Brian Vickery: In many ways, it seems as though the 4+5 formula contains best practices for any company. Do best-performing FOBs do it better?
Acha Leke: We found that the four critical mindsets are more relevant for family businesses. The five strategic actions can be applicable to any business, but many don’t do them. The family businesses that applied the four mindsets with the five actions were able to move up at least one or two quintiles over a five- to ten-year period. So there’s huge value-creation potential by applying this formula.
FOBs as investors and operators
Brian Vickery: One point that stood out to me from your article was that FOBs tend to have a higher ROIC than non-FOBs of a similar size, which is important to PE investors. Why are some of these family businesses better investors?
Igor Carvalho: When we broke down ROIC to its core components, we looked at operating margins, or EBIT margins as share revenues. And then we looked at capital turnover, or revenues over shareholder equity. We found was that FOBs in our sample outperformed non-FOBs both in operating margin, indicating that they’re better operators, and in capital turnover, indicating that they’re better investors. There was some nuance when we broke down our data set into companies of slightly different characteristics.
For instance, when we looked at company size, we found that midsize FOBs—which are the companies in our data set that have revenues of between $150 million and $5 billion—tended to be more efficient investors. They generate almost 9 percent higher capital turnover ratios of 1.14 versus 1.05 for midsize non-FOBs in our sample. This is largely driven by better PP&E [property, plant, and equipment] revenue ratios, which were almost six percentage points better than non-FOBs. This suggests that FOBs use capital more efficiently to extract more revenue per dollar invested. When we looked at large FOBs—companies in our sample with revenues of between $5 billion and $100 billion—we found that they tended to be more efficient operators, generating EBIT margins that are 1.5 percentage points higher than those of non-FOBs. This was mostly driven by lower cost structures, specifically by lower COGS [costs of goods sold]-to-revenue ratios, even when some of the other cost elements, like SG&A [selling, general, and administrative expenses], were relatively similar to non-FOBs.
In terms of investment causes, we found that FOBs made decisions efficiently and effectively. They can make decisions without passing them up a chain of command or dealing with uncooperative boards, which reduces friction and allows these companies to identify bets that they see as value generating and move assets quickly to those areas. This element of capital allocation is tremendously important. A consistent pain point of capital allocation has to do with tyranny of inertia, which is the tendency companies have to keep sending the same amount of capital every year to the same areas of the company. FOBs in our conversations were good at avoiding that tyranny of inertia.
On the operations side, the proximity that founders have to the business helps them gain a better perspective of what’s going on and where the areas of opportunity are. For example, we talked to the leaders of a multigenerational South Korean conglomerate. The chairman of the company visits the production lines every week and knows employees by name, which helps break down silos and shows him where areas of opportunity for efficiency might be. A lot of companies are trying to make managers think like owners, but if you position owners to manage, you avoid that issue altogether.
FOBs are also very ingrained in the places where they operate: they have a deep understanding of their countries and industries, so they can influence regulation and domestic policy. This privilege comes from years of building personal relationships with stakeholders across the value chain. Last, the fact that these companies have a family identity can be an advantage in certain markets. A family’s reputation is a powerful driving force for getting things done and a sign of accountability.
Acha Leke: Taking a step back, the younger family businesses are better investors: they’re better at identifying opportunities and going after them. If the product–market fit is not suitable, they can pivot quicker because they’re more agile and nimble. As they grow and they mature, they become better operators because they have a deeper understanding of their relationships with customers and suppliers. In some cases, they have multiple generations of families running the business who have that knowledge.
Investment opportunities in FOBs
Brian Vickery: Acha, what have you learned through your work with PE firms in Africa? How can PE investors find opportunities in FOBs, and what should they watch out for?
Acha Leke: Family businesses contribute to more than 70 percent of global GDP and 60 percent of global employment.2 So they’re relevant in emerging markets and in many developed markets. PE firms must learn to understand the mindsets of family businesses and the implications they have for a PE partnership, then decide whether the company is an opportunity for investment.
One tension I’ve noticed is the lack of long-term perspective among PE investors. Some family businesses think ahead to multiple generations, whereas some of the PE investors think about exiting in five to seven years. Another area of tension is the cautious financial stance of family businesses. Their leverage ratios are lower in general, which doesn’t mean they don’t take on debt. A PE firm may want to lever up, but the FOB could be resistant.
But there are also several areas of opportunity. If you look at the early-stage businesses, they grow revenue twice as fast as nonfamily businesses. As they mature, the growth tends to mirror that of nonfamily businesses. Why is that? In some cases, there’s a loss of the founder’s entrepreneurial edge, and the next generation is not as hungry. PE firms can help them understand where the growth opportunities are and go after them. Second, in some cases, FOBs are too cautious about their finances. In downturns, they tend to do better than nonfamily businesses because they’re quite cautious, so we see a lot fewer FOBs that go bust. But that also means they don’t quickly come out of recovery periods. So a PE firm can help them think about how to accelerate the growth coming out of the recovery period.
Third, in some cases, too many family members may be involved, so they struggle to professionalize the business. I’ve seen many of the PE firms, at least in Africa, help in that area. They help professionalize both the boards and the business, bringing in external management. The outperforming companies have a lot more nonfamily members involved in the decision-making process. Fourth, PE firms can help with governance, putting in place the right governance mechanisms to effectively run the business. And last, investors can help a FOB drive their performance management more proactively to increase operational excellence.
Brian Vickery: If I’m a PE firm looking at FOBs, I could take the 4+5 formula and use it in two different ways. I could evaluate a business, determine whether it has all the hallmarks of a business that’s likely to outperform, and decide whether this is a business that I want to own. Or I could use the formula to look for companies that don’t do that well across all these dimensions and pick opportunities where I think I can make a real difference.
Acha Leke: They could also use the formula to determine if they want to stay away from a business. If they have a number of these challenges, they may struggle to benefit from the investment. The 4+5 formula can help investors identify businesses where they could help add value, or they can use it to identify the main attributes that create that value.
Balancing investor aspirations with FOB attributes
Brian Vickery: There are several attributes you have identified that help FOBs outperform but aren’t things PE firms often do. If there is a set of characteristics that we see in firms that outperform and PE firms want to come in and change some of those characteristics to get the financial outcome that they’re interested in seeing, how do you see firms wrestling through that conflict?
Igor Carvalho: There’s a bit of nuance. The data we have on dividend yields, for example, helps to dispel this notion that FOBs are used merely as a means to extract value rather than reinvesting. Dividend yields for the family aren’t too low necessarily. These companies exist with sophisticated participants in efficient markets. There has to be a balance of the dividends, whether to sustain the family lifestyle or to fund, finance, or deliver the required returns for a PE firm; dividends can be balanced against the needs of the business for growth and reinvestment.
Similarly, in terms of leverage, low debt ratios are one of the elements that afford resilience and help sustain longevity in FOBs. But too little leverage is problematic to the extent that it limits the company’s ability to bounce back from moments of crisis or limits investment in the future. So those are areas in which PE firms can play a significant role.
Last, when we think about talent and longevity of talent, we find that elements of talent development that build trust and loyalty in a company have positive downstream effects when you take a long-term perspective. Talent isn’t just about the tenure of the talent—it’s about the quality of the talent. The outperforming FOBs that focus on talent don’t just retain talent for the sake of retaining talent. They really focus on attracting and developing the best talent. They focus on making it attractive for the best talent to stay within the company. Those are things that a PE firm might want to consider when investing.
Acha Leke: As part of a firm’s due diligence, they should understand what degrees of freedom they have and what actions the company may not be excited about. As a PE firm, it’s important to understand the family—to understand not just the business but also the people behind the business—and then they can understand which actions would make the family most comfortable. It’s important to have those conversations up front before a firm makes the deal to avoid tensions.
