November 15, 2023
Fairlight generally views public companies that are led by owner-managers or their families favourably. This is because the key decision makers are naturally incentivised to perform at their best, minimise risks and think longer-term by virtue of their sizeable personal wealth tied to the business. In other words, family businesses often suffer less from ‘the principal-agent problem’, where management pursue their own interests before those of shareholders.
Members of the Fairlight team recently returned from Europe after visiting the Fund’s seven European investments, five of which are family businesses. The results of these visits reinforced the team’s conviction in these investments and our appreciation for how family ownership has been instrumental in their past successes.
Thinking in decades
Fairlight believes that businesses that take a long term view and invest countercyclically can successfully fend off competition and take market share during the recovery. This isn’t easy, especially in a public market environment where management is continuously assessed on quarterly earning numbers. We believe though that significant family ownership can often help to fight the urge to cut costs during economic downturns and allow countercyclical investment to take place instead.
To make this point, we provide the example of portfolio-holding Bechtle, a German reseller of IT hardware, software and services which we profiled here last year.
Bechtle was founded in 1983 and today, Karin Schick, the daughter of one of the founders, and her family still control more than 30% of the company’s shares. While they are not involved in the day-to-day operations, they support a supervisory board tasked with setting the long-term goals for the business, some of which extend to the year 2030.
Under this structure, management aren’t concerned about meeting quarterly numbers, instead they remain laser focused on executing against these long-term goals. Since 2006, Bechtle has been growing four times faster than the overall German IT industry, mainly thanks to continuous market share gains.
These gains have been particularly strong during periods of economic weakness. During the crisis of 2009, for example, when Bechtle’s revenues contracted 4%, its operating profits fell 28% as management didn’t aggressively reduce its loyal workforce to soften the blow. This decision was vindicated the following year with sales rebounding 24% compared to only 5% for the industry, while profits increased 40%. This behaviour was mirrored years later during the European Sovereign Debt Crisis and the Covid-19 pandemic.
We met with Bechtle’s management in Germany in September and pleasingly this mentality of investing countercyclically remains intact. Despite rising interest rates and a slowing German economy, Bechtle is still growing its headcount and investing to attract more young people to the business. Looking ahead, we believe Bechtle is once again well positioned to capture share and deliver outsized earnings growth when economic conditions improve.
Acquirers of choice
It’s Fairlight experience that family ownership is not beneficial just when it comes to achieving sustainable growth, but it also helps to reduce risk. For example, a widely accepted principle amongst investors is the notion that most acquisitions destroy value. While we agree in principle, our experience has been that significant family ownership helps to avoid many of the common pitfalls of acquisitions, and often can turn this growth lever into an important source of value creation.
The history of portfolio-holding Interpump, profiled here, helps to illustrate how, for instance, a family-run business can employ a more empathetic approach to deal making than the average trade buyer or private equity firm to become an acquirer of choice for other family businesses that are experiencing succession issues.
Interpump’s origins date back to 1977 when Chairman and major-shareholder Fulvio Montipò came up with a better design for high pressure piston pumps which considerably lengthened their lifespan. Montipò has always been a believer that growth, in his own words, ‘brings safety’. So once market share gains in the original business were exhausted, he supported a policy of reinvesting profits into acquiring many niche industrial businesses.
Most of Interpump’s acquisition targets are also family-run businesses, often located in its surrounding areas of Northern Italy. Interpump never exerts pressure on them to make a quick deal but rather seeks to build long-term relationships with the potential sellers, offering to buy their businesses when they feel the right time has arrived. Once a deal closes, Interpump incentivises the existing management to stay, granting them significant autonomy. Rather than pushing for cost cutting measures, Interpump instead supports business growth via targeted investments and the sharing of best practices. In September, the Fairlight team was able to observe Interpump’s investment in automation while visiting the factory floors of many of its subsidiaries.
Having implemented this low-touch patient approach for more than two decades, Interpump has developed a reputation for being a preferred buyer amongst those entrepreneurs who value their legacy more than extracting the maximum amount of money from a sale. We expect this to continue to enable Interpump to keep acquisition multiples low and thus generate attractive returns for its shareholders. For context, since its IPO in 1996, Interpump has compounded EPS at a 13% annual rate while maintaining a return on capital well above 10%.
Attractive quality and valuations
It's important to note that the effectiveness of family ownership and management can vary widely from one case to another and it is not necessarily a silver bullet for long term success. Many listed companies with large family ownership trade at depressed valuations due to market concerns around poor governance and the risk of minority shareholders being at the whim of a volatile founder or second generation family members. The success of a family business depends on various factors, including the competence and ethics of the family members involved, the corporate governance structure, and the competitive landscape in which the company operates, all of which need to be evaluated in the research process.
Fairlight aims at investing almost exclusively in businesses that have demonstrated their ability to compound shareholder wealth over a long period of time. This tenet certainly carries through for our European family holdings which have been able to show a return on equity close to 18% on average over the past decade and with low variability (see Figure 1). Whilst this is reassuring, what matters most are the expected future returns. Fairlight’s European family businesses, which in aggregate account for circa 15% of the Fund’s portfolio, currently trade on an average and median P/E ratio of about 21 and exhibit high cash conversion. Given the demonstrated history of outperformance it is our view that this represents attractive value for a long term investor (see Figure 2).
The Fairlight View
An important part of the Fairlight research process is evaluating management incentives and ensuring management are acting in our best interests as minority shareholders. While most listed companies use options or cash bonuses to incentivise executives, we believe large family ownerships can align management behaviour with Fairlight’s long term investment horizon. Our recent trip to visit our European holdings reinforced this notion and is timely, given the attractive valuations we believe are currently on offer.