We often say while talking about our investment philosophy that we prefer companies which are led by ‘First generation, owner-operator with skin-in-the-game’. Why do we have such a preference?

A company is called to be owner-operated when it is led by the promoter(s) who own the majority stake in the company.

It is said to be first generation owner-operated if it is led by the founding promoter(s). Think Relaxo Footwear or Wonderla Holidays.

Over time the leadership could be passed on to the next generation though it will continue to be termed as owner-operated. Think Garware-Wall Ropes which is currently led by 3^rd generation or Amrutanjan Healthcare led by 4^th generation.

The baton could also be passed on to a professional management team; qualified and experienced managers who would now run the show on behalf of the promoter family. Think Marico or Asian Paints, where promoters only vote at board meetings on key strategic decisions, leaving the complete execution to professionals.

So broadly we categorize leadership in three buckets:

1. Owner-operated (better if first-generation)
2. In transition – from owner-operated to professionals or next generation
3. Professionally run

The riskiest is often the 2^nd category. After running the show for decades, a promoter, in general, find it extremely difficult to let go of control of an organization which he created from scratch. He struggles with the thought that what if he gives full flexibility but the team ends up screwing, it is not just a financial loss but a reputational loss too. Professionals, on the other hand, struggle to change the culture of an organization which was hitherto run by the promoter (a.k.a. Lala). Family run businesses often have a lot of family members, immediate as well as relatives, involved in the day to day operations, which could make things further complicated for a professional CEO.

The recent Infosys saga is an apt example of how challenging succession planning is and how dirty things can get when the transition fails. A new CEO often rejigs team, brings a new strategy to the table, and him leaving in the middle of the execution could be devastating for the company. At the bare minimum, it takes the company a few years behind and leads to opportunity costs which could prove to be brutal in the current hyper-competitive environment.

Whether it’s a large company or small, this transition is always challenging. We have seen this in various small companies too, in many cases first-hand over last decade. Asian Granito and Orient Bell both are relevant examples where professional CEOs joined but transition failed with promoters resuming the CEO role. (We will shortly share a case study on Asian Granito in a separate post).

The risks are there even when the control is being transferred to next generation, though nature of risk is different. In many cases, the differences between the siblings lead to the division of the business in separate companies, but in many cases, it just lingers on affecting the business adversely. In the last couple of decades, we have seen several dozen family-controlled businesses split up among next-generation– Reliance group, RPG group, Greenply & Greenlam among others.

There are also examples of smart succession planning by founders so as to avoid any impact on business, like in the case of Chittilappilly group, where V-Guard and Wonderla Holidays are independently managed by founder’s sons Mithun & Arun.

When the succession planning isn’t taken care of proactively, it often leads to family feuds and ultimately the business suffers, as happened in the case of Liberty Footwear.

3^rd category of Professionally-run are businesses where execution is successfully delegated to professionals. This is true for most large companies and all multinational corporations (MNC). While investing in these businesses, the bet is actually on the business and not so much on any specific individual. For example, if one is investing in Hindustan Unilever, Nestle or Coke, its okay if you don’t even know the name of current CEO leave alone knowing him. These are strong franchises existing for over a century and have stood the test of time with strong checks & balances in place. Nestlé’s ability to come out of Maggi fiasco shows how strong these franchises are. Warren Buffett was probably talking about such businesses when he said “I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Skin-in-the-game

Simply put, it means those running the show benefit from a positive outcome and they also suffer when things go wrong. An owner-operator with 60% stake in the company, stands to get rewarded in a big way if he is able to grow the company from say Rs 500 Cr. market capitalization to Rs 5,000 Cr. In this case, the interests are aligned with minority assuming he has high integrity and doesn’t siphon off money or draws unreasonably high remuneration. This may not be true for a professional CEO who draws a fixed salary irrespective of company’s performance. There could be incentives based on profitability but those could be counter-productive encouraging focus on short-term profitability versus what’s good for long-term sustainability. ESOPs also have a similar shortcoming. A professional CEO would rarely make unconventional choices because a wrong decision can cost him his job, and maybe career, whereas in most cases he wouldn’t have any meaningful upside if it’s a success.

We believe it is the owner-operator who is truly incentivized to think long-term and only he has the capacity to suffer in the short-term by avoiding fads and staying focused on sustainability.

How to judge skin-in-the-game for an owner-operator?

1. Promoters stake is the key and higher the better. The maximum allowed by SEBI is 75%. What should be the minimum criteria? Like everything else in investing this too is a shade of grey and not black/white. Ideally, we would like to see at least majority stake i.e. 50% or higher, but it is also important to trace how it fell i.e. going back to IPO and all subsequent dilutions. There could be cases where it fell because of some family settlement or JV partner selling out to a PE or some other legitimate reason.
2. Share Pledging: Its generally a negative if the promoter has pledged his shares and borrowed money against them. The only exception could be when he has given it as additional margin to help the company raise debt.
3. Net-worth of Promoter: What is the listed company’s share in promoter’s net-worth? It is important to know if the promoter is in similar business through private companies and whether he has interests in other businesses through private or listed entities. Ideally, we would prefer an owner-operator who is only into one business segment (focused) which is entirely channeled through this single listed entity (interests would be fully aligned).

How is Stalwart Advisors’ portfolio positioned?

We currently have 15 businesses in the portfolio and following are the traits:

1. Owner-Operated: 11 (including 7 First-Generation Entrepreneurs)
2. Share Pledging: 2 (8% each)
3. Average Promoter Holding: 60%
4. In similar business outside listed entity: 0
5. Interest outside listed entity: 4

Skin-in-the-game is an essential criterion while making key financial decisions. How is SA placed in that regard?

Unlike many money managers/advisors who would have multiple portfolios/schemes/services based on various themes like micro-cap, small-cap, mid-cap, large-cap, multi-cap, sectoral, value-buy, growth-story, turnarounds, B2C, B2B, special situations, export theme, unorganized to organized etc. we just have one portfolio called ‘Stock Ideas’ and this has all our best ideas. We don’t have 10 different portfolios, but just one. The team is also investing own capital in same stocks.

 Supplementary Reading:

1. Basehitinvesting’s ‘The Competitive Advantage of an Owner-Operator’ 
2. HBR’s ‘Founder-Led Companies Outperform the Rest — Here’s Why‘
3. Intrinsic Investing’s ‘Owner-operator & shareholder value creation‘
4. Ambit’s Thematic Research ‘Family-owned Businesses and Challenges‘