The Importance Of Structure by Michael McGaughy, Minority Report
In my research and investing I stress three things: people, structure and value. I look for companies that are controlled and managed by quality people, have corporate structures that align minority and majority shareholder interests and trade at valuations that are below fair value if not outright cheap.
This post is about structure and is the last of three main posts that provide insight into my research and investment process. The two other posts are about people and valuation (see here and here).
Structure is the hardest to write about. It is boring when compared to writing about people and is not easily quantifiable like valuation. Nevertheless I think it is extremely important and something that investors don’t pay enough attention to.
By mapping a business group’s structure investors can identify potential leakages, or situations where controlling shareholders can transfer something from the listed company to their privately owned vehicles.
It is also time consuming. Mapping corporate structures of large business groups sometimes requires days or weeks of trolling through corporate filings, websites and news articles. It took two weeks for me to map China’s two largest petrochemical conglomerates, CNPC and Sinopec, for my 2012 report on Chinese conglomerates. And I could easily have spent more time on both.
Business Groups
Business groups represent the ownership interests of an individual, family or government entity that controls two or more companies. The group may or may not be legally defined. It can be a formal holding company or just a loose collection of friends that co-invest in many projects together.
They can account for a large role in national economic growth, especially in frontier and emerging economies where they control numerous businesses. Many times they account for a large portion of economic activity. In the early 1980s the Salim group’s revenue accounted for about 5% of Indonesia’s GDP (related book review is here).
Business groups can be large and complex. Below is partial map of Fosun, one of China’s largest privately-owned business groups, when I attempted to map it in 2014. At that time the group had over 300 entities. In one of the group’s more recent filings, it lists economic interests in about 500.
Based on my experience I guesstimate that 20-40% of the value in most stock markets is controlled by a relatively small number of people – say 5 to 30 well-connected families and individuals. Another 20-50% is controlled by the government through ministries, sovereign wealth funds or other government-linked companies and entities. The remainder are companies that have a distributed shareholder base, subsidiaries of MNCs or companies that are not part of the larger business groups.
Taiwan is a good example. One of the largest business groups in Taiwan is the Formosa Plastics Group which controls ten listed companies. Together their value is over 10% of the entire value of all the companies trading on the Taiwan stock exchange.
Governments are also the controlling shareholders of many large listed companies. In a report I wrote on South East Asian business groups in 2011, I found that about 31% of the large companies listed in ASEAN were controlled by government-linked entities. The largest was Singapore’s Temasek which controlled companies that accounted for almost 14% of the region’s total value of large investable companies. In my 2012 book on China’s business groups, I found that the Chinese governments’ proportion of control was even higher at about 60%.
Group Structure Brings Additional Risks
The group structure brings risks to investors. There is a large incentive for controlling shareholders to transfer assets, cash or something valuable from the entity they own only 51% of to that entity they own 100% of. “Expropriation of minority shareholders” is the way financial types and corporate governance experts phrase it. “Screwing over small shareholders”, is more succinct in my view.
There are many ways for this to happen. The beauty behind human ingenuity and imagination means that if there is proper incentive, someone will find a way around the existing rules and laws. Investment bankers, lawyers, and corporate strategists are paid big bucks for devising such structures.
The remainder of this blog illustrates two schemes the controlling shareholder might deploy to take money away from minority shareholders: adverse related party transactions and something I like to call long term pump-and-dump.
Adverse Related Party Transactions
Related party transactions are deals or transfers of some sort between two companies that are both controlled by the same person or group. They are like moving money from one pocket to the other. It stays with the same person. However if one of the company’s shares are listed, then moving money from one company to the other hurts small shareholders of the listed company.
All related party transactions should be at ‘arm’s length’. This means that the sale from one controlled entity to another is executed at the prevailing market price and that it would make no difference than buying or selling to or from a company inside or outside the group. However determining market prices can be subjective and open to interpretation by the two companies involved. The ‘market price’ can be set to benefit one entity at the detriment of the other.
The following is a hypothetical example of how this works.
Let’s call the very rich owner of a large business group BIG TYCOON. BIG TYCOON is the eldest son of the conglomerate’s founder. His father invented and marketed what is now a very popular candy. To increase sales, BIG TYCOON’s father expanded from simple manufacturing into many other related businesses. These include distribution and logistics (to get the candy to market), convenience stores (to sell the candy), and paper manufacturing (to make candy wrappers).
Because he’s the eldest son, BIG TYCOON took ownership when his father passed away. Unlike his father, BIG TYCOON enjoys the money and lifestyle of owning a successful business more than actually running it. He’s not a bad guy in the sense that he beats his wife or children, but he’s simply not interested in the candy business or running a public company.
The outline of BIG TYCOON’s conglomerate is shown below. He owns 51% of Manufacturing Company and 51% of Convenience Store Company. He also owns 100% of Distribution Company. As their names imply, the Manufacturing Company makes candy. Distribution Company distributes it and Convenience Store Company sells it.
The Manufacturing Company and Convenience Store Company are both listed on the stock exchange. The other 49% of both companies is owned by institutional and retail shareholders. The latter two are called “minority shareholders’, since they own less than 50%.
With 51% ownership in both public companies, BIG TYCOON has a firm grip on both Manufacturing Company and Convenience Store Company. Even if all other shareholders get together, they won’t have enough votes to override BIG TYCOON’s decisions.
This structure gives BIG TYCOON near absolute control over all three companies despite owning a little more than half in two of them. He can make decisions that may or may not be in the interest of the minority shareholders of the two listed companies.
In fact there is a large incentive for BIG TYCOON to treat minority shareholders badly. Why settle for 51% of the profits, when he can steer more
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