The shareholders are revolting

Myths and legends about different ownership models for consumer businesses

A shareholder, yesterday

What is the best ownership model for consumer businesses? On the face of it, that sounds like a pretty dry technical question but in practice discussion of the merits of being floated on the stock-market versus being owned by a private equity investor or one of several other possible ownership structures seems to create a lot of passionate debate.

Just look at the current anguish about stories of the John Lewis Partnership considering taking in an outside shareholder for the first time, ending its period of being entirely owned by its employees. As we discussed here a couple of weeks ago, my problem with this strategy by JLP is less about how they raise money and more about what they might spend it on if they do.

That response to the JLP story is probably a clue to what I’m about to say now about different ownership structures. The passionate debate can end up lacking any nuance and trying to ‘pick a winner’ when the reality is that every ownership structure can work well and every ownership structure can fail badly.

In fact, I know several retail PLC CEOs who wish their businesses could be taken off the market and privately held, and several CEOs of privately held businesses whose next goal is to float them. As we’ll see in this article, they might even all be right.

Let’s consider some of the options and see why.

Floating freely - the PLC

Many of the businesses you know and love on the High Street are ‘floated’. That is to say that at some point in time they have listed some or all of their shares on one of the stock markets and made them available to buy and sell.

Why would you do that? The simple answer is that a stock market is a source of capital - by creating some new shares and listing them on the market you are effectively raising new investment capital for your business. Even better, that isn’t a one-shot game - if you do well and everyone likes your shares then there is always the possibility of issuing more in the future if you want to raise some additional capital for a new project or to expand your business.

That all sounds great - so how could there be any drawbacks to being a PLC? Well, here are a few:

• It’s expensive - being a PLC means you have lots of small shareholders and to protect those shareholders the stock market will enforce a lot of rules around the regular publication of financial results, the adherence to particularly standards of corporate governance etc. And those costs mount up - I’ve seen businesses which were far too small to really be floated who were effectively spending almost all of their underlying profit on the cost of being ‘on the market’.

• There is a danger of short-termism - because you have to publish results every quarter or half-year, and they will have the very immediate and visible result of driving your share price either up or down, Boards can end up very fixated on that results publication schedule, making short term decisions to drive profit now rather than investing for the long term.

• The ability to raise capital is a fair-weather friend. I mentioned above that when things are going well you can issue more shares to raise capital and that is true, but when times are tough and your share price is dropping that can be very expensive or even impossible to do.

• The market isn’t always right. Despite all the effort that goes into analysing and understanding companies which are floated on the stock market, there can be irrationality in ‘the markets’ attitude to a particular business or sector, leading to stocks being valued at less than they should be. Retail shareholders are a herd, and like any herd they can stampede when spooked.

The moneymen cometh - Private Equity

Few ownership structures come in for more hostility than the private equity firms. PE houses will “asset strip your business for a quick sale”. They “are really short termist”. They “will load up your business with debt, leaving no room for investment”. I’m sure, in the eyes of these critics, the PE houses have plans for your first-born child too.

The high point of PE-phobia for me was probably the assertion that when UK retailer Debenhams went into administration at the end of 2020 the underlying reason was that it had been savaged by its PE owners. The small point missing from that analysis was that the business had by 2020 been floated on the stock market for 14 years, but so deep was the hatred for the PE sector amongst some commentators that they will still bend themselves out of shape trying to argue that what happened under private ownership in 2004-5 led directly to the business failing so much later.

The reality is that a private equity company is a business whose core operation is trying to make money by buying and selling other businesses. The key to understanding what really goes on in a PE-backed business is that the ‘selling’ bit is much harder than the ‘buying’ bit. The argument that the investor will just hollow out the business, cut all the costs, massage the short term profits and then sell the business on rests on the assumption that there is a pool out there of really stupid buyers who won’t spot that. Business life would be much easier if that was true, but sadly I haven’t seen much evidence of it.

When done well, PE investment can offer real opportunities for a business. Rarely does a PE investor want to buy your business just to ‘look after it for a while’. Usually they buy because there is a plan to increase the value of the asset - expand it at home and abroad, launch new products, merge it with competitors or some other transformation. As such, the PE investor should bring expertise in that kind of transformation to the table, as well as follow-on capital to fund it. Many businesses have indeed gone on extraordinary transformation journeys backed by PE investors who understand that they need to make long term investments even in order to make short term returns.

So no drawbacks to being a PE backed business then? No, sadly there are plenty.

• Any one of the critiques of PE behaviour listed in the first paragraph of this section can happen. There are indeed plenty of short-termist, asset stripping investors out there who still think that is the route to generating value. Just because being owned by a good PE firm can generate real value doesn’t mean that it will. All PE investors are not created equal.

• As a sector PE has probably become, over this last decade of very low interest rates, too dependent on financial engineering and debt. If I buy a business for 100 and sell it for 110 I’ve made a 10% return. But if I buy it for 100 having borrowed 80, then sell it for 110 then even if I have to pay 85 back to the bank I still make a profit of 25 on my initial outlay of 20, which is a 25% return rate. As such, any PE return is essentially a function of the business turnaround (getting 100 to 110) and the level of debt involved. The maths of the latter has certainly led to some deals having too much debt and some businesses are being caught out by that right now as interest rates rise.

• Having a single shareholder (or a small number of them) creates a different set of Board disciplines. In particular, keeping alignment between investor and management team is critical and there are some spectacular examples out there of discord between those groups leaving businesses becalmed and sinking.

Keeping it in the family - family owned and employee owned businesses

I’ve lumped together two other frequently-discussed ownership structures in this final section - family ownership and the kind of employee-owned model that John Lewis uses.

In principle, both have similar strengths. Ownership is long term and so, presumably, the investment horizon will be long term too. These businesses exist outside the short term pressures of the market and so should find it easier to adopt strategies that put brand health, employee wellbeing and other non-financial goals at the heart of the business.

Indeed, these models are often held up as an alternative to the grubby capitalist worlds of the PLC or the PE house and many a politician has suggested in particular that the JLP partnership model should be a benchmark for other businesses and even for ‘UK PLC’.

What could possibly go wrong?

• These models make it very difficult to bring in outside investment in any form other than debt, so when a big restructuring is needed or when times are hard they can find it difficult to respond. Even when times are good, the lack of access to capital means they need to keep a lot of cash on their balance sheets, limiting their ability to invest.

• With private owners or committees of elected partners you are at the mercy of the business acumen of a small number of people who may not have been exposed to changes happening in the wider market in the way that more commercial investors should have. Many private businesses were consequently too slow to embrace the rise of the internet, for example and others have struggled to make unpopular but necessary decisions like store closures or restructurings, ending up with too high a cost base.

• Even worse, with a small number of owners or a set of committees can come politics, and indeed many senior execs working for family-owned businesses will report that they have to invest a huge amount of time managing the fact that one brother won’t talk to another or trying to figure out how generational succession will work, distracting them from actually running the business.

The right structure for you?

So far, then, we’ve proven that almost every way of owning a business can be flawed, and it is no surprise then that any analysis of the retail businesses struggling right now will include examples from every possible structure.

So are we all doomed, then? Not in my view, because any analysis of the retail businesses doing really well right now will also include examples from every structure.

So if ownership structure is insufficient to distinguish businesses that succeed from those that fail, what else can? Many things, obviously, go into making a business a success but from my point of view there are some aspects of ownership that can definitely help:

• The quality of the shareholders - whether that is one PE house or family or a bunch of institutional shareholders for a PLC, having a shareholder register full of investors who understand the market, know the business and support the management is a huge asset.

• The quality of the Board - the right composition for a Board will vary across these different ownership structures but getting the right group of people around the table and fostering good quality discussions that are challenging but supportive is probably the biggest driver of success for any business. (Incidentally, I was delighted to record a podcast on exactly this topic last week, if you’d like to hear more on Boards, NEDs and their role)

• Looking out, not in - if the management team, shareholders and directors are looking out at the market, finding opportunities for the business and working out how to make them happen, as opposed to wasting time in ego-driven internal battles or family politics then they are much more likely to deliver results.

In conclusion, then, every ownership model sucks. But equally, every ownership model can work. As ever, the answer is people - bright, outward focussed, strategically aware people who are willing to work together to protect and grow the business will always do well.

What do you think? Am I being to hard or soft on one model or another? Have a horror story you want to share? Comment here and get involved in the discussion.