Controlled Companies Built for Comfort, Not for Performance

Controlled corporations - those US public companies where insiders get extra voting rights or the ability to elect the directors - claim that such special rights increase their returns for all investors. But the truth is that controlled companies are built for corporate comfort.
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Controlled corporations - those US public companies where insiders get extra voting rights or the ability to elect the directors - claim that such special rights increase their returns for all investors. But the truth is that controlled companies are built for corporate comfort, not shareholder performance.

Only some 78 companies in the S&P 1500 index feature multi-class shares, the mechanism that gives insiders extraordinary governance power disproportionate to their capital invested in the company. But they include some of the best-known companies, like Alphabet (the former Google) and Ford. And they attract a huge amount of attention - both good and bad. For instance, the Council of Institutional Investors, a group of pension funds and other institutional investors controlling some $3 trillion, recently said that initial public offerings by companies like Alibaba, First Data, Groupon, LinkedIn, Square and Zynga "fundamentally compromise accountability to shareholders and entrench insiders."

On the other hand, proponents of controlled companies claim that unequal voting rights enable boards and managements to focus on long-term strategy by dampening the corrosive pressure from a short-term public stock market. Opponents claim that such governance simply entrenches boards and managements, as well as being inherently unfair.

Who is right?

First, let's deal with the performance argument. Two comprehensive Investor Responsibility Research Center Institute (IRRCi) studies conducted three years apart looked at 13 years of corporate performance data. Researchers from Institutional Shareholder Services (ISS) found no pattern that multi-class companies outperform. In fact, these companies generally underperform. The most recent study finds that they generally underperform non-controlled companies. Specific companies may out-perform over various time periods, but, in general, having a special, controlling class of shareowners conveys no structural advantage to a company as far as performance is concerned.

But if multi-class controlled companies aren't built for performance, what are they built for? Comfort.

Yes, for the comfort of the company insiders. Consider the following:
  • The boards of multi-class companies have fewer independent directors - by more than 15% -- than non-controlled companies. That means the favored insiders have to deal with fewer pesky outsiders asking probing questions.
  • About two-thirds of directors at these companies have served on their boards for more than 10 years. That's almost double the average for non-controlled companies. In other words, the boards of multi-class companies are crammed full of directors who are very familiar to the insiders.
  • Nearly 60% of controlled companies have no minority directors - not a single one. That's a diversity rate 50% worse than non-controlled companies.
  • Executive officers of companies - CEOs, CFOs and the like - comprise 36% of the directors at controlled companies. It's only 25.6% at non-controlled companies. Directors are less diverse in experience, as well as in race. Diversity is important because those different experiences and viewpoints challenge group think. Group think is comfortable, but dangerous precisely because the assumptions behind it are not challenged.
  • Controlled companies pay their CEOs an average of10.9 million, some3.2 million more than non-controlled companies. That should make the insiders very comfortable

Taken all together, boards are longer-tenured, less diverse, less independent and share similar backgrounds. In other words, insiders at multi-class control firms create boards of directors that look and think like them. And then those directors pay the CEOs enough to keep everyone comfortable.

Now, that may be good or bad, but, in the end, the fact that there is no systematic performance advantage for a multi-class structure means performance of these companies is corporate specific and time-period specific. That makes sense; some entities thrive under pressure and some under comfortable conditions.

When things go right, controlled companies can be the financial equivalent of benevolent despots. They can make great decisions quickly and share the wealth.

The real issue for investors is what happens when things go wrong. With control locked in for the insiders, they can become autocratic tyrants, enriching themselves and having no accountability for bad decision after bad decision. When that happens, ordinary shareholders don't have the remedies they do at non-controlled companies. That's an added risk. Some investors in controlled companies may be getting paid for taking that risk. But, overall, it seems clear that many ordinary shareholders are not feeling nearly as comfortable as the corporate insiders who are the primary beneficiaries of this unequal power structure.

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