Control + complexity = disaster

Ricardo Espírito Santo Salgado. Image: Nisopedia/Wikipedia. Licence: CC BY-SA 4.

Ricardo Espírito Santo Salgado. Image: Nisopedia/Wikipedia. Licence: CC BY-SA 4.

The saga of Portugal’s Espirito Santo, the huge, sprawling family-controlled banking-to-healthcare business which collapsed in 2014, is just getting started. Its patriarch,  Ricardo Espírito Santo Salgadowas recently released from house-arrest after posting €3bn bail, and faces a court case brought by investors in his family’s empire. They claim that they were misled when they were asked to inject €1bn into the businesses in 2014.

The details of what went wrong will come out in court, no doubt, but it seems obvious that the fundamental problem was that nobody really understood what was going on in the Espirito Santo empire.

Evidently they should have asked more questions before they handed over their money, but it is also true that the family - which has come out of this mess badly - gave in to the temptation to keep things opaque, in order to keep control.

Complexity is a by-product of growth in many family businesses. In the first generation the founder often creates something that is often far from streamlined. Starting and growing a business is a question of trial-and-error, false starts and experimentation and the successful business can be a Heath-Robinson affair. Founders are interested in creating a business that makes money, and are not too concerned about best practice.

Blurred lines

In itself, that is not a problem. But there comes a time when the mess should be straightened out. When a firm goes public, for instance, it is important that everybody knows who owns what. There are often grey areas here - who owns the firm’s premises?  - which reflect the blurry nature of owner-management.

All this is one reason why the second generation of a family business is, typically, marked by “professionalisation” - ie, bringing in best practice and ironing out the wrinkles that accumulated during the fast-growth stage. Increasingly regulators and politicians, not to mention investors, want to know that a business is run well. That means transparency.

The most extreme example of what can happen when this process is not followed comes from South Korea, where the chaebols - unthinkably complicated family-controlled conglomerates which include LG, Samsung and Hanwha - dominate the country. The chaebols consist of dozens of businesses and are controlled by the founding families using cross-holdings.

For example, the founding Li family own just 1.3% of shares in the Samsung group, but control 53% of votes. At SK, the figures at 0.4% and 52%, says the the Korean Fair Trade Commission.

This has led to all sorts of dubious behaviour over the years. It culminated, perhaps, in Hyundai’s decision in late 2014 to splurge $10bn on some prime real-estate to build a snazzy new HQ. Shareholders were horrified, but the structure of the group meant they were powerless to stop the purchase. (Though dividends have since increased.)

Now the South Korean government is cracking down on cross-holdings, and both Hyundai and Samsung’s families are being forced to reduce their holdings in some companies, to reduce their control over their groups. This is a welcome move, but the expectation of control has clearly become entrenched in the chaebols, just as it did at the Espirito Santo empire. Untangling the mess will be painful and expensive for everybody.

Control is a positive for family businesses - it allows quick decision-making - but brings with it temptations. It is far better to iron out those wrinkles early, before bad habits start - because when governments and courts start getting involved, the outcome is rarely pretty.

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