Tricks to ensure the next generation becomes capable to take over the family business

This article was first published by the Economic Times, on November 15, 2022, Co-Authors: Sougata Ray, Navneet Bhatnagar

https://economictimes.indiatimes.com/news/company/corporate-trends/the-tricks-to-ensure-the-next-generation-become-capable-to-take-over-the-family-business/articleshow/95529582.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

Leadership succession is a critical transition for family-controlled businesses. Successor selection is a crucial decision that determines the future strategic direction of both the business and promoter family. In practice, family businesses often do not realize the need and importance to plan for succession. Some that do recognize it, continue to postpone that decision. This happens primarily due to three reasons. First, often the incumbent leaders are engrossed in operational aspects of the business and do not feel an urgent need to plan for succession. Another reason, especially with large promoter families, is that the complexity of family dynamics and tangled interface with the business, render succession, a tough decision to make. Third, and most critical, is the lack of preparedness of the next generation leadership, which makes the incumbent leader hesitant to pass on the baton. This is often reflected in our interactions with senior generation participants of our executive education programmes for family business leaders. Senior family business leaders express their reluctance to transfer leadership charge as they lack confidence in the capabilities of their next generation members.

It is important to note that succession is not an event but a process which needs to be planned for years in advance. Promoters of a few large family businesses in India have experimented with non-family successors. However, successor choice for most family firms is often restricted to the family talent pool, which is limited to the family size. While non-family businesses can quickly replace a non-performing leader, for a family business this is not so easy because of kinship ties and lack of alternatives. For a next-generation family business successor, failure costs the survival of both the business and family. Hence, given the high cost of a failure, an incumbent family business leader must not only plan early for succession but also take effective measures to groom the next generation members. This is the biggest succession challenge family businesses face today.

Next generation leadership building takes time and careful planning. It requires diligent cultivation of mentee-mentor relationship between the senior and younger generation leaders. Our research studied 19 successful cases of inter-generational leadership transitions since 2004 in large Indian family businesses. We traced these transformational journeys to identify crucial leadership building measures adopted by these family businesses. The study found that these next generation members followed a systematic development pathway, which equipped them for the leadership role. These leaders were exposed to the family business and its operational challenges at an early age. After their graduation, they joined the family business at middle management level. They gained experience in business operations and developed an understanding of ground-level challenges. They also learnt manpower management and interpersonal skills. In the subsequent phase, they went to world-class institutions to obtain a business management degree, which equipped them with knowledge of strategic frameworks and leadership capabilities.

A critical part of this journey was the work experience they gained in large international organisations after obtaining their business degrees. Working outside the comfort-zone of their family business made these next-gen members independent business decision-makers. It built their leadership strength as they had to prove their capabilities and bear the consequences of their decisions. After 2-3 years of working outside, they joined the family business at senior leadership level. During this phase, they worked closely with family and non-family mentors. They understood the strategic and leadership challenges of the business. They became effective change agents, improved legacy systems and practices, and led their business to the next level of growth. Proving their leadership mantle within and outside the family business, with diverse work experience in India and abroad, these next-gen members earned respect and acceptance from internal and external stakeholders. In a span of 5-8 years, they took complete leadership charge. The senior generation leader stepped out of the executive role and continued to provide strategic guidance.

For succession to be effective the next-gen members must have the ability and willingness to take on leadership responsibility. This can only happen when they are equipped with a wide range of knowledge, experiences and capabilities. Structured training and outside work experience play a very important role in leadership development. Business families that plan early and take timely measures to groom their next-gen members, can implement effective intergenerational leadership succession. 

Why the Rs 4.6 lakh crore pledged promoter shares matter for India Inc.,?

This article was first published in the Financial Express, on November 14, 2022, Co-author: Sougata Ray; https://www.financialexpress.com/industry/pledged-shares-valued-at-rs-4-6-trillion-the-good-and-the-bad/2812080/

Gautam Adani, hailed as the richest Asian and the third richest person in the world in October 2022, acquired 63.15% stake in Ambuja Cements and 56.69% in ACC in September 2022. Part of the acquisition was funded through pledging the entire acquired stake in both the companies, worth $13 billion. It once again highlights the popularity and importance of pledging as a financing tool for the Indian family business owners who usually have the dominant or controlling stakes in the companies.

Pledging at a varied degree is quite widely prevalent around the world. However, in countries where diversified ownership is more common, such as the United States, pledging is generally done by owners, directors, and executives to hedge and diversify their personal wealth or to meet personal needs. However, in India, pledging by family promoters often serves as a mechanism to generate financial capital for the firm or other affiliate firms belonging to the same business group. 

Promoters of almost a quarter of all companies listed on the National Stock Exchange (NSE) of India have pledged their shares to some degree. The average being a staggering 44 percent of the holdings of promoters in these companies. In the last quarter of financial year 2022 (January-March 2022), the value of shares pledged by promoters of NSE listed companies stood at Rs 4.6 Trillion. In a country like India, where more than 90% of the listed firms are family firms and concentrated shareholding is the norm, the exposure of investors and financial institutions to pledging can result in a systemic risk. It may not be so in many other countries where diversified firm is more of a norm when compared to concentrated ownership.

During the last couple of years, there have been many instances where promoters have lost ownership control in well-known large family firms. Of course, this outcome happened due to a combination of over-ambitious or bad decisions. But in many of them, the promoters had pledged their shares to financial institutions and when the share prices started to fall, the institutions sold the pledged shares in the open market. This resulted in the promoters losing ownership in their family firms. The situation was exacerbated due to the pandemic when the share prices of most companies took a hit. 

Just like the mark-to-market concept in the case of financial derivatives, when the share prices fall and the asset cover falls below a predetermined value, the financial institution raises a margin call to the pledging shareholder. Consequently, the shareholder is required to either top-up the loan with more shares or pay off a portion of the loan’s principal to increase the existing asset cover back to the pre-determined value. If the shareholder answers the margin call in the stipulated time, they will continue to own the shares. If the shareholder is unable to answer the margin call, the financial institution has the right to sell the shares in the market. The news of a margin call is generally perceived negatively by investors and the sale of a block of shares of a company in the open market accentuates the negative sentiment associated with the stock. Investors may indulge in panic selling of the stock. The increased supply of shares puts downward pressure on the stock price, thereby warranting further sale of shares by the lending financial institutions. 

In research conducted by the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, the authors found increased crash risk, lower return on assets, increase risk aversion, and negative investor reaction to the news of pledging. We observe that the potential loss of ownership control faced by many firms that have pledged their shares is overwhelming and would have significant impact on the promoting families and the other stakeholders of those companies if the promoters were to lose the pledged shares due to an unforeseen circumstance.

However, we also find many instances of family business promoters that have effectively used pledging as a tool to finance strategic initiatives for expansion, new venture creation, acquisition, etc., and to buy back shares in their own firms. Such promoters have not only used pledging for growth, liquidity, market performance, and ownership consolidation, but also reduced pledging thereafter in a systematic way. Examples include firms such as Asian Paints, Apollo Hospitals, and Granules India. Therefore, pledging per se is not bad – it is a legitimate, legal, and effective tool to raise funds by the promoters. When access to capital is limited either due to tight liquidity in the overall economy or stretched bank limits and high debt-equity ratio of the firm, the environment may not be conducive to raise equity or the promoters may not want to dilute their stake, in all these situations, pledging comes in handy.

Pledging has been around for decades in India. However, its impact has become more accentuated now due to the VUCA world that we live in. Awareness about its possible negative consequences has also gone up. It is amply clear that the promoters need to be prudent and strategic in using pledging as a financing tool. A decision to pledge must be associated with a clear plan for usage of funds, returns from them, and a path to de-pledge the shares. The promoters should avoid getting into a trap of excessive pledging, being overconfident about the prospects of the firm and under preparing and underestimating the external risks. The family business leaders taking the decision to pledge the shares must consult the family members and keep them updated. The funds from pledging should be used responsibly, with immense accountability and transparency. The Board and particularly the independent directors have an important role to play in this regard. Timely disclosures and effective communication will help calm the nerves of the other investors. Financial institutions should closely monitor the pledging situation in a firm, as well as that of the companies affiliated with the same business group, when deciding to buy, hold or sell their investments in a firm.