THE FOUNDER EFFECT
“How are you thriving in a tanking industry?” This is the question I asked an old friend of mine when we caught up for dinner in late July 2020 for the first time since COVID restrictions were eased.
He founded a recruitment business some 10 years ago, and now has established offices in Sydney, Melbourne and the ACT. In 2020, he watched as some of his multi-national peers retreated offshore and whilst some of his local peers went into administration.
Although he vehemently disagreed with my use of the word “thriving”, I used the term from the perspective that he had managed to maintain his staff, work with his clients through cashflow issues and stay in the game. He now has greater respect and loyalty from his staff and clients, a lean and adaptive firm with increased market share.
What is it about the founder effect? It’s not a coincidence that at the time of writing, 6 of 9 of our portfolio holdings are Founder Led Businesses (FLBs).
Some data points on FLB stock performance:
· Rudiger Fahlenbrach’s study of Founder-CEO’s published in the Journal of Financial And Quantitative Analysis found that investment in FLBs between 1993 and 2002 outperformed the benchmark by 8.3% p.a.
· Bain & Company’s analysis of S&P 500 firms between 1990 and 2014 found that the stock performance of FLBs outperformed their professionally managed peers by 3.1 times over the period.
It is our opinion that the drivers behind the outperformance can be categorised into financial and cultural behaviours:
· Less proclivity to debt. The average FLB in the S&P 500 was found to carry 52% less debt than their professionally managed peers.
· Capital allocation and investment decision making that is geared towards long term growth and competitive advantage. Fullenbach found that on average FLBs invest 38% more on capital expenditures (Asset size adjusted).
· More successful in mergers and acquisitions, measured by Fullenbach by deal characteristics, acquisition count and acquisition ratios.
· The average S&P 500 founder-CEO’s annual compensation was 32% lower than their index peers.
· Innovation culture. A study undertaken by three professors at Purdue’s Krannert School of Management found that FLBs generate 31% more patents than their S&P 500 peers. The study also found that FLBs create patents that are more valuable and are more likely to make bold investments to renew and adapt the business model.
· Longer time horizons. The average founder-CEO’s tenure was found to be 16.4 years in comparison to 6.4 years.
· Founder CEOs are generally economically aligned with their shareholders, and a substantial part of their net worth is held in stock ownership.
· To start a business from the ground up requires detailed research of the landscape, products and services and competitors. Experience over an average tenure of 16.4 years exposes a founder CEO to industry nuances, trends, talent etc delivering a formidable blend of comprehensive knowledge, networks and experience (Andreessen Horowitz).
· In his blog, Ben Horowitz (A leading venture capitalist) highlighted “moral authority” as one of the key traits for why his firm prefers to invest in FLBs. He poses that a businesses’ identity becomes “entangled” with assumptions that were made at founding. A founder CEO is more likely to reiterate and question the underlying assumptions they instituted then a professional CEO.
· “Frontline Obsession”. Zook of Bain & Company recalled the story of a 94 year old MS Oberoi, founder of Oberoi hotels, holding up customer feedback forms 1 inch from his eyes to see what his customers were saying.
· After interviewing hundreds of founder CEOs, Fullenbach surmised that founder CEOs view company building as “their life’s work” and retain a behavioural-emotional attachment to their firms.
It is no surprise that investing in FLBs is becoming an investment-style as demonstrated by the approach of Andreessen Horowitz and Mirae Asset with the introduction of the Global X Founder-Run Companies ETF (BOSS).
We expect more long-term investors to lean towards FLBs over time, particularly in an era where technology companies dominate the S&P 500 index and where the average tenure of a company’s life-cycle within the S&P 500 index is forecast to be 12 short years by 2027 (Innosight).
At the founding of Duro Capital, to define our investment philosophy and the thematics we pursue, we undertook a detailed assessment of Chadd’s past investment decisions that had resulted in him delivering a personal portfolio return of 72% p.a. (November 2015 — December 2020).
Whilst leaning towards a founder led investment approach, a handful of outstanding past investments made it difficult to narrow our opportunity set to this degree. Even now, 3 out of 9 of our portfolio companies are professionally managed. In life and investment, we prefer not to speak in absolutes.
Some would argue that had Larry Page and Sergey Brin not handed over the reins of Google to Eric Schmidt, the Google that we know today might look somewhat different. The founders created the product cycles. Schmidt maximised them.
Notwithstanding, in light of the data, research and our own personal portfolio success, some overarching themes resonate and form the basis of our approach. Long-term. Alignment. Owners mindset. Customer focus.