Special report | Governance

Avoiding the dinosaur trap

State firms and family conglomerates are Asia’s favourite kinds of companies. Both must change

Tata’s tiny mistake

ASIA IS A land never conquered by institutional shareholders. Only 28% of the region’s stockmarket consists of firms with diverse owners (see chart 4). Most of these are in Japan, where businesses are controlled by managers and employees who by long-established protocol politely listen to and then ignore what fund managers say. State-run firms make up 40% of Asia’s total and family-run firms, often conglomerates or “business houses”, account for 27%. The proportions vary from country to country (see chart 5). In China state-run firms dominate, whereas in South Korea and India business houses are prominent. All this has been true for a long time and it is tempting to think it will never change. That would be a mistake.

Start with state firms. In the first decade of the 21st century a landmark event in capital markets took place: Chinese state- owned enterprises (SOEs) floated in Hong Kong, Shanghai and New York. Investors ignored the old rule that buying state firms’ shares is suicide and coughed up $117 billion in the biggest 20 deals alone, which ranged from railways to banks and construction. At the same time India floated its state-owned electricity and oil firms. Coal India, a Soviet-style colossus with an empire of opencast mines, also made it to the stockmarket and briefly became the country’s most valuable firm. In Indonesia chunks of the banking system ended up in state hands after being bailed out in the Asian crisis. Malaysia maintained its own kind of state capitalism with powerful state holding companies as well as “Bumiputera” firms, controlled by ethnic Malays as part of an official policy of affirmative action. Singapore’s state-backed firms, such as SingTel and SGX, its stock exchange, started expanding abroad. By 2009 state firms dominated the league tables of the world’s most valuable firms. Their share of Asia’s stockmarkets peaked at 57% in 2007. In contrast to European and most Latin American privatisations, where the government relinquished control, Asia used a hybrid model, with the government remaining a dominant shareholder. Other elements of state capitalism thrived. Sovereign-wealth funds, set up to invest foreign-exchange reserves or oil revenues, ballooned in China, Singapore, Hong Kong, South Korea, Malaysia and even tiny Brunei. And everywhere state-run banks gained market share after the 2007-08 crisis as private lenders retreated and governments tried to stimulate their economies.

Today the picture looks very different. Asia’s 65 biggest state-owned firms have lost a trillion dollars in value since the peak in 2007. Their share of Asian companies’ market value has fallen to 40%. Investors hate them again. Their aggregate price-to-earnings ratio is almost half that of non-state firms.

There are three sets of problems. First, chummy relations with the state come with obligations as well as perks. This is most apparent with state-run banks. Thanks to a government-directed lending boom in 2008-11, China’s lenders have rotten books. In India state banks have seen more than a tenth of their loan books sour and are under political pressure to “extend and pretend” dud loans to crony firms.

Second, Asia’s state firms have been damaged by graft and incompetence. In April Song Lin, the boss of China Resources, a big, diversified SOE, was placed under investigation for corruption. Coal India has underinvested in equipment and dug up too little coal, prompting a fuel crisis at India’s power stations. During Vietnam’s boom in 2005-10 some of its well-connected state firms got carried away, borrowing heavily and diversifying without good cause. A default by Vinashin, a shipbuilder that had accumulated an astonishing $4 billion of debt, helped spark a banking crisis.

Third, SOEs, particularly those in consumer-facing industries, are dealing with very dynamic markets and may not be nimble enough to cope. This risk is most obvious in banking and telecoms, where private internet firms are making inroads into state-firms’ businesses. NTT DoCoMo, a Japanese mobile-phone company, has struggled to keep up with savvier private rivals. In China Alibaba now offers Yu’e Bao, an investment product that invests in fixed-income securities and long-term deposits, giving customers a higher return than traditional bank accounts. Other internet firms are following suit. State banks are losing customers and may have to pay higher interest.

Don’t wait for the bomb to go off

The best firms are reforming fast (see article on China Mobile), but governments may be tempted to do nothing. The biggest listed Chinese and Indian state firms each employ between a quarter and half a million people and are enmeshed in webs of patronage. However, left unreformed, state firms can become financial time bombs, with stagnating earnings and massive fixed costs, a combination that could lead to huge losses.

China restructured its SOEs in the 1990s and early 2000s and is talking about doing more. In November its leaders stated that market forces should play a “decisive role” in the economy. Liberalising finance and interest rates will increase the pressure on SOEs to reform. With their lending margins getting thinner, state banks may be less inclined to offer cheap credit to state firms. Several SOEs have already announced restructurings that give outside investors a bigger role.

Sinopec, a big energy firm, has said it will invite outsiders to invest in its vast petrol-station arm. CITIC began life as a politically well-connected conglomerate spanning banking, mining and property. It was one of the first mainland firms to float assets in Hong Kong, in 1990. The Hong Kong arm has had a torrid time, making a loss on derivatives, among other things, but is under new management and appears to have stabilised. Now CITIC plans to inject all of its mainland assets, worth $36 billion, into the listed Hong Kong arm. The idea is that scrutiny from global investors will improve performance.

There are some signs of reform outside China, too. Vietnam is trying to clean up its SOEs by selling off their non-core assets and plans to cut their total number by 75% by 2020. It may also raise caps on foreign ownership. In India most policymakers say they want to break up Coal India to boost competition; the question is whether they mean it. The requirement to recapitalise government banks may also spark a renewed debate about forcing India’s state lenders to consolidate.

However, the idea that the government should cede all control of state-run firms is contentious everywhere. How this is resolved will probably depend on what sector the companies are in. Industries that are “strategic” domestic quasi-monopolies, such as power transmission, will remain under tight government control. Industries that are customer-facing and in competitive markets may adopt the Singapore model. There Temasek, a state holding vehicle, has stakes in many firms, including Sing Tel, DBS (a bank), Singapore Airlines and Neptune Orient Lines (a shipping firm). But it does not meddle in their management, and these are well-run companies. Despite its government links, Temasek is arguably a force for good governance.

Running state firms efficiently in tiny Singapore is one thing. Doing it in continent-sized economies such as China and India is quite another, especially when huge vested interests are involved, as they often are. Still, the challenges are no harder than those faced by the next most common species in Asian business: family-controlled conglomerates.

Business lore has it that the third generation of family managers destroy their firms. In Asia the opposite may be true. Striding through a Starbucks coffee shop in Jakarta is John Riady, a razor-sharp 29-year-old with an Ivy League education. His grandfather, Mochtar Riady, was born in Java to a Chinese family. After the second world war he founded Lippo, one of Indonesia’s big family conglomerates. John Riady straddles the old and the new worlds. A director of Lippo, he says he often discusses problems with his grandfather and his father, Lippo’s chief executive. But he also displays a modernising impulse. “My generation’s challenge is how do we institutionalise the firm without losing the entrepreneurial drive. If you look at the US, for every Ford and Cargill family, thousands didn’t make it.”

Keep it in the family

Across Asia the family firm has proved remarkably durable. The 1997-98 financial crisis clobbered many groups. Of South Korea’s 30 biggest chaebol, 11 failed, including Daewoo, one of the largest. Globalisation was supposed to obliterate family firms’ comfy business models. But those firms’ share of Asia’s stockmarket, at 27%, has in fact risen over the past decade. The only Asian countries where family firms are not important are China, which took a detour into state capitalism (though even there they are making a comeback), and Japan, where American administrators dismantled the family groups after the second world war. Japan’s unique corporate ecosystem of meek shareholders, cross-holdings and links between suppliers and banks is an echo of the original family firm.

Business houses are often owned by ethnic minorities. One-third of India’s stockmarket is run by clans with roots in the western states of Rajasthan and Gujarat, such as the Ambani family, or by Parsis such as the Mistry and Tata families, who control Tata Sons. In South-East Asia ethnic Chinese dominate. Three-quarters of the combined fortunes of that region’s 20 richest men is in the hands of ethnic-Chinese tycoons. Some have used their ancestral links to further their wealth. Dhanin Chearavanont, Thailand’s richest man, controls CP Group, one of the country’s largest conglomerates. It was the first big foreign investor in China in 1979 and now has a large food operation and a stake in Ping An, an insurance firm.

Business groups are partly a hangover from the era of government licensing and closed economies. Firms had to sprawl into adjacent industries to grow. But mainly the groups are a response to weak institutions and laws, inefficient markets for labour and capital, bad infrastructure and a lack of trust. Faced with such chaos, it makes sense to bring as many processes as possible inside the firm.

That logic can be observed in Myanmar, Asian capitalism’s last frontier, whose decaying commercial capital, Yangon, now boasts many night clubs and Range Rovers. The rudiments of commerce are missing; businesses have to remit cash abroad using money-changers. The biggest listed firm is Yoma Strategic, which is quoted in Singapore and worth $600m. Controlled by Serge Pun, a local man of Chinese descent, it is well run and a favourite partner of foreign firms. It is diversifying into schools, coffee, logistics, vehicle leasing and more. Andrew Rickards, its chief executive, explains that “the opportunity here is unlike anything else in our lifetime…But one of the downsides of being isolated for 50 years is things have developed very differently in terms of business practices.”

China is light-years ahead of Myanmar, but its institutions are still developing and its markets are weak, which has favoured conglomerates. Firms of all sizes diversify. For example, since the early 1990s Fosun, a private firm set up in Shanghai, has been entering industries vacated by a retreating state, from pharmaceuticals to mining and insurance. It is now eyeing new areas such as the internet, health care and tourism. Its chief executive, Liang Xinjun, says he and his co-founders admire Warren Buffett, the boss of Berkshire Hathaway, an American conglomerate.

At its best the Asian conglomerate is formidable. At its worst it is a nightmare

At its best the Asian conglomerate, tightly controlled and broadly spread, is formidable. At its worst it is a nightmare. For an economy as a whole, concentrated economic power can cause problems. In India seven of the ten biggest business houses have been embroiled in corruption scandals, and the ten most indebted business houses account for 13% of the banking system’s loans. Some are insolvent but, in effect, too big to fail.

There are other drawbacks. Succession can be a problem (an important consideration in Hong Kong, where the average age of the four richest tycoons is 86). Professional managers may find it difficult to get on with patriarchs. A hierarchical culture may discourage entry into dynamic new business areas such as the internet. The inability to issue shares without diluting family control limits the firm’s ability to raise capital for expansion or takeovers. A lack of accountability to outsiders can mean profitability is neglected. And being spread thinly across many industries can mean no business achieves global scale.

Well-run firms are adapting elements of global best practice to local conditions. One example is Astra International, Indonesia’s second-biggest company by market value ($26 billion) and probably its best. It is controlled by Jardine Matheson, another family-run conglomerate, with roots in Hong Kong. Astra is itself a venerable conglomerate, active in cars, banking and mining, among other things, and expanding into areas such as insurance. At the same time it is a very modern outfit, with professional management, an exemplary balance-sheet and a growing emphasis on R&D and on its brand. A powerful corporate culture is a competitive advantage, says Prijono Sugiarto, its boss. “People look at our corporate governance. They know we have integrity, they know we’re honest and they know we are professional.”

As firms mature and compete in global markets, the pressure to reform the conglomerate model in order to stay competitive becomes more intense. Japan’s corporate system, although not exactly comparable to Asia’s business houses, holds many lessons about the dangers of complacency. Far too many diversified firms have become unfocused and sloppily run. Sony, for example, has made a loss in four of the past five years and is a shadow of its former self.

Japan is slowly adopting a more open model of management. Banks, insurance companies and firms used to own chunks of the stockmarket to keep outside influence at bay, but their ownership of the stockmarket has fallen from 60% two decades ago to 30% now, according to Goldman Sachs. This is partly because of accounting rules introduced in 2001 that require losses to be marked to market. Now Shinzo Abe’s government is promoting outside directors on company boards and prodding public-pension funds to take a more activist approach to investing. This new, harsher climate may be having some effect. Both Hitachi and Sony are getting out of struggling business lines.

Success begets obsolescence

As economies get richer, institutions improve and firms become more global, conglomerates, usually family-owned, should become less relevant. There are glorious exceptions such as Hutchison Whampoa (see article). But even Asia’s two biggest and most successful business houses are doubtful advertisements for the virtues of conglomerates.

Tata Sons may in fact be a case study of their flaws. About two-thirds of the capital employed in the group is generating less than its cost of capital. Most of the domestic units are doing badly. Tata has been bailed out by its superb IT-services arm, TCS, and by Jaguar Land Rover (JLR), a British carmaker. Both units are globally active, operate at arm’s length and make up the overwhelming majority of the group’s market value. Tata now looks like a giant IT multinational and an excellent luxury-carmaker attached to a ragbag of dodgy Indian assets. Cyrus Mistry, its newish boss, has so far done little to grapple with the problem.

Samsung may have already evolved beyond the family conglomerate. Its second-generation chairman, Lee Kun-hee, helped globalise its culture in the 1990s, introducing merit-based pay and hiring foreigners. Samsung was originally influenced by the sprawling Japanese corporate model but has become far more focused. Its technology arm, Samsung Electronics, now accounts for around three-quarters of the group’s market value, up from below half in the mid-1990s. And Samsung Electronics’ earnings are themselves highly concentrated. In the first quarter of this year mobile phones and tablets generated 76% of its operating profits.

A focused global firm with a global culture sounds closer to a conventional multinational than a traditional business house. Mr Lee’s son, Lee Jae-yong, is poised to succeed him, but the family directly controls only a small proportion of the shares, and institutional investors now have about $150 billion at stake.

Samsung has shown how a successful business house can evolve into an institutionally run multinational. It also illustrates the necessity, the difficulty and the rewards of going global. More Asian firms need to follow its example.

This article appeared in the Special report section of the print edition under the headline "Avoiding the dinosaur trap"

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