Sunday, 18 September 2016

Understanding a holding company

Many people have seen listed holding companies, but few  people really understand how they work. When you begin investing for the first time, you are going to encounter something known as a holding company. In fact, many of the most successful companies in the world are really holding companies.  This basic introduction the holding company will explain what holding companies are, why you need to understand how they work, and some things to consider before investing in one.

The basics – What is a holding company?

A holding company is a company that doesn’t have any operations, activities, or other active business. Instead, it owns assets. These assets can be shares of stock in other corporations, limited liability companies, limited partnerships, private equity funds, hedge funds, publicly traded stocks, bonds, real estate, song rights, brand names, patents, trademarks, copyrights, or virtually anything else that has value.

A sample holding company. 

To understand the concept better, imagine that you and I decided we wanted to invest together. We, and members of our family, create a new company called Icarus Holding NV. . Then, we issue 1 million shares of stock at $10 per share, raising €10 million in fresh cash. We vote on a Board of Directors, hire one of us as CEO, and build an office.The next day, we show up and start investing the money. We (meaning Icarus Holding NV) do several things:
  • We incorporate a new business called Belgian Burgers. It is 100% owned by Icarus Holding NV. We contribute €1 500 000 in cash to the business, hire a manager to run it, and open a Mc Donalds franchise that we expect to earn €170 000 in profit before taxes.
  • We have Icarus Holding NV open a brokerage account. We deposit €3 000 000 in cash into the account and buy a collection of high quality blue chip stocks. We expect these stocks to generate € 150,000 in pre-tax dividends each year. 
  • We start a new company called Andromeda Hotels that is 100% owned by Icarus Holding. We contribute €2 000 000 of our cash and have this new subsidiary borrow €2 000 000 from a bank, giving it a capitalization structure of €4 000 000 in assets, €2 000 000 in liabilities, and €2 000 000 in book value. We use the €4 000 000 in cash to buy a Ibis hotel franchise, which we expect to generate €320 000 in pre-tax profits for us after interest expense and all other costs. The debt is not guaranteed by the holding company because we decided to only allow non-recourse liabilities in case the hotel isn’t successful.
  • We buy €2 000 000 worth of bonds, which we believe will generate €100 000 in annual interest income.
  • We use €500 000 to buy gold and silver bullion.
  • We park the last remaining€1 000 000 in cash at our local bank in institutional money market funds that pay 6% interest, generating €60 000 in pre-tax interest income each year.


Holding company financial statements.

The consolidated balance sheet of our holding company is going to show €12 000 000 in assets, €2 000 000 in debt, and a €10 000 000 net worth, or book value. Other than an office, which we will ignore for now for the sake of simplicity, our balance sheet appears as follows:Icarus Holding NV.

Balance Sheet
  • Belgian Burgers – 100% ownership (€1 500 000 assets, no liabilities)
  • Andromeda Hotels – 100% ownership (€4 000 000 assets, €2 000 000 liabilities, €2 000 000 net worth)
  • Bonds (€2 000 000 assets, no liabilities)
  • Stocks in Brokerage Account (€3 000 000 assets, no liabilities)
  • Bank Balances (€1 000 000 assets, no liabilities).
  • Gold and Silver Reserves (€500 000 assets, no liabilities).
The holding company income statement is going to show € 800 000 in operating income (profit before taxes). That would be an 8% return on equity because €800 000 divided by €10 000 000 in net worth is 8%. It would be a 6.7% return on assets because €800 000 divided by €12 000 000 in assets is 6.7%.

How to think about a holding company.

Imagine you were the CEO of our fake company, Icarus Holding NV. When you show up to the office each morning, turn on the lights, grab a cup of coffee, and go sit at your desk, what do you actually do?As you can tell, the thing that makes us a holding company is that we have no day-to-day role in any of the investments! Each is run by its own management team. In other words, as a holding company, our job is executive oversight and / or passive investing, depending upon our corporate strategy. Our job is to put the money to work and determine if management is doing a good job. If we own enough stock to control an investment, we can fire the managers and replace them at our own discretion.
In other words, you aren't going to be making happy meals at our Mc Donalds franchise. That is the job of Belgian Burgers, a 100% owned subsidiary with its own employees, managers, financial statements, contracts, bank loans, etc. The profits from the subsidiary can be used for new investments or expanding existing subsidiaries. In most countries you get a tax advantage for this.

The benefits of the holding company model.

What if something horrible happened? For example, what if our Ibis Inn hotel franchise went bankrupt? If the holding company itself didn't co-sign on the debt, it isn't liable for the loss. Instead, we would record a €2 000 000 write-off in our net worth as a capital loss on our shares of Andromeda Hotels
The holding company model protected our other assets from this one subsidiary. We didn't lose our Mc Donalds franchise , or our stocks, or our bonds, gold, silver, or bank balances. We only lost the money we invested into that one subsidiary.
This is how large corporations protect themselves. Nestle, for example, is effectively a holding company because it has different subsidiaries for different purposes. Some subsidiaries own the brand names such as the Kit Kat cookies. Other, totally separate subsidiaries own the manufacturing plants that make Kit Kat and pay the company that owns the brand name a licensing royalty. That way, if the firm is sued, Nestle could never lose the Kit Kat brand name, the factory would go bankrupt.

Do you guys own some holding companies?

Full disclosure: Long Nestle.

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