Understanding a Holding Company
A Basic Introduction to Holding Companies and How They Work
Whether you are beginning to invest in securities issued by corporations, such as common stocks, preferred stocks, or corporate bonds, or you are doing case studies on private companies because you are considering investing in your own business, it won't be long before you 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 was designed to help you understand what holding companies are, why they play such a vital role in the modern economy, and some things you might consider before investing in, or forming, one.
Please note that this article is designed for beginners. If you are looking for a more advanced explanation that is suited for wealthy individuals and professional investors, I wrote about this same topic on my personal blog awhile ago in a post called How a Holding Company Works. It gets into more of the asset protection elements of a holding company, such as the ability to isolate valuable intellectual property into so-called "silos", among other topics. Neither this article nor that post are investment recommendations but, rather, an academic overview meant to help you understand the structure, purpose, and benefits of holding companies in certain specific contexts.
First, Let's Start With the Basics: What Is a Holding Company?
Broadly defined, a holding company is a company that doesn’t have any operations, activities, or other active business itself. Instead, the holding company 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.
For example, one of the most respected blue chip stocks in the world, Johnson & Johnson, is really a holding company. That is, the firm itself, in which you are buying shares when you acquired stock, doesn't actually do anything in the sense that people think it does. Instead, as a result of its complex history, Johnson & Johnson holds ownership stakes in 265 separate, individual businesses the same way you might own shares of different businesses through a brokerage account. These businesses are grouped under three major headings - consumer healthcare, medical devices, and pharmaceuticals - but they are actual, stand-alone companies located in nearly every country on the planet, staffed by local employees, with their own bank accounts, their own offices, their own manufacturing facilities, and more.
At the top, Johnson & Johnson's stockholders elect a board of directors to protect their interests. That board, among its other responsibilities such as determining the dividend policy, hires the CEO. The CEO, in turn, hires his direct subordinates. This group of people, together, has the power to determine the CEOs and key executives at the companies the parent Johnson & Johnson controls. The parent holding company supports the subsidiaries by lowering the cost of capital due to its overall strength.
That is, it can go out, issue bonds at rock-bottom rates, then lend money to its own subsidiaries at rates the subsidiaries couldn't get if they were stand-alone enterprises. This reduces interest expense and, in turn, increases both return on equity and return on assets.
Next, Let's Walk Through A Sample Holding Company
To understand the concept of a holding better, imagine that you and I decided we wanted to invest together. We and members of our family create a new company called Blue Sky Holding Company, Inc. We file the paperwork with the secretary of state and pay the fees. Then, we issue 1 million shares of stock at $10 per share, raising $10 million in fresh cash. We elect a board of directors. That board hires one of us as a CEO. We build an office.
The next day, we show up and start investing the money. We (meaning Blue Sky Holding Company) do several things:
- We incorporate a new business called Frozen Treats of America, LLC. It is 100% owned by Blue Sky Holding Company. We contribute $1,500,000 in cash to the business, hire a manager to run it, and open a Dairy Queen franchise that we expect to earn $170,000 in profit before taxes.
- We have Blue Sky Holding Company open a brokerage account with a discount brokerage firm such as Charles Schwab or another major institution. 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 Southworth Hospitality, LLC that is 100% owned by Blue Sky Holding Company. 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 Hampton Inn 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. That means if the subsidiary goes bankrupt, we are only on the hook for the equity we have invested in it.
- We buy $2,000,000 worth of tax-free municipal bonds, which we believe will generate $100,000 in annual interest income.
- We use $500,000 to buy gold coins 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. (When I originally wrote this article many years ago, we were in an ordinary interest rate environment where such a thing wasn't difficult. At the moment, you wouldn't be able to earn 6% but let's presume that a return to normalcy is in the cards as there is reason to believe the United States will be unable to maintain a zero-percent interest rate environment indefinitely.)
What Our Holding Company Financial Statements Would Look Like
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:
Blue Sky Holding Company, Inc. - Balance Sheet
- Frozen Treats of America, LLC – 100% ownership ($1,500,000 assets, no liabilities)
- Southworth Hospitality, LLC – 100% ownership ($4,000,000 assets, $2,000,000 liabilities, $2,000,000 net worth)
- Tax-Free Municipal Bonds ($2,000,000 assets, no liabilities)
- Blue Chip Common 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 fictional company, Blue Sky Holding Company, Inc. 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, support, setting risk management parameters, and putting the right people in the right places to align with our corporate strategy (if we own enough stock to control an investment, we can fire the managers and replace them at our own discretion). When subsidiaries pay out dividends to us, we then invest that money by putting it to work in other opportunities.
This means we can take money from one slow-growing operation and plow it into expansion for a more promising subsidiary.
In other words, you aren't going to be making ice cream cones at our Dairy Queen franchise. That is the job of Frozen Treats of America, LLC, a 100% owned subsidiary with its own employees, managers, financial statements, contracts, bank loans, etc. Instead, you are going to watch the CEO of that company, make sure he or she is hitting the targets the board expects of you, work to help them achieve those targets, and figure out how to constantly increase profits while reducing risk.
The Benefits of the Holding Company Model
What if something horrible happened? For example, what if our Hampton 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 Southworth Hospitality, LLC.
The holding company model protected our other assets from this one subsidiary. We didn't lose our Dairy Queen 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. Procter & Gamble, to give a real-world illustration, is effectively a holding company because it has different subsidiaries for different purposes. Some subsidiaries own the brand names such as "Tide" detergent. Other, totally separate subsidiaries own the manufacturing plants that make Tide and pay the company that owns the brand name a licensing royalty. That way, if the firm is sued, Procter & Gamble could never lose the Tide brand name. Instead, the factory or distributor would go bankrupt.
Another excellent example is the Burlington Northern Santa Fe railroad. It is one of the largest railroads in the world. Many years ago, Warren Buffett used his holding company, Berkshire Hathaway, to buy all of the shares of the railroad, transforming it into a wholly-owned subsidiary. BNSF has billions upon billions of dollars in debt, which help fund its massive capital expenditure budget for railroad track, railroad cars, and other infrastructure. None of this debt is guaranteed by Berkshire Hathaway.