I was lucky enough to hang out with some very successful folks last month when Pete Seligman, the unofficial ‘Don of Search Funds’, hosted the EtA Forum in Sydney. It’s a two-day event that brings together business dorks to share ideas and compare notes. My kind of people!
For the uninitiated, ETA is short for Entrepreneurship Through Acquisition – or, in other words, entrepreneurship through buying a business. It’s a strategy wherein folks buy an existing company and build it, rather than starting a new one from scratch.
As someone who has built a couple of businesses, I know first hand how much it can suck.
It’s like starting a fire with a hand drill.
You gather dry wood and start drilling – rolling a spindle between your hands, moving them back and forth to create friction. As you continue drilling, a small, hot ember forms in the notch of the fireboard. You carefully place this fragile ember on a bed of tinder and gently blow it, encouraging it to grow.
A small flame and a lot of blisters to show for it!
Buying a business means skipping all the effort, pain and risk of creating that small ember.
Instead of making a hand drill, you buy a blowtorch.
Yes, it requires a significant financial investment, but the strategy lends itself to folks that are better suited to taking a company from 1 to 10, instead of 0 to 1.
Anyway, the EtA Forum attracted a bunch of interesting people.
Whilst we’re all working on slightly different and interesting things, what I was most surprised to learn was people’s common interest in building holding companies (Holdcos).
Holdcos are all the rage on SMB Twitter.
I’m also a big fan. My business partner and I are building one. The notion aligns perfectly with our investing and life philosophy – steady, compounding growth over a long period of time.
There’s not a great deal of literature about private holding companies, particularly considering Australian corporate and tax nuances.
Accordingly, I thought I’d share my take on the philosophy, strategy and structure of holding companies.
Holding companies explained
A holding company is an investing structure designed with a long-term goal to compound equity value in a tax-efficient manner.
That’s a bit of a mouthful, so let’s break down how it actually works in practice.
It typically starts with an upfront investment by an individual or a group of investors to fund the first business acquisition.
The free cash flow that is generated from this business is used to acquire (or seed) new businesses, often with a combination of debt.
As cash builds up in the companies, it’s reinvested – either into growth, or used to acquire new businesses.
Over time, the cash flow flywheel kicks in, and equity value in the group begins to compound.
If you can maintain high returns of invested capital, the magic of compounding can create serious wealth for the investors.
The notable examples of holding companies in the public markets are Berkshire Hathaway and Constellation Software.
In the private landscape, some well documented firms in the US are Permanent Equity and
How is a holding company different from a private equity firm?
Private equity firms (PEs) and Holdcos typically start the same way.
They both acquire a business and aim to improve the financial performance of it.
The common strategies are:
- Operational improvements: Streamlining operations, optimising supply chains, and reducing unnecessary overhead costs.
- Revenue growth: Expanding the customer base, entering new markets, launching new products or services, and enhancing sales and marketing efforts.
- Talent: Hiring experienced managers to implement best practices and improve the day-to-day operations of the company.
- Financial engineering: Restructuring a company’s debt to improve its financial position, allocating capital to areas with the highest growth potential and working capital management.
- Governance and reporting: Bringing better governance practices to their portfolio companies, including more robust financial reporting, compliance, and transparency.
- Cultural and organisational alignment: Ensuring the company’s culture aligns with its growth objectives to provide a conducive environment for value creation.
But while PEs and Holdcos often start the same way, the key differentiator is the investment time horizon.
PEs usually have an exit strategy in mind when they invest or buy a company. Common exit options include selling the company to another entity, taking it public through an initial public offering (IPO), or selling it to management or employees.
PEs usually have a 5 to 7 year horizon to buy, improve and flip their businesses. This creates time pressure to execute growth strategies which will lead to growth in business value. Because the window of time to execute these strategies is short (in the grand scheme of things), making drastic changes to a company can create systemic problems.
Poor cultural and systems integration, and overloading the balance sheet with debt, are common criticisms. There are well documented case studies of how PE-backed companies have eroded value, rather than creating value.
Holding companies are different because they don’t have an exit strategy in mind.
That doesn’t mean they’re out here like Dominic Toretto, living life a quarter-mile at a time. Instead, it means they take a longer view, and don’t gear their strategy around that limited 5 to 7 year exit horizon. (Yes, management may decide to divest assets over time, but it’s not the end game.)
By taking a long-term view, management can be more thoughtful about growth strategies and portfolio construction. This is important, because business improvement initiatives often take years – sometimes decades – to come to fruition.
The other importance of a long horizon is the compounding journey.
Tax advantages and capital compounding
“The first rule of compounding is to never interrupt it unnecessarily” – Charlie Munger
From an investor’s perspective, one of the key differences between the PE and Holdco models is the capital compounding journey.
In a Holdco structure, there is no predefined end date. Accordingly, it allows managers a long-term horizon to redeploy capital into the Holdco – keeping the money working, instead of distributing it. All profits generated from the portfolio companies are either reinvested into growth, or used to acquire or seed another company.
Contrast this to the typical PE model, where firms will sell down the business and distribute the profits every, say, five years. The PE investors incur a cost everytime there’s a liquidity event.
These costs are a combination of hard and opportunity costs, including:
- Transaction fees
- Idle cash
- Redeployment risk
The cost of taxes
When a business is sold, investors will pay some form of capital gains tax – a tax that is separate from the income tax already paid on business profits.
Capital gains taxes vary by country. For instance, in the US, the long-term capital gains tax rate can be up to 20%, while in Australia, it ranges between 12% and 30%. Regardless of the rate, a tax is imposed on the gains made from selling a business, and its impact on financial returns is significant.
The cost of transaction fees
Selling a business is often a long, messy, and arduous process.
It’s typical for businesses to outsource this task by engaging a corporate advisor or investment banker. An investment banker is similar to a real estate agent for businesses – their job is to sell the company to a qualified buyer at an attractive price.
The typical arrangement for an investment banker involves a monthly retainer, as well as a success fee that falls within the range of 5% to 10% of the sale price. In addition to these fees, businesses are also required to pay accountants and lawyers. Most businesses budget around 2% to 5% of the transaction value for these additional expenses.
From a financial perspective, the exit fees incurred are sunk and no longer contribute to the investors’ benefit.
The opportunity cost of idle cash and redeployment risk
Let’s say you owned a business in a growing market that was compounding cash earnings at 20% per annum, and was going to do so predictably, over a 30 period. You’ve basically got yourself a golden goose.
Under the PE structure, investors would realise the returns of the goose and sell it after seven years. Once tax and transaction costs are paid, the net proceeds sit as cash in a bank account, earning little to no returns.
They’re then parked in an equities index fund, like the S&P 500, until a new investment opportunity is found. The S&P 500 is essentially a basket of businesses that generates an annual return of 7% to 8% – as opposed to the business the investors previously owned, which was generating over 20%!
Yearning for a better return, you give this money back to your fund managers to hunt for another golden goose – which, by definition, isn’t easy to stumble upon!
Everyone would have been better off keeping the golden goose instead of slaughtering it at an arbitrary time horizon.
To demonstrate the impact of taxes and transaction fees on long-term returns, let’s crunch some numbers in a fictitious case study.
Meet our 2 investors:
- Mark the Grey, the wizard of Holdcos (a hat-tip to Mark Leonard of Constellation Software)
- Ryan, the “PE guy”
Mark and Ryan both own identical businesses – a capital-light SaaS company that is growing at a healthy 20% of equity value on an annual basis.
The difference between them is their capital strategy.
Mark holds the business for 20 years and enjoys continuous equity compounding effects without any capital gains taxes or transaction fees. At the end of 20 years, Mark eventually sells his business and pays capital gains tax of 20%.
Ryan owns the same business which compounds at 20% per annum – but the difference is he’s a PE guy, meaning he has to sell his asset every five years, and then reinvests the proceeds into a new business doing the same 20% return.
Therefore, at the end of every five years, Ryan exits the business, pays 5% of the proceeds to investment bankers, accountants and lawyers, loses 20% of the net gain in taxes, and then reinvests the balance into a new venture and generates the same 20% return. The cycle continues over the 20 year period.
Let’s look at the financial impact of Mark vs Ryan.
Over a 20 year period, Mark’s strategy of holding his business for the entire time has resulted in him creating $29.4M of wealth. Compare this to Ryan, who flips his business every five years, attracting transaction fees and taxes. He only generates $19.1M of value at the end of 20 years.
In the end, Mark accumulates close to 1.5x more wealth to investors than Ryan.
If you extend the time horizon to a 50 year hold period, the gap vastly increases.
Mark’s strategy creates $1,929.4M of value, vs Ryan’s $510.2M – a 3.8x difference!
Structuring a holding company
In an Australian context, I’ve seen Holdcos structured (including ours) as a standard Company Pty Ltd.
This company holds the shares of your portfolio of operating businesses, which are also company structures.
It’s important to note that the Holdco doesn’t trade – it simply holds the shares/investments in your group.
Here are a few things to note regarding the Holdco structure:
- Cash dividends, via profits of your businesses, are paid up to your Holdco. This is where cash accumulates – it’s then used to invest in new businesses, or loan to portfolio businesses at a capital charge (interest rate).
- Ownership in subsidiary companies is typically greater than 50%, enabling capital allocators at the Holdco level to control capital flows.
- Any debt or legal liability on the operating companies is secured against the shares in the operating company, so the assets in the Holdco are not at risk.
Company vs Trust
A company structure at the Holdco level gives the manager optionality to retain capital at the Holdco, unlike pass-through structures like discretionary trusts, which force you to distribute profits every year to shareholders – usually at marginal tax rates higher than 25%. This alone means deferring up to 25c in the dollar of ‘top-up’ tax by retaining profits in a company, as opposed to paying profits out to individuals.
Some holding companies issue new shares to acquire assets. This can sometimes have an anti-compounding effect, as the existing shareholder base is diluted everytime more shares are issued.
Extreme equity efficiency is when all growth is financed via internal cash flows and debt. The end result is a very wealthy shareholder base, and unicorn companies that can grow for decades without issuing equity.
Constellation Software is a wonderful example of this – no new shares have been issued since its IPO in 1995, and shares in Constellation have grown 154x since then. It must be nice!
How to track the value of your holding company
Around 85% of my net worth is tied up in private companies via my Holdco (mainly holdings in small and medium-sized businesses and start-ups).
Because these investments aren’t publicly traded, there’s no ‘live’ share price to measure the value of the portfolio. This sucks for me, because I’m an accountant, and accountants love to track these things.
So my business partner and I built a tool for this very thing. Since 2015, we’ve maintained a financial model in Google Sheets which tracks the value of our entire portfolio.
Here’s how it works:
- We have a tab for each investment.
- Every month we upload the financials from our accounts (Xero) into the model, which spits out a valuation based on our predetermined assumptions (for valuation multiples etc).
- For minority investments, like shares in a start-up, we mark these to take into account whenever there’s a revaluation event (e.g. the company raises a new round of funding).
- We also carry a bit of cash on our group balance sheet, so we take this into account as well.
The output is a dollar value of our entire holding. We also track how this value has compounded over time, similar to how Warren Buffett would measure the performance of Berkshire Hathaway.
It’s useful to view from a macro perspective. And whenever I’m feeling a little unmotivated or deflated, it helps to remind myself how far we’ve come – and how far we have to go!
Want to use this model to track your financial empire? Download our Holdco Portfolio Tracker here.
Still have questions about holding companies? Reach out to us here at SBO Financial.