A holding company, simply, is a company that holds (or owns) other companies. Some popular public holding companies include Warren Buffett’s Berkshire Hathaway, banks like JP Morgan, and financial service and insurance companies.
Holding company benefits include autonomy, diversification, and legal protection, among others that will be discussed in this article.
The are 3 official types of holding companies that are publicly traded in the stock market:
- Holding Company
- Bank Holding Company (BHC)
- Financial Holding Company (FHC)
And within smaller (private) corporations, there is also the Personal Holding Company (PHC). The PHC is a classification used by the IRS to tax companies that are formed primarily to hold investments. For a company to classify as a PHC, and receive special PHC taxes, it must meet these specifications:
The Income Test states that at least 60% of the corporation’s adjusted ordinary gross income for the tax year is from certain dividends, interest, rent, royalties, and annuities.
The Stock Ownership Test states that at any time during the last half of the tax year, 5 or fewer individuals must directly or indirectly own more than 50% in value of the corporation’s outstanding stock.
Now that we understand the different possible types of holding companies, let’s circle back to the 3 types of public holding companies and their benefits.
The Basics of Public Holding Companies
A holding company is a company with ownership in other companies. It can completely own another company, it can have majority control over a company, or it can simply have part ownership of a company.
Majority control of a company generally means owning a majority of the voting shares of a company (also known as a controlling interest), while part ownership of a company could be achieved by owning any number of shares of a company (through the stock market or otherwise).
To explain the concept of a holding company with an example, I will pull the same example from my post about Related Party Transactions, which is another important topic related to companies in the stock market which hold/ own other companies.
Say you had a corporate structure, with the parent company (aka holding company) like this:
Parent company “Yummy Soda Inc.”
- Wholly owned subsidiary “Can Packaging, LLC”
- Wholly owned subsidiary “Yummy Soda Brands, LLC”
- Wholly owned subsidiary “Yummy Soda Sales, LLC”
In other words, Yummy Soda Inc is the holding company for Can Packaging, LLC, Yummy Soda Brands, LLC, and Yummy Soda Sales, LLC.
The words wholly owned subsidiary refer to a situation where a parent company completely owns another company. As the subsidiary creates profits, those will be transferred to the parent/ holding company in the form of a dividend.
As you can see in this example, a company could choose to spread out the various operations of their business into multiple subsidiaries, and have 3 companies doing the job of one, and passing profits back to the holding/ parent company.
Holding Company Benefit #1 – Diversification of Risk
A company may want to structure itself as a holding company in order to diversify the risk. As an example, if the Can Packaging, LLC business went bankrupt because the cost of aluminum to manufacture cans skyrocketed, then the rest of Yummy Soda Inc would still be okay because each business is standalone.
Corporate structures are generally designed to be standalone entities that function independently. The use of an LLC is a widely known practice of this concept, where the owners of an LLC (limited liability company) are shielded from the unlimited liabilities that a company might generate in the course of business. Two examples of that concept:
- If an LLC took on debt in its own name, the creditors can’t come after the owners to collect the debts
- If an LLC gets litigated against, those judgements can’t be passed down to the owners (in general)
A business can incorporate a public holding company and own the various subsidiaries inside that holding company, and have each wholly owned subsidiary doing business with each other to ultimately enrich the parent company.
Each subsidiary would need its own management, after all it is its own company, but management at the parent company could dictate how it wants profits to come back to the holding company.
As an example, the Yummy Soda Inc company could direct the Can Packaging, LLC and Yummy Soda Sales, LLC (distribution) companies to operate at break-even, while letting all of the profits flow to Yummy Soda Brands, LLC, which would eventually be paid as a dividend to Yummy Soda Inc.
Again, if any one piece of these businesses goes down—whether for financial, legal, or other reasons–the parent company and other companies (and their assets) can’t be taken away, thus diversifying the risk.
Holding Company Benefit #2 – Autonomy and Capital Allocation
For this next benefit, let’s look at the classic example of a brilliantly run holding company, Warren Buffett’s Berkshire Hathaway.
Berkshire makes over 50% of its revenues from its insurance business, but its insurance business comprises of wholly owned subsidiaries in that space—GEICO, Gen Re, and others.
Buffett knows that his circle of competence, or specialty, lies not in running the day to day operations of an insurance business, or a candy business (See’s Candies), or an ice cream business (Dairy Queen), but rather in taking capital and reinvesting it in other businesses.
A holding company allows Berkshire to allocate profits from the businesses it owns into other great opportunities as it sees fit.
It also allows Berkshire to own a business without having to manage the business.
The Point of View from the Subsidiary
The subsidiaries underneath the parent company’s umbrella generally enjoy the arrangement as well.
A holding company like Berkshire usually buys a business but retains the managements of those businesses, letting them focus on what they do best—running the business.
Then, as the CEO of the holding parent company, Buffett takes over some of the tough decisions faced by most CEOs at publicly traded companies—like what to do with the profits?
Many a CEO have been criticized by their wasting of profits on share buybacks, acquisitions, dividends, or business reinvestments (and for good reason). There’s not always a clear path for the most optimal use of a corporation’s profits for shareholders, which adds another intense layer to the already heavy demands of leading a public corporation as CEO.
A public holding company, when executed correctly, can allow the CEO of a subsidiary to concentrate on running the business, while also allowing them the freedom to run it without much oversight from the parent (other than making sure enough profit is flowing back to the parent).
Holding Company Benefit #3 – Flexibility for Financial Companies
This last benefit has to do with the additional classifications explained above, for Bank Holding Companies (BHC) and Financial Holding Companies (FHC).
Each of these special holding companies can provide flexibility, but also come with rules.
As was made very clear during the Financial Crisis of 2008- 2009, banks have historically been subject to heavy regulations and reforms. The responsibilities and regulations involved with stewardship of the public’s money, through banking or investment advice or otherwise, include strict requirements of what a company can and can’t do in regards to operations.
For example, banks are required to meet stringent Tier 1 Capital tests, essentially maintaining enough capital reserves in order to pay back enough depositors as a form of safety for the system.
Just like with the regular public holding company, a bank holding company (BHC) doesn’t involve itself with day to day operations (of a bank). Instead, it holds ownership stakes in a bank company (or companies), either wholly owned or partially owned (like through stock ownership).
The BHC to FHC Transfer Allows Flexible Business Structures
A BHC contains the same advantages as a regular holding company, but for BHCs, they can include special flexibility through the conversion to a FHC (Financial Holding Company).
Simply put, a FHC allows a BHC to do non-banking activities.
These non-banking financial activities include (as sourced from Investopedia):
- Insurance underwriting
- Securities dealing
- Merchant banking
- Securities underwriting
- Investment advisory services
See, a BHC wouldn’t be allowed to operate in those ways unless it was converted to a FHC. And so these large financial conglomerates such as Goldman Sachs and Bank of America (who is involved with securities with its wholly owned subsidiary Merrill Edge) can make profits in many different ways than just through simple loans and deposits (aka traditional banking).
To become a FHC, a company must:
- Be a BHC and meet additional standards for capital and management
- Be a nonbank company with at least 85% of gross revenue in financial services
GAAP Accounting for Public Holding Companies
Now, just because a holding company can make for creative corporate structures doesn’t mean that these types of companies can go around hiding liabilities or assets as they please.
The Federal Reserve outlined rules on the Consolidated Financial Statements for Holding Companies, which complies with both SEC and GAAP rules.
In a nutshell, a public holding company must include all of its subsidiaries’ financial results in the total consolidated financial statements for the parent if it holds a controlling interest—meaning at least 50% of the outstanding voting stock.
The full summary for the general instructions of these rules are here, with a snippet below:
Some common sense examples to highlight would be a loan from the parent to a subsidiary, for example. While technically a liability to the subsidiary and an asset to the parent, these cancel themselves out in effect to the holding company and would be excluded from the consolidated financial statements.
Limitations to Holding Companies and Diversification of Risk
As mentioned, a public holding company could be shielded from the bankruptcy of one of its subsidiaries, thus preventing creditors from collecting additional monies owed from the parent company.
However, sometimes a holding company may act as a guarantor on a loan to a subsidiary from a bank. A holding company may want to do that in order to secure better credit (i.e. a lower interest rate) on behalf of its subsidiary for obvious reasons.
In that case, a holding company would be on the hook for a defaulted loan since they signed off to guarantee it, even if the subsidiary goes bankrupt with no fault to the parent.
Special situations like that really highlight how not every holding company is the same, and that more thorough reading of annual reports and the footnotes in a 10-k describing debt covenants and other liabilities is also key to understanding a public holding company’s structure and accompanying benefits or limitations.
A public holding company is a unique detail of some companies in the stock market, which has unlocked key contributors to the compounding of capital for many investors.
Investors who are aware of such corporate structures can better understand the true risks or limitations of the performance of a publicly traded holding company.
By its inherent nature, an investor could conclude that a holding company operating like a conglomerate may take a hands-off approach to an acquisition, whereas a “regular” corporation might look for more synergies. However, an investor could also conclude that a holding company with many subsidiaries which appear to function solely as shields against litigation or financial risk may instead function more like a “regular” corporation than a capital allocator machine like Buffett’s Berkshire.
Either way, the devil is in the details in financial statements, which underlies the importance of understanding the basic rules and functions of public holding companies.
In my own portfolio, I found that 4 of the 16 stocks I own today are holding companies, and only one of those are a financial services company. So don’t assume that it’s only financial-type companies like Berkshire that will operate as a holding company.
As you navigate your research on publicly traded companies and start to notice the holding company structure, I highly recommend again that you also study the Related Party Transactions section that is also required to be disclosed by the SEC. In there, you should find coherent summaries about how any subsidiaries are interacting inside of a parent company, if it is at all notable.
I hope that you’ve found this article helpful, and these examples instrumental in helping you understand how a public holding company works.