The HoldCo Conundrum

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Frequent readers know of my love for creatively structured investments, especially in regards to permanent capital (as I outlined in detail earlier this year). Whether its balance sheet investing, evergreen funds, or PE firms turning into life insurance companies - I never get tired of reading about how an investor found a way to gain long-term, patient capital for their efforts.

However, despite this love for esoteric structures, my actual recommendation on how much complexity our clients should incur in their portfolio admittedly can differ greatly. In the Search for Structural Alpha, I advocated for taking on structural complexity for increased expected return and/or lower expected risk in their Beta-oriented investments. In Simple Investments, Complex Investments, I advocated for radical simplicity except in cases where complexity can add substantial value.

And the question of complexity also comes up in the many cases in which our clients ask me for advice on their fundraising. Rather than go the well-trodden path of simply raising a fund, and/or simply buying a company, they look for new, novel structures from which they expect benefits such as more control or better financial outcomes (as I outlined in The Deal Structure Conundrum).

And I want to talk exactly about such a novel structure today - the holding company, or as the cool kids call it today, the HoldCo.

What is a HoldCo, and what are its expected benefits?

A HoldCo, by my definition, is an investment vehicle that is built for an essentially unlimited timeframe. The managers/founders of the HoldCo seek to bring on investors by issuing shares in the HoldCo, with which they go out and make acquisition according to their defined investment strategy. This investment strategy can differ, but typically you see some sort of industry focus (i.e. IT services, Industrials) and/or some sort of strategic focus (i.e. Buy & Build, Distressed/Special Sits, etc.).

So far, this is not very different from the overall investment strategy of a private equity fund. The difference, in my experience, comes from the structure: Rather than a co-investment, which might make a single deal with a pre-defined (but of course not guaranteed) time to exit, or a fund, which makes a number of investments with the goal of selling them after a few years, a HoldCo typically has no pre-defined exit date for its acquisitions. They are meant to be permanent, with an eventual exit typically planned either by buying out existing investors, selling the entire HoldCo, and/or by listing on a stock exchange. 

Lastly, HoldCos try to create additional synergies at the portfolio company level, for example by centralizing certain functions such as HR or Finance, as well as through prudent capital allocation (more on that below).

So why would GPs decide to raise a HoldCo rather than an individual deal or a fund?

First, Permanent Capital. Rather than having to raise a new fund every couple of years (or perhaps even deal-by-deal), fundraising for a HoldCo is permanent - the capital that is raised is typically locked in for an indefinite period without a clear due date. Unlike a closed-end fund or an evergreen fund, money is typically never redeemed from the HoldCo - if investors want their money, they need to sell their shares to someone else.

Which brings us to our second benefit: That costs are incurred at HoldCo level and not via management fee. Cost for salaries, employees, offices, etc. of the investment team are incurred at the holding level and thus paid for with investor capital and/or operating cashflows. In practice, this also means that there is no formal cap to such expenses - I’ve seen examples where HoldCo-level expenses were simply shown as absolute values, but far exceeded what would be paid in the case of a standard (1-2%) management fee. Of course, as assets grow, this effect can also go the other way and actually be lower than what would be payable in a fund model.

Third and last, the long-term compounding and its associated benefits. To name a few in quick succession:

• Long-term compounding lets the HoldCo hold on to well-performing assets for long periods of time. There’s no need to sell a winning asset. This also creates the possibility to acquire assets that on their own might not be an attractive investment, but could fit well into a well-diversified portfolio of companies - i.e. a cheap, but profitable ‘cash cow’ financing another unprofitable but attractive subsidiary of another firm.
  

• Potential to create long-term synergies among portfolio companies. Especially for HoldCo’s that operate in a single industry, there’s a lot of potential to not only streamline costs but also cross-sell. A SaaS-oriented HoldCo might have sales staff sell not only one but multiple solutions to the same customers. Admittedly the same can be done at the level of a Buy & Build case - but not across different companies in the same fund.

• Multiple expansion. In theory, the bigger the HoldCo gets, the more valuable all the portfolio companies become - especially as the aforementioned points of cross-financing and synergies come into play.

Taken together, it’s no surprise that former PE operators and former founders want to build their next business as a HoldCo: They can raise a major round without having to worry that they have to return the capital anytime soon. Most expenses, such as a salary or deal-level expenses, are ‘pass-through’ to the HoldCo level. And lastly, if done right, they can turn a group of niche companies into a highly valuable business through synergies and the subsequent multiple expansion.

Or at least, that’s the theory.

Why I’m sceptical of HoldCo’s (as an LP)

I am well aware that there are many HoldCo’s, both listed and unlisted, that have done well. But as always, I try to think about the average investment in a given asset class. And in my view, the average HoldCo does not live up to its alternatives such as a private equity fund or an individual ‘platform’. Let’s look at the expected benefits of a HoldCo through my lens as a potential investor.

First, permanent capital. To a GP, the idea is tempting: Raise money once, and work with it as long as you can. Even if your investors eventually want to sell, they don’t get their money back, but have to find someone else to take over their shares - which might even be you, if a buyback is possible at a favorable price.

However, to LPs, I think this is a less attractive proposition. While the idea of long-term compounding does indeed sound attractive (see Thinking About Reinvestment Risk), there are very few ‘undiversified’ assets that a diversified investor would never want to sell - or at least have the option of selling. I understand that it is somewhat absurd that some PE funds sell assets to themselves that often also have the same LPs, meaning that you sell out of a company and get back money from that fund, only to then wire the funds to the same GP to buy the same company again. It is exactly this phenomenon that has fueled the rise of continuation vehicles. But in many more cases, there are often better buyers for a certain company, especially as it grows from one stage of its evolution to the next - even the standard 10-15-year fund term is longer than many investors (and GPs!) realize. For myself, there are very, very few investors that I would entrust my capital with for an indefinite amount of time, and none of them manage money as a HoldCo.

Second, how costs are incurred. While I do see some benefits over a fund (where there are often valid accusations of large GPs enriching themselves through the management fees), I have issues with incurring costs of the investment team at the HoldCo level. For a fund, this is separated, meaning investors at least stop paying as the fund is wound down. Equally, for an operating company, operating costs to some degree are either part of the overall business and/or at least support individuals that also work for the business. However, especially for less operationally involved HoldCo’s, I see issues with expenses, especially in the early days: Over the year, we’ve invested in more than one HoldCo-like structure where the expenses at HoldCo level ate up a substantial part of the initial funding, and the cashflow of the first business they acquired. Of course this can change as the business grows in size, but at least from my experience, there is no guarantee that that happens. The result? A perhaps not-so-badly performing, small portfolio, with its profits eaten up. Multiple arbitrage doesn’t help if EBITDA/cashflow becomes marginal.

Third, the long-term compounding and its benefits. Once again, something that looks good on paper, but rarely manages to be done properly in practice.

• Long-term compounding can make sense, but the question is at which rate can be compounded, especially after deducting costs. Many HoldCo’s that I’ve seen actively pursue companies that are not rapidly growing businesses, but rather stable, slower growers. How well can they compound after initial synergies are realized? Often, I’ve seen more value created in the first 2-3 years rather than the latter ones, which in my view speaks for a sale and subsequent reinvestment. Of course, there might be exceptions to the norm, as always - but you can check the stock market yourself to see how few businesses really have managed to stick around for the very long term.
  

• Expected and actually realized synergies might differ substantially. In my opinion, a lot of the value creation in private equity does not come from alleged synergies or long-term growth plans, but rather a good purchase price, quick realization of basic synergies (think centralizing ERP, removing redundancies, etc.), and a subsequent sale to a party (ideally at a higher multiple) that has the clear skillset to create value over the long term. HoldCo’s have this value creation capabilities, in theory - but once again, in practice, this is simply not the case for a variety of reasons, especially for small HoldCo’s. Many LPs and GPs that I speak with that are active in the lower mid market (where HoldCo’s operate as well) actually think that you should assume that there is no value creation, or even some value destruction (on an EBITDA basis) - which needs to be offset through low purchase multiple, smart use of debt, and a small but limited degree of multiple expansion.
  

• Multiple expansion sounds great, but can easily turn into multiple contraction. In one of my family office jobs, we funded a team looking to set up a HoldCo - at the end of 2021. Cue 2022, in which public markets corrected substantially, and thus, the valuation of our ‘listed peers’ on which we based our multiple expansion thesis. All of a sudden, the company we wanted to become (well-diversified, publicly listed) started to trade at a multiple lower than the targets we are looking to acquire. We tried to reflect that in our purchase price multiples, but you can imagine how many sellers were willing to all of a sudden lower the price of their highly profitable business just so our multiple expansion case could make sense.
  

• Discounts to NAV. A last point specifically to the HoldCo’s that have made it to a public listing: Most of them actually never manage to trade at the (alleged) price of their underlying assets, but actually at a discount to their net asset value (assets minus liabilities). Reasons include the aforementioned factors, such as a lack of redemption options, ongoing holding costs, or simply a case of multiple contraction for a portfolio of unrelated assets with no expected catalysts. (It’s a trial of passage for any aspiring value investor to buy Porsche SE or another comparable HoldCo because the stock is worth less than their large underlying stock position - only to then realize that the majority owners typically have no intention of unlocking any of that value.)

Last but not least - many HoldCo’s seem to suffer from massive flaws in governance. While everyone wants to call themselves the next Warren Buffett, almost nobody is willing to commit to his degree of respect of their shareholders. Take hedgefund manager Bill Ackman, who described his acquisition of Howard Hughes as the groundwork of a Buffett-esque holding company - but charges a 15M$ annual base fee plus a carry equal to 1,5% of any increase in equity valuation. Or my personal favorite: The story of Boston Omaha, a holding company founded by a great-nephew of Warren Buffett, which is flat since it’s IPO over 10 years ago (partially due to ongoing share issuance to the founding team). Furthermore, the CEO and Buffett relative ended up leaving in 2024 - but not without having the company buy back his shares at an almost 400% control premium ($7.3M). And then set up a competitor, too.

Why I’m sceptical of HoldCo’s (for the GP)

I am very mindful that my view of HoldCo’s might come off as quite negative. Once again, I am also very aware of the many positive examples of HoldCo’s, such as Berkshire Hathaway, Constellation Software, or unlisted peers. But that might simply be selection bias - in my experience, there’s just so many more bad HoldCo’s than good ones.

But perhaps that doesn’t matter to you at all. You might be the GP, not the LP - so why not pick a structure that’s somewhat ‘en vogue’ and might actually be more favorable to you than comparable models even if things don’t go as planned? I still think that a HoldCo, in 9/10 cases, is not an ideal vehicle for an aspiring GP.

First of all, the structural challenges, as outlined above. As I mentioned, while a HoldCo looks good on paper, most experienced investors will likely be sceptical of such structures unless you can prove them wrong - meaning not only favorable investor rights (think defined holding periods, milestone-based funding, good governance etc.), but also a clear explanation with a HoldCo is the preferred structure for your project at hand. If you can raise money from investors at terms more akin to what I outlined above as less GP friendly, good for you.

But more realistically, raising notable sums of money for a HoldCo without exceptional track record or reputation might be hard, if not impossible. Institutional investors (think family offices, private equity firms, funds of funds) will likely not want to back a lightly regulated structure without a clear path to liquidity - and/or might simply not have such a pocket for such investments between traditional direct investments and fund investments. More entrepreneurial investors such as business angels or smaller family offices might be willing to back you, but they can either not provide you with sufficient funding, or might end up being not so-hands off after all. (More on that in The Reality of Family Office Fundraising).

Compare that to what I deem the three relevant alternatives:

One, a management buyout as an initial ‘platform’. There are countless co-investors (think family offices, PE funds, or even individual investors) happy to back a small-cap investment, especially if there is a somewhat experienced operator at the helm. They might also provide you with additional capital for future add-ons. But they’d likely not fund a HoldCo with no clear initial target or little to no governance. (You can perhaps also make the case that a VC-like fundraise might fall into this category - but while it might offer more favorable terms in regards to day-to-day governance, you’d likely still require investor approvals on acquisitions or your budget, and are also subject to a liquidation preference.)

Two, raising deal-by-deal. Essentially, the ‘independent sponsor’ route. You might be an experienced investor looking to now go off on your own, but don’t want to raise a fund (yet) and/or perhaps want to be more involved in individual deals. You acquire the company, can charge a reasonable management fee (and/or one-off deal fee) and likely also a carry. A search fund with less operational involvement might also fall into this category. But once again, investors don’t want to back you blindly - they want to see a target and a clear path forward.

Third, raising a fund. Perhaps the closest to a HoldCo given the flexibility on expenses (at least at the level of your management company), transactions (no need to pre-approve a deal that fits your investment criteria) and holding period (10+1+1 years, if not longer if agreed upon with investors). But once again, there are some key, LP-friendly differences - such as a clear exit orientation, admittedly high but capped expenses (with certain expenses such as salaries which are not allowed to be paid by the fund), as well as clear governance mechanisms on what can and can’t be acquired.

Of course, all of these structures have valid downsides. Management buyouts typically leave the operators with a minority stake in the business (think 20-50%) and strong control rights for the investors. Deal-by-deal fundraising is, well, deal-by-deal and might have management fees that are lower and thus incentivize the team to go for more transactions (with more one-off fees). A fund, if set up in a GP-friendly way, might offer the most flexibility, but is much harder to raise without an exceptional track record. 

But nevertheless, I think that all three options are better choices to GPs than a HoldCo: If you don’t have the reputation that would have LPs follow you almost blindly, chances are that a less unusual structure will be less challenging in regards to fundraising. As I outlined in The Deal Structure Conundrum, even some of the most successful founders in our circle of clients are having a hard time with unusual, HoldCo-like structures - which I believe was not the case if they just opted for a market-standard structure like a fund. Can it be done with such a deal? Yes - but I wouldn’t advise picking an unusual, slightly more founder-friendly structure with a 10% chance of success if a market standard structure might put that chance of success substantially higher. (In my opinion, ‘market standard’ structures for serial entrepreneurs are already very founder-friendly - think limited approval requirements, basic investor reporting, and often only a symbolic advisory board.)

And finally, if you don’t believe my reasons as outlined above: Just see what is trusted by the market. Or to say it differently, see what LPs invest in. And that is either individual operating companies (public stocks), or private funds (the countless alternative investment managers out there). And much less so HoldCo’s or other exotic structures.

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