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Holding Companies: Benefits & Costs for Private Equity Investors
Darius Pandole
Partner
New Silk Route

By definition, a holding company is a company organized with the intention of acquiring equity ownership in other companies. Holding companies are popular in India, mainly in two forms – (1) corporate groups running multiple and varied businesses; and (2) private equity funds looking to create platforms to consolidate multiple assets within specific sectors or verticals, in which there are not many companies of the required size and scale.
 
This structure lends several advantages to either the corporate group or the investor.
 
Firstly, a holding company can gain control over its subsidiaries without investing the entire equity requirement. Thus,a holding company allows for structural leverage due to its ability to control the business of its subsidiaries by holding majority (just over 50% shareholding), but at the same time allowing for fresh external investment for the balance stake.
 
Secondly, it can assist in raising capital based on the consolidated financial strength of its subsidiaries, which otherwise could be difficult for each individual subsidiary company. Flexibility to reorganize and structure finances is also available for individual businesses. Another key advantage of a holding company structure is that while it allows investment in multiple businesses under one parent company, it also ringfences each business from the risks of the other, by preventing the business performance of one business from affecting the performance and valuation of another.For investors, this offers the option to gain an exposure to any preferred business along with the flexibility to structure the investment (as debt, equity etc.) to meet their investment objectives.
 
Holding companies created by PE firms typically hold majority stakes in the underlying portfolio companies. A common platform not only provides back-end synergies to the group companies and efficient tax planning, but also maintains the identity of individual brands under its subsidiaries. In India, for instance New Silk Route PE has set aside US$100 million to invest in mid-sized food and beverage firms via its ‘Gastronomy’ platform, with two investments complete – Bangalore based Vasudev Adiga’s and Mumbai based Moshe’s. 

The consolidated revenue of the holding company, being larger than that of the stand-alone firms in its portfolio, makes them more attractive in initial public offerings (IPOs) of shares, an important route for PE firms to sell their investments. A holding company could also be an attractive target for strategic acquisitions, wherein these companies could be sold individually or collectively, thereby facilitating an exit for the investor.
 
In India, in the infrastructure sector, individual project companies called special purpose vehicles (‘SPV’) are set up to undertake Infrastructure projects. Groups of such SPVs are then held by a single holding company. A holding company structure becomes necessary, since relevant regulatory authorities are required to award concessions relating to the infrastructure projects in specific SPVs. A holding company structure also enables each individual entity to gather pre-qualification experience, facilitating bidding for additional projects. It also provides flexibility to the lenders where holding companies can provide guarantees and their risks are diversified vis-a-vis the project SPVs.
 
As per the regulatory framework in India, holding companies which do not undertake any operations and are engaged only in the business of holding investments in other companies, may be classified as Non-banking Financial Companies (‘NBFC’). There are a separate set of regulations applicable to NBFCs in India, which need to be complied with. Also, foreign investment in such investment holding companies is subject to approval from the Foreign Investment Promotion Board of India. According to the new Companies Act 2013, a company will be regarded as a holding company of another, if the former holds or controls more than 50% of the total share capital of the latter, i.e., equity (voting and otherwise) and preference share capital. This is significantly wider than the test under the Old Act and will have an impact on the determination of related-party transactions, inter-company loans, etc.
 
In addition to a cumbersome regulatory framework, the holding company structure has certain inefficiencies that need to be recognized. For instance, in cases where the holding company is not the sole owner of its group companies, distribution of dividends is accompanied by two layers of dividend distribution tax. Secondly, there is a requirement for a holding company to transfer a part of its profits to its reserves which may result in trapped cash that is difficult to upstream to the ultimate shareholders. Thirdly there is limited liquidity for minority shareholders in a holding company as the promoters can retrieve profits from the subsidiaries disproportionately through mergers and demergers; due to which minority investors often seek fall back options along with related structures to secure an exit. As a consequence, the capital markets have often attributed a ‘holding company discount’ when valuing such companies.
 
In conclusion, if the holding company structure is designed appropriately in light of the objectives and scale of its businesses, it can lead to synergies and efficiencies in the underlying businesses and the commercial benefits therefrom can outweigh the tax and regulatory inefficiencies.

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