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Ask Mint | The risks and rewards of holding companies

Ask Mint | The risks and rewards of holding companies
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First Published: Sun, May 24 2009. 10 06 PM IST

Updated: Sun, May 24 2009. 10 06 PM IST
What could be common between the Akamba tribe living in some remote corner of Kenya and some of the world’s best-known companies? Both love intricacies. The Akamba tribe loves creating intricate wood carvings whereas the corporate world loves creating intricate corporate structures.
Control of some of the best-known companies passes through so many layers of corporations controlling other corporations that it is really difficult to tell who is controlling what. The company at the bottom of the pyramid may be producing the actual goods and services, but the holding company at the top pulls all the strings.
Johnny: That’s interesting. One corporation sitting on top of another, which again is sitting on top of another. If it goes up like this then we can easily reach the moon.
Jinny: Well, for that you can thank our corporate world for creating holding company structures.
Johnny: Can you elaborate on what exactly a holding company is?
Jinny: A holding company is a company that exercises control over other companies by holding their shares or voting power. For instance, company H, holding the shares of different companies such as A, B and C, which are engaged in different businesses. This could be the simplest example. In fact, holding companies can exercise control over other companies through complex layers of many companies. For instance, company H holding the shares of company D which, in turn, holds the shares of companies E and F which, among themselves, hold the shares of companies such as A, B and C.
The remarkable thing is that a holding company need not get its hands dirty by actually producing goods and services. Its only purpose of existence could be to exercise control over other companies. A holding company can just sit at the top like some feudal lord and exercise control over diverse companies down the line. The companies down the line are known as subsidiaries of the holding company.
Illustration: Jayachandran / Mint
To exercise this control, however, it is not necessary for a holding company to own 100%, or even the majority of the nominal value of shares of its subsidiary. Control can be exercised even by owning less than 50% of the nominal value of shares, provided the holding company enjoys the majority of voting power or the power to control the composition of the board of directors by virtue of some agreement.
Johnny: Well, there could be many sources of real power. But tell me, Jinny, what are the main advantages of exercising control through a holding company?
Jinny: Holding companies may not be puffing out any smoke from their chimneys, but that doesn’t mean holding companies just sit idly at the top of the corporate hierarchy. Holding companies do perform some very crucial jobs. Their main job is to invest in, control and manage other companies.
A separate company, exclusively looking for opportunities of new investments in other companies, managing and controlling such investments, brings more efficiency. The aim of a holding company is to efficiently move out of business lines with declining profitability and quickly move into markets or products with promising profitability.
Holding companies can exclusively focus on redeploying capital at their disposal to maximize return. Business expansions can be made simply by acquisition of stocks of different companies. There is no need to merge the assets and liabilities of the two companies, as commonly seen in the case of mergers.
The structure in which each of the different business units is a separate investment also makes economic sense. It could provide financial flexibility. For instance, a holding company may borrow money and pass it down the line to its subsidiary as equity.
Further, the holding company structure can allow ownership in diverse companies with lower risk. Holding company structures help in containing the risk of a particular business to a subsidiary without putting the whole business group at risk.
Even if one of the business units goes bankrupt, the creditors of the failed unit can’t make any claim against the good assets of other business units.
Johnny: That’s interesting, Jinny. You need not sell your elephant to bury your dead horse. There could be other advantages, too, but I don’t want to jump to any conclusion unless you tell me about the other side of the picture. What are the disadvantages of a holding company structure?
Jinny: The holding company structure does have some drawbacks. First and foremost, the holding company structure, by offering financial flexibility, can also increase the temptation to bite off more than what one can chew.
You can control a subsidiary even without owning the majority of shares and that’s what sometimes encourages the investment of surplus capital into new businesses having nothing in common with the core business. Things sometimes may get out of control. You may find an airline company holding an interest in a duck farm.
Second, the financial flexibility offered by a holding company structure can also bite in reverse. It can encourage reckless dissolution of business units at the first sign of trouble. You can be tempted to shoot your duck on the slightest provocation.
Johnny: That’s true, Jinny. Carrying excess baggage can sometimes break your neck.
What: A holding company exercises control over its subsidiaries by holding their shares or voting power.
Why: Holding company structures are popular because they offer several advantages, such as better deployment of capital with lower risk.
Why not: Holding company structures can encourage reckless dissolution of businesses at the first sign of trouble.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, May 24 2009. 10 06 PM IST