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January 02, 2014

Pros and Cons of investing in Holding Companies: The PE Perspective

Darius Pandole, Partner at PE Firm New Silk Route, has an article in Business Standard on the topic. Extracts:

The +ves:
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.
The -ves:
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.

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