Holding companies have been around for ages. Perhaps the most famous holding company of all time is Berkshire Hathaway, Warren Buffett’s $600 billion investment vehicle. Some of the most successful companies in history have been holding companies. In essence, a holding company is a company that owns other companies or assets, and does not have any business activities or operations itself. Berkshire Hathaway, for example, occupies just one floor in a building in Omaha, because its business activities are conducted through its subsidiaries. In this article, we will explain everything you need to know about holding companies.

The assets that a holding company can own are varied. They may, as with Berkshire Hathway, be stock in other business entities, whether private or public; or they may be bonds or other financial instruments; music rights; patents; real estate; or anything that has economic value.

What a Holding Company Does

Johnson & Johnson.is another example of a holding company. It does not actually have any business operations of its own. Instead, Johnson & Johnson owns 250 different subsidiaries that produce a variety of products in the consumer healthcare, medical devices and pharmaceutical industry. Each subsidiary operates largely as a separate company, with its own management, facilities, assets, bank accounts and financial statements. The chief executive officer (CEO) of Johnson & Johnson, is appointed by the board of directors, and appoints the leaders of each of the subsidiaries. Johnson & Johnson’s size allows them to lower the cost of capital of each of its subsidiaries, giving them competitive advantages from being part of the Johnson & Johnson family. One example of this is that Johnson & Johnson could use its size to borrow money at very low interest rates, and then borrow those funds to its subsidiaries, at rates lower than those subsidiaries could get if they operated outside of the Johnson & Johnson family. By reducing the cost of capital, Johnsonj & Johnson helps those businesses increase their economic earnings.

Just because holding companies have no business operations of their own, does not mean that they do not do anything. For instance, Warren Buffett and his vice chairman, Charlie Munger, spend most of their time thinking about capital allocation and reading through annual and quarterly reports in search of businesses that they can invest in. Their job is to find opportunities that they can allocate their capital to, so that they can earn their investors a return on capital greater than the cost of capital and in such a way that they outperform the stock market.

More activist holding companies, such as Johnson & Johnson, may be more involved in the operations of their subsidiaries. They may exercise oversight over their subsidiaries, involve themselves in managerial decisions, set risk management parameters, among other things. The most important thing that a holding company does is find the right people to head its subsidiaries. Ideally, a subsidiary will need little to no oversight, because the quality of management is so high.

A holding company’s management is also responsible for reinvesting the dividends paid out by its dividends, either by ploughing them back to those subsidiaries, or finding new opportunities. In making this decision, the key idea is that capital is deployed where it will earn the greatest economic earnings.

How actively a holding company oversees its subsidiaries really depends on the philosophy of the founders. Berkshire Hathaway has the most decentralized structure of any S&P 500 company. For Berkshire Hathaway, this is a selling point. The owners of other companies know that if they choose to join the Berkshire Hathaway family, they will not be subject to interference, instead, they will be free to run their businesses as if they still owned them. This fosters an owner’s mentality among managers, helping to align the interests of the management of the subsidiaries, with those of Berkshire Hathaway.

On the other hand, some holding companies are very active on the operational side. They may actively create businesses, launch new initiatives, and direct where their subsidiaries should invest.

Whatever model prevails. Capital allocation decisions are the most important aspects of a holding company’s work.

The Benefits of a Holding Company

The most obvious benefit of a holding company is that it is not liable for any debt assumed by its subsidiary. So, a subsidiary, like one you would use to sell your exclusive shoes, could go bankrupt and rather than having to directly work to pay off those debts, the holding company could write-off a portion of its net-worth to reflect the capital loss from the bankruptcy. Of course, if the holding was a meaningful enough portion of the holding company, then the survival of the subsidiary would be tantamount to the survival of the holding company.

The holding company model protects assets from the losses of other assets owned by the holding company. In the example in which a subsidiary goes bankrupt, other subsidiaries would not therefore also go bankrupt. So not only does the holding company only suffer capital loss, the other subsidiaries are unaffected in so much as they will not be called to honor the debts of the bankrupt subsidiary.

In the same way, a holding company’s other assets, whether they are gold, stocks, bonds, real estate, or other assets, will not be called upon to bail out the bankrupt subsidiary. The holding company’s loss is limited to the capital loss from its investment in that subsidiary. Again, we should emphasise that this is not a get-out-of-jail-free card: capital loss can be large enough to rock a holding company and if it’s big enough, it can lead to the collapse of the holding company, or force it to sell assets in order to survive. The legal segregation does not preclude economic loss and other knock-on effects.

These protections are crucial to why many successful companies operate as holding companies. Another real-world example is Procter & Gamble, which uses a number of subsidiaries to innovate new products and solutions. Some of its subsidiaries have brands, such as Tide detergent. Others own manufacturing plants that make products within the Procter & Gamble ecosystem and these manufacturers pay the brand-owning subsidiary a licensing royalty. In that way, if the manufacturer was sued, Procter & Gamble could not lose any of the brand names within its ecosystem. Instead, the manufacturer or distributor would go bankrupt.