I had an interesting exchange on X/Twitter today with a principal in one of the hottest new trends, Permanent Equity/Hold Cos. These are private companies that focus on buying existing companies and holding them permanently.
This isn’t really a defined asset class but I think of the companies they target as more traditional, cash flowing, and profitable businesses (ie not venture funded) with slower growth to no growth. They tend to use low amounts of leverage (compared with typical PE deals) to finance the companies and most of the hold cos focus on a diverse set of businesses.
There are all types and sizes of these hold cos. From ones that own a couple of HVAC companies financed with SBA debt to $100m plus companies with lots of investor capital. I recognize that there are other models similar to this that buy in a more focused way like Constellation Software but I put those in a different category.
The tweet was talking about the advantages of a more permanent holding structure over the typical private equity model. Rafael Quinn wrote:
These are all very true and admirable statements which I whole heartedly agree with but it did get me thinking. Why is this better and what are the limits to it being better?
Leverage and Churn
The common complaints about traditional leveraged buyout funds are that, as the name suggests, they use a lot of debt and need to constantly churn investments. When the model works, the debt juices equity returns and the churn ensures there is some liquidity event that allows the investor to get their money back. Funds are usually structured as 10 year vehicles.
Of course, there are issues with the model. First, the debt side of the equation juices returns when things work out but it also does the opposite on the downside. But during the heyday of private equity since the Great Financial Crisis, debt costs were steadily dropping and we haven’t had a real recession in14 years, these concerns seemed over blown.
The second issue of churn is one that Rafael highlights in his tweet. PE firms go raise money and then start deploying it by buying companies but they don’t have all the companies lined up yet to buy. It takes time to find the targets, negotiate, close, etc. Investors in PE firms receive capital calls when the companies are bought and have to leave the money earmarked for the fund in treasuries or something very safe and liquid while they wait.
Then in 5-7 years they sell all the companies and return the hopefully now increased amount of cash to their investors. That sounds great but if you don’t want the money now you are left figuring out where to re-invest it. Fortunately your kindly PE fund manager is always raising another fund, so you can just plow it back in.
I agree with Rafael that this makes very little sense. If the companies you bought were good, wouldn’t you just rather hold them? Not only do you give up good cash flowers but you’ve also got all the money parked in treasuries each time it comes in and out of funds.
Enter The Permanent HoldCo Structure
To solve that problem, it’s become more popular to structure permanent holding companies. Brent Beshore, as far as I know, pioneered this model with his company, Permanent Equity, and even developed a unique 39 year investment requirement to bring in outside capital1.
Other holding companies are closely held with no investors beyond the principals. Some claim that the companies they buy will never be sold. I don’t know how that works unless they are contemplating some kind of multigenerational, hereditary deal. Eventually either the companies in the holding company will be sold or the holding company itself will be sold by going public or to new partners or to some other buyer.2 But this is a quibble.
What I started wondering is why buy a bunch of different companies? What is the advantage that one has where that makes sense? My initial answer to that question is that the returns you can get in small private businesses are high but they don’t scale well.
Small Companies Get Good Returns
As Greg Crabtree noted in his book Simple Numbers 2.0, a modestly profitable small business generates at least a 50% and many times up to 200% return on equity with very little leverage. The problem is they tend not to be growth machines and even if they are the methods that drive profitable growth are hard to discern and often lose their effectiveness as you plow more money into them.
The hold co model solves for this. You can continue getting great returns by taking the cash flow from one business you own and investing in another. Smaller companies tend to sell for less so you have a better chance of not overpaying.
If I can buy a companies making $500,000-$2,000,000 in net income for 4 times profit, I’m getting a 25% return if the business just stays steady. If I can buy it for 3x, I’m at 33.33%. Those are good returns. Public stocks only get 8-10% on average.
The problem comes if I start buying bigger companies. The field gets a lot more competitive. If I’m at PE’s average 8x now I’m down to 12.5% and at 10x, I’m only getting 10%. That isn’t any better than the long term stock average for what are smaller and more risky companies. Enter the leverage. If I can add 4-6x leverage, I’m significantly increasing my returns (and my risk).
I see why holding companies focus on buying more companies rather than growing the ones they have. It makes sense when you are getting pretty reliable 25-33% returns. And that’s not to say that there is no growth. Most companies have some problems that the hold co principals can help fix. Any additional growth will generate those 50-200% returns. I’d just wager that steady and profitable growth is harder to come by than another small company to buy.
The Limits to the Model
I really like the hold co model. It clearly makes sense but I do think it has limits and I’m not sure if the practitioners of the model have recognized them. One limit is going to be the management capacity of the central holding company to ensure that its member companies continue to perform. Keeping tabs while allowing the companies to remain semi-autonomous becomes an increasingly complex challenge as the number of companies grow.
Another downside of the model is a lack of central efficiencies. Each industry is different, has different payment terms, software systems, employee terms, etc. The complexity of managing these across dozens of companies would be daunting.
Redeployment of capital would also become an issue at some point. As your earnings mounted, your ability to find enough small companies to re-invest your capital into will become more and more difficult.
Finally, I could see the values of the target companies rising the more successful the model proves to be. The holding companies are relatively unusual vehicles right now but a few more years of twitter promotion and we might be lousy with them.
The Law of Large Numbers
Eventually the model won’t work. A few truly exceptional allocators will make a run at being the next Berkshire but many others will just give into the temptation to go bigger, reduce returns, and try to use leverage to juice them. They’ll become increasingly indistinguishable from traditional PE firms.
But for now, I love the model. Get in while the getting is good!
As I understand it investors get dividends as they go but can’t get a return of all their capital until the 39th year.
A lot of the principals tend to be younger so the pull of the grave isn’t as urgent.
Great piece.
A few comments:
Holding companies are not a new concept. Tyco, Dresser, Danaher, and even Transdigm are all examples of holding companies that have gotten so big that they went public. At one point, they were small private holding companies. Of course don't forget Berkshire !
Permanent Equity is not really a holding company, although they have incredibly long time horizons with their 28-yr old fund.
Yes, the PE model has the deficiencies that you mention, but it also has a transparent liquidity time horizon that investors can count on. Many investors need liquidity, liquidity to pay bills, to fund school operations, etc, and so the more illiquid uncertain nature of holdco liquidity is both its greatest trait and its vulnerability as a vehicle that can attract LP capital.
appreciate the post Alan! Best, Peter