In Business 201, I want to talk about two aspects of business. The structuring of global capital and investment vehicles. And the best ways to bootstrap capital growth.
On the legal structuring side, we have to understand the three core concepts that underly legal structures in the financial and investment industry.
- Investment Structures
- Control Structures
- Tax Structures
None of these structures are simple and we will dive into them in the later articles. But in principle the classification works as this:
Investment Structures: Are legal structures that serve the sole purpose of pooling money and making it available for financial transactions that form wealth/capital generating portfolios. And in the ideal case, the best portfolios.
The best portfolio has two main criteria that make it best. (1) It generates more risk-adjusted returns or alpha than other portfolios. (2) It solves the problem of the creator of these portfolios to shuffle wealth from other investors to him.
The arsenal of investment structures is huge. It covers all types of funds – from hedge funds, mutual funds, index funds, whatever. The portfolio strategy is always a portfolio of investment strategies executed via the legal structures employed. The purpose is always a return on investment. It does not matter if the investment strategy is focused on minority investments (passive investment / portfolio selection) or on majority investments (active investment).
This stuff is typically taught in CFA programs, Blackrock kind of grew on quantitative risk management and is a par excellence example of pooling massive amounts of money and deploying it into global investment portfolios.
Control Structures: Control structures are different. They also want to generate returns to their owners, but in a different way. There are in principle two key vehicles for the control structure : The conglomerate – or an entity which is in principle a holding business which does control its holdings from outside or as seperate entities – and MNCs – any kind of single-purpose entity that can become as large as the investor wants it to be.
The key difference is the “single entity” (A multi-national corporation) vs “many entities under one roof” (Conglomerate) concept. A conglomerate does not create reporting, direct and organizational structures between its holdings and between itself and its holdings. It rather holds its portfolio similar to an investment fund.
The difference to an investment fund is that the purpose of the holding is – on an abstract level – very simple: investment funds buy and hold with active or passive strategies, but they stay active by giving guidance via governance bodies mostly and replacing key management, and investment funds are “fund management” vehicles where a bunch of smart guys gets money from many other guys to execute on an investment thesis.
A conglomerate is typically very few smart guys, that pool money from very few close friends and close network to execute on a philosophy of how to run a business. In the ideal case a conglomerate becomes a chaebol or : a conglomerate owned fully by a single family or individual, that invests money from this family. But that could also make it a family office ran by family. A family office is very similar, but invests into companies run by others and it invests for alpha and returns, not for control. If a single-family office is run by the family and runs for control and active management, it is basically a chaebol.
If you have more people investing money, but everything else is like a chaebol, you have something like Warren Buffet when he started. Once you start adding investements into other entities, you have the modern hedge fund strategy of Warren Buffet.
The choice between chaebol and a Buffet-esque hedge fund is run by key drivers. You run a chaebol if you are fully capable of operating the entire capital under you under a conglomerate structure or a pure control structure. Once you decide that your network gives you opportunities which are even stronger than your own, you start investing in third party busiensses. Thereby shifting money between your own active control investment strategies and third party activities. And once you realize that your own strategies or your network and its strategies are so strong that your own capital is not sufficient to execute on all opportunities, you are turning into a hedge fund by taking third party capital to invest and deploy.
This can go on and on untill your own investment ideas deplete and the strengths or your network is depleted as such that all opportunities it presents are weaker than any public opportunities, then you turn into a fund or a non-control investment vehicle.
For a conglomerate, what you focus on is having the option to make money by combining by mergers and acquisitions and by breaking apart by divestitures, spin outs and so forth of the actively held portfolio you are holding.
Once you go away from that multi seperate entity control structure and say you want a single entity that operates under run roof, you are going the MNC or multi-national corporation way. Independent of whether it is publicy traded or not, the qualifying feature of the MNC is that it forms one united entity. That means the level of operational integration is going beyond mere integration via control using governance bodies, but your employee levels start talking to and interfacing each other. If you let every employee in your conglomerate talk to each other and change trade secrets and resources, you basically violate the “seperate entity” concept and violate the legal regulations of such entities. Hence the need to formally merge companies and form a MNC.
With such integration comes the problem of the disintegrated operational units becoming harder to sell off. The individual holdings of the conglomerate, once forming an MNC become “illiquid”. And with no easy way out of the position and being stuck with this way of things, you are starting to talk synnergies and integrating the companies even more.
Very simple. But as simple as it is, it should be clearly understood. If you are launching a new business line in your company, you should wonder if you are planning to integrate resources and to retain that unit, of if you create a new entity.
Tax structures: Now comes the next and last level and something that is too complex to really pinpoint in a short blogpost. It is clear that long-term investments that are illiquid and are meant for long-term capital build-up are taxed differently than opportunistic investment structures. On the fund side, you ahve trusts (funds with a purpose, very long life cycle and vehicles that do not allow you to extract money out of them easily). Or you call them dividend-reinvesting everygreen funds. Evergreen means they have no end and can run forever. And divident-reinvesting means tehy do not distribute profits that need to be taxed. Such funds typically only come as variable capital structures. That means you can issue now shares and shares are being bought back by the fund. This way the fund can continue to exist on its own, and people can cash out by selling their shares. Or you have closed end funds that tie capital for 10 (PE and VC) years or 50 years (Ship building, real estate funds).
Those funds are best taxed when they are non-controlling. Once they are activist investors and controlling, taxation heads more towards the conglomerate level or MNC level. If they are activist short-term holding and buy and sell within a year, they are called speculative and are taxed heavier both on the fund side for each investment and for the investor in the fund.
And then when you get back to MNCs and conglomerates, you are looking at organizations with many subsidiaries that have to tax profits. Something they solve by moving the taxable profits to a country that is low in income taxes and reduce taxable income in the subsidiaries in regions that tax heavily.
again, this area is complex. But it also defines where things are happening and it has a huge impact on where funds and companies operate their headquarters.