Among the most interesting holdco justifications is the need to protect the realizable value of tax assets, often in plentiful supply at diversified holdcos, as the argument for diversification is often an escape from the awful economics of the legacy business, the source of the NOLs that gave rise to the tax assets.
At first blush, this might seem prudent – avoiding asset impairment is a good practice. And yet, tax assets seem a curious rationale for a holdco, let alone a diversified one. It seems to be a case of making a mistake by forgetting the objecitve, which is to earn high returns on capital.
Tax assets, it must be said, come in many forms. Those that arise from differences between tax and financial account treatment of depreciation or similar „timing“ differences are pretty solid assets. Like the cash cycle they are basically short term in nature and can be expected to be realized in the near term, and no later than the useful life of the operating assets that gave rise to them. NOL tax assets are a horse of another color. These tend to pile up in operations that are consistently loss making and which have few prospects for earning enough to recover those tax assets in the future. In holdcos, the operations have often been shut down or sold, leaving behind some capital of the cash box sort and a pile of „assets we would like to find a use for“.
The problem is that the IRS makes this rather difficult. Internal Revenue Code Section 382, which sets the rules that have to be followed in order to realize tax assets explicitly limits several actions, like selliing or merging the firm as well as some other complex rules. The point of the IRC is to prevent people from selling defunct businesses as tax shelters. You have to continue to operate a business yourself.
Finding a use for these assets is actually remarkably tough in a world in which there is no inflation and asset prices are sky high. Think about it this way. Imagine you are a firm, like Hudson RPO (HSON), and you have $300mn in NOLs, supporting $60m or so in DTAs. (Pretty good if your market cap is $35m). Now, NOLs usually expire, so you have to earn offsetting income within 20-25 years. But even if you had 30 years, you would need to earn $10m a year every year for those 30 years. But you don’t have operations that can generate this sort of profit, certainly not consistently. If you did, you wouldn’t have $300m in NOLs, you would have a balance sheet comprised of operating assets.
Therefore, you need to BUY a business that has that earning power and you are going to pay a going concern multiple to do so. It will take something between 100-200mn probably to do this deal. You cannot offer stock, because that would give the new firm too much ownership and limit the DTAs. You have to pay cash. But your box isn’t big enough for that. So you have to try and purchase lots of little firms – you can see why diversified holdco structure seems to be the best way to go – it is the only way to get all the looks you need. But then you have to operate lots of subscale oddballs under one umbrella, or you try and rollup an industry – like HVAC firms in Arizona.
Sure you can seed a business – but then you probably don’t need to be a diversifed holdco, what you want is to become a dominant operating company, which means you need someone who is not a financier, probably; you need someone with a passion for solving a specific human problem.
There are some reasonably probable ways to turn small piles of capital into profits – buying cashflow real estate at low cap rates will create a stream of earnings. Except that in most cases, it will be more efficient to hold the real estate outside of the holdco. So really what is the point? Buy some land and become a land trust?
Similarly, you could buy securities that pay interest or dividends, but pretty soon you become an investment company, which limits the sorts of investors you can have and forces you to go private or become a CEF with a licensed management company. Either way, an investment company isn’t taxed directly, so the benefits of the tax assets disappear.
I find the DTA thing strange for another reason: taxes on corporate profits aren’t that high. During periods of high taxation and high inflation, DTAs can be great – you can almost always expect that rising revenue and rising nominal profits will enable you to use fixed value NOLs and shelter significant tax. In the 1960-1980s, those tax rates were about 50%. But along with the reforms that made it harder to take deductions like NOLs, tax rates were dropped significantly. At the 21% we have now, a dollar of NOLs is only worth 21 cents. And only once. A dollar invested in a good business is worth considerably more than that – every year.
It seems silly to trap capital inside of such a structure in service to a tax optimization strategy at the expense of reinvesting it in better opportunities that happen to limit the ability to claim and shelter taxes. It is putting the tax shelter ahead of the objective – which is to earn high returns on capital. This is the sort of thinking that arrogant retail investor commenters on Seeking Alpha employed to explain the brilliance of their investments in MLPs, until they blew up. „Look at my yield! And I get to shaft the tax man, too! I am so smart!“. Then Kinder Morgan blows up and … crickets. Why copy them?
So why then do managements work so hard to defend these assets, when they should be focused on improving the capital base and the operations of the holdco? Well, here Whitman’s discussion of communities of interest and communities of conflict come into play. DTAs are a great excuse for management to entrench itself and add poison pills like rights offerings ostensibly to protect DTAs from being limited by a change in control, which ensures that THEY remain in control.
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