Should the holding company or the operating company borrow?

Where the cash and assets sit

In a typical structure the owners hold a holding company, and the holding company owns the operating company that actually does business. The operating company invoices the customers, holds the bank accounts, owns the equipment and inventory, employs the staff, signs the leases and holds the licenses. The holding company owns shares, and often nothing else.

A lender's security is only as good as what it can reach. A lien on receivables, inventory and equipment has to be granted by the entity that owns them; a borrowing base can only be built from the borrower's own receivables. So lenders want the borrower, or at least a guarantor that grants liens, to be the entity where the value is. Why buyers set up a holding company covers the reasons for the structure itself; this page is about where the debt goes inside it.

Lenders lend where the cash is. The question is not which entity signs, but whether the lender can reach the operating company's cash and assets directly.

Structural subordination, in plain numbers

When a holding company borrows and the operating company does not guarantee, the holding company's lender is a creditor of a company whose only asset is shares. If the operating company fails, its own creditors are paid first from its assets: its lenders, its suppliers, its landlord, the tax authorities, its employees. Only what is left flows up to the holding company as the shareholder.

Suppose the operating company's assets are worth 10,000 in a wind-down and it owes 7,000 to its own creditors. The holding company's lender can reach at most the remaining 3,000, whatever it is owed. If the operating company's creditors are owed 10,000, the holding company's lender gets nothing. That is structural subordination: the loan is junior not because any document says so, but because of where it sits in the corporate chart.

For a senior lender this is unacceptable, which is why holding-company-only senior loans are rare. For a junior lender it can be the whole point.

Guarantees up, down and across

Lenders close the gap with guarantees and liens that run between the companies in the group. There are three directions, and most senior loans use all that apply.

Upstream and cross-stream guarantees raise a legal question: a company that guarantees another's debt without receiving a benefit can have the guarantee challenged if it becomes insolvent. Credit agreements handle this with savings clauses that cap each guarantee at what the guarantor can bear, and lenders pay attention to whether each company actually receives something, such as a share of the proceeds or shared services. It is a drafting point for counsel, but it explains why lenders ask how loan proceeds will be used by each company. Joint and several borrowers explains the co-borrower version.

What lenders usually require, by situation

• One operating company, bought through a holdco. The operating company borrows, or the holdco borrows with the operating company as co-borrower or guarantor. The holdco guarantees and pledges the shares. This is the standard acquisition structure.
• A line of credit or asset-based loan. The operating company must be the borrower, because the borrowing base is built from its receivables and inventory. See how a borrowing base works.
• An SBA loan. The operating business is the borrower or a co-borrower. Where a separate company owns the real estate the business occupies, SBA's eligible passive company structure lets the property company borrow with the operating company as co-borrower. The propco/opco structure covers real estate held separately.
• A group of operating companies. Either one facility with all of them as co-borrowers or guarantors, or separate loans for each. More on the trade-off below.

When holding-company debt makes sense

There are good reasons to borrow at the holding company. They usually involve debt that is meant to be junior, or a group that is meant to act as one.

Junior capital. Mezzanine, preferred equity or a seller note can sit at the holding company deliberately. The senior lender at the operating company then has a clean first claim on everything that produces cash, and the junior capital is structurally behind it without a long intercreditor fight. Junior holdco lenders price for that position, often with PIK interest that accrues instead of drawing cash from the operating company. Senior lenders sometimes prefer this arrangement to a second lien at the operating company.

Several operating companies. A buyer rolling up businesses, or a family with several companies, can borrow at the holding company with every operating company as co-borrower or guarantor. One facility, one set of covenants tested on combined results, and the ability to move cash where it is needed. The alternative, separate loans at each operating company, ring-fences each business, so one failing does not drag down the others, but traps cash: each company's lender restricts what can leave it. Lenders to a combined group will look at each company as well as the total, and a weak one can hold back the whole facility.

The acquisition vehicle. In a purchase, the holding company is often the entity that signs the purchase agreement. The loan can be made to it, as long as the operating company joins as co-borrower or guarantor at closing.

Paying holding-company debt: distributions and tax

A holding company has no customers. Every payment on its debt, and every dollar of its overhead and tax, has to come up from the operating company. That is where holdco structures most often break.

• Permitted distributions. The operating company's senior loan will restrict what it pays to its shareholder. Any holdco debt service must fit a permitted-payment clause, usually allowed only if there is no default and the company meets its covenants after the payment. See restricted payments.
• Blockage. When the operating company trips a covenant, upstream payments stop. The holdco lender needs to accept that, or the senior lender will not sign.
• Tax distributions. Where the group is taxed as a pass-through, the owners owe tax on income they may not receive in cash. Credit agreements commonly permit distributions to cover it; see tax distributions under a loan.
• Tax structure. Whether cash can move up without a second layer of tax, and whether holdco interest can offset operating income, depends on how the entities are classified: a consolidated corporate group, an S corporation with a qualified subsidiary, or disregarded LLCs. Settle this with a tax advisor before the credit agreement is drafted, because the covenants have to match it.
• Intercompany loans and management fees. Some groups move cash through management fees or intercompany loans. Senior lenders read these as distributions by another name and restrict them the same way.

Coverage has to be tested where the debt sits. A lender looking at the whole group will count holdco debt service against operating earnings; a holdco lender will look at what the operating company is allowed to send up, not at what it earns. Fixed charge coverage is often the test that catches upstream payments.

Getting the structure right before closing

Borrower structure is hard to change once a loan closes: moving debt between entities means consents, new guarantees and new lien filings. Settle it in the term sheet. The lender package should show the legal chart, which entity owns which assets and contracts, where each loan will sit, who guarantees what, and how cash moves up to service anything above the operating company.

Transparent draws that chart into the financing model and the lender presentation, and tests coverage at each level so the permitted-payment terms can be negotiated with numbers rather than assumptions. Holdco vs opco debt sets the two side by side, and how we underwrite explains the approach.