In this article, I’m going to focus on a Strategy we call the Portfolio Incubator Strategy. To gain increased returns and manage risk, we’ve developed a Portfolio Incubator within our Fast FI Club that’s used to sculpt deals, private investments, privately owned IP, and customize a Holding Company Portfolio.

When people talk about buying businesses, oftentime they discuss Deal Flow which is important, but that’s only one part of what makes an investor successful. The Portfolio Incubator Strategy focuses on generating the perfect deals and investments through deal sculpting rather than relying solely on multiplying the deals investors get their eyes on.

At an institutional level, this means that the organization can sculpt acquisition deals and investments according to their investing strategy, purpose, and mission.

At the individual level, this means an individual investor can take a wholistic view of all their streams of cash flow in order to build a holding company that aligns with their unique purpose, mission, investing strategy, and abilities. The individual might want to include writing books, maintaining a blog, patents and inventions, or self managing companies which they can accomplish by sculpting their portfolio to their needs.

The benefit of this approach is that you can utilize a Portfolio Incubator Strategy to create your custom Holding Company Portfolio and design your parameters into each deal, cash flow stream, and investment.

What is a Holding Company Portfolio?

The Holding Company Portfolio is similar to the entity structure and investing strategy that Warren Buffett used to scale his investing portfolio to become the richest man in the world. Although many top investors utilize similar investing mechanisms, it’s rarely understood outside of private equity.

I’ve adapted the core strategy and translated it to a process that we setup within our deal structures and investment strategies. To explain the idea, let’s start with a metaphor.

Imagine a quilt.

Each section can be customized individually, then sown together into a whole. By aligning all the unique designs, you can achieve a personalized quilt that’s unique to your needs.

A Holding Company Portfolio is similar. The Holding Company Portfolio says that the best investments are the deals that you have control over setting the parameters of the investment. For our discussion, I’m going to focus on business acquisition and deal making, but the portfolio incubator is a flexible framework that can work beyond business investing.

A few levers of investing that you’ll want to consider are:

• Growth: Dial up growth with debt, technology focused investing, and immediate reinvestment of returns into growth activities.

• Cash Flow: Small businesses offer a unique ability to cash flow at a high return. By prioritizing cash flow you can accelerate the use of cash to fund expenses, other investments, and lifestyle choices now, rather than wait an ambiguous number of years for future returns.

• Return: Small business investing offers incredible returns (read 32% Return – The Investing Strategy that Beats Billionaires), which can be amplified by being an anchor investor who brings other investors into a deal. How about you add a side car agreement or an equity kicker to a deal you participate in? The buffet of options are endless with a Holding Company Portfolio approach.

• Risk Management: Increase or decrease the required debt ratios. Add the audits of your choice, or perhaps manage tailwind risks. All this and more can be done with custom written investment theses, and a Portfolio Incubator (More on this later).

• Impact Investing: What causes are meaningful to you? By being the large fish in a small pond, you amplify your ability to make your investments impact the cause of your choice while still maintaining a high return on investment.

• Diversification: Whether it’s geographic diversification, industry diversification, or class diversification, deal sculpting focuses your efforts on your risk management needs.

• Black Swan Risks: Do you believe there’s a coming economic depression? War? Maybe there’s simply a unique hedge you want to design based on your current portfolio’s risk. Perhaps there’s a 1% chance of a catastrophic event that you want to protect against. Why not customize part of your portfolio for that contingency while not sacrificing return?

When you’re the early, large, or primary investor in the deal, you get a large say in how the contract, operating agreement, cash flow terms, and the full deal structure is written.

This is the benefit of being a large fish in a small pond and sculpting a deal from the start.

This is also the core element of the Holding Company Portfolio technique. Design custom investments that allow you to assemble the portfolio that fits your needs.

Holding Company Portfolio Commandments

Since our Holding Company Portfolio focuses our efforts on deal sculpting rather than blind deal flow, our approach to investing takes a different track. We want to focus first on the guiding framework and develop a set of investing theses that mutually support each other. Then we move into the execution phase.

Here are the tenets of a Holding Company Portfolio:

1. Small is Beautiful: Small business investments mean that we have more control over sculpting the details of the deal. This in turn allows us to create the outcome we’re looking for. Small businesses also sell for lower multiples and offer higher returns then most other asset classes.
2. Deal Sculpting over Deal Flow: Forming a deal from scratch or getting in early with experienced acquisition entrepreneurs allows you to integrate your portfolio needs into the initial deal structure. A good way to accomplish this is a seed search fund within a Portfolio Incubator (more to come on this) or simply finding acquisition entrepreneurs early in the search process. Generally, you want to stay away from start-ups within the Holding Company Portfolio strategy for these three reasons.
   1. Failure Rate: Start-ups have a high failure rate and require a much larger number of investments to diversify the risks that start-ups carry.
   2. Uncertain Portfolio Make-up: Start-ups have less certainty over the end portfolio result when compared to buying existing businesses. This means you can’t effectively control the levers of investing discussed previously, thus negating the goals of the Holding Company Portfolio.
   3. Start-ups aren’t Scalable: Some start-ups scale others don’t, but they don’t provide a scalable way to sculpt your portfolio allocation. When developing a Holding Company Portfolio using a Portfolio Incubator, we seek to limit our start-up exposure to 10% or less of our full portfolio construction.
3. Utilize a Portfolio Incubator: A Portfolio Incubator is an ideal mechanism for deal sculpting as envisioned within the Holding Company Portfolio. Within a Portfolio Incubator, an investor or investor group can develop theses, hire executives to execute a search targeting those theses, and onboard an executive team to run a newly acquired business. This allows the investor group to sculpt their deals from the start and align them with their portfolio needs.
4. Develop 10+ Roll-up Investing Theses: It takes 10+ uncorrelated asset classes to effectively manage a portfolio’s risk. Investors can accomplish this by developing mutually reenforcing investing theses utilizing a roll-up structure and working with companies like ours to execute the Portfolio Incubator Strategy. This allows you to scale your investing solution while diversifying risk and sculpting the deals to your needs. As you build out your core portfolio, you can continue to generate additional roll-up investing theses to further buy down your risk and balance your portfolio adding greater diversification.
5. Long Term Perspective: Developing a portfolio of roll-ups isn’t a short term strategy. This means  you’ll want to plan 3-5 years out and create a ladder of investments gradually moving your investments from lower-performing, public market investments into your Portfolio Incubator to create your Holding Company Portfolio of tailored deals.

Let’s walk through how to go about designing your Holding Company Portfolio and get into the core mechanisms for success.

Step 1: Envision your Perfect Portfolio

In order to determine where you want to go, it’s important to take some time and establish a vision for your ideal portfolio. To start let’s begin with developing a snapshot of where your portfolio is today.

Portfolio Snapshot: Balance Sheet and Risk Profile

What are your current assets? Let’s take a moment and fill out a Balance Sheet and a Risk Profile to help you develop a more complete picture of your portfolio as it stands right now.

Let’s begin by developing a Portfolio Balance Sheet and Risk Profile. Click here to open our resources page and download our free Portfolio Snapshot Spreadsheet where we offer a template to develop your portfolio’s Balance Sheet & Risk Profile.

Create a list of your assets and write out your past returns to determine how correlated they are. This can be as complex or simple as is useful for your situation. If you don’t know how to grade your assets’ risk profile, talk with your CPA or investment advisor to help develop your risk profile.

In order to get a complete picture of your risk portfolio, it’s important to include both expert judgement and an understanding of a risk model. Judgement looks for the gaps in the risk model and where the model breaks down whereas risk models apply the basic portfolio risk theory to your actual returns.

Judging Risk

• How does this asset perform compared to your other assets in the normal business cycle ups and downs? Look at companies that operate in similar industries and how their earnings look in past recessions and expansions. Does your asset’s value or cash flow follow a normal business cycle or is it countercyclical or entirely unrelated?

• Geographically how diversified is the asset from your other assets? Is your asset highly susceptible to the local market, the national market, or some other geographical function?

• Is this asset on a long-term upward or downward trend?

• What other factors affect the success or failure of your asset?

• How would this asset perform in an 80 year financial storm (2008 Financial Crisis, 1930’s depression) in relation to your other assets? I suggest looking at Ray Dalio’s video primer and his book on long term debt cycles to get an understanding of the 80 year economic storms. How would this asset perform in the 4 seasons of investing (high interest rate inflationary, low interest rate growth market, low interest rate stagnation, high interest rate deflation).

Managing risk is a more complicated topic than I can fully delve into here. Suffice it to say that historical data for investing is important to understand while also highly suspect in forecasting the future since that data changes the decisions investors make today. 

Investing narratives rule until they’ve over-inflated asset prices attached to that narrative; then they fail. Commonly accepted investor wisdom, generally hits its widest adoption right as the narrative fails to deliver historic returns due to the dynamics of decreasing yield and increasing asset prices (aka a bubble). When narratives fail, bubbles pop.

Portfolio Goals

What are your portfolio’s goals?

We want to specifically quantify what you’re trying to achieve with your portfolio to determine how to best sculpt your Holding Company Portfolio.

This is where the basic tenets of deal sculpting come into play. Here’s a list of the different asset levers mentioned previously for consideration: growth, cash flow, return, risk management, impact investing, diversification, and black swan risk.

Ask yourself:

• What are my portfolio’s goals?
• What is my risk tolerance?
• What are the levers of deal sculpting that matter the most to me?
  • Levers: growth, cash flow, return, risk management, impact investing, diversification, and black swan risk.
• Where do I want my portfolio to be in 1 year? 3 years? 5 years? 10 years?
• What’s my personal and portfolio’s long-term legacy?
• What are the key success milestones over the next 3 years?
• How will I measure success?

Step 2: Deal Sculpting: Develop your Uncorrelated Investing Theses

Now that we have a clear set of portfolio goals and a picture of the risk management profile we’re targeting, we want to create or adopt 10 separate investing theses that reenforce each other. Each will serve as a roll-up allowing us to gradually build-out a high performing, risk managed portfolio of high return small business assets. Since we set the parameters of the investing thesis, we have control over the investing levers that allow us to setup risk and return and reinvest as desired by acquiring new assets in each individual roll-up.

This is the Portfolio Incubator strategy. We develop a process to incubate the right deals to create our Holding Company Portfolio.

Step 3: Seed Platform Search Fund

After we develop a set of investing theses, then we fund the seed search fund(s) theses or invest in other roll-up theses in line with our portfolio goals. The target here is to hire an operator to run the search and onboard the new acquisition. Each acquisition has an Overwatch Executive Team and an executive overseeing the search and acquisition process. This person may be a transitional role or the final executive who will be running the business.

If the funds are available we can hire multiple seed operators and handle multiple seed roll-up acquisitions at once, although generally this is staggered to allow for a pipeline of acquisitions.

The goal is to lay-out a plan for growth through acquisition that will allow us to continue to buy down risk within the roll-up by acquiring multiple acquisitions with relatively uncorrelated businesses that use the same core competencies as well as consolidate best practices and an overwatch team who can audit the business and serve as the board of advisors.

The Overwatch Team

The Overwatch Team is a team of executive operators and advisors who are available to coach and step into operations if anything goes wrong in running any business in the network, any search, or the actual onboarding of a new business. They serve as board members and external auditors to business finances, processes, and operations. Furthermore, the Overwatch Team are made-up of high performing operators who could be tasked to step into a business and run critical processes during transitions or rebuilding periods. The overwatch team is also available if there is a need to rebuild the management team. 

A network of top level fractional executives provides a boon to every business in the network since the right specialty can be pulled in from within the broader ecosystem. We utilize a pay-as-you-go model that lends to a cost advantage over a full hire or hiring a fractional executive service which routinely cost twice as much or more than our methodology allows.

Step 4: Acquisition of a Platform Business with an X-Factor Strategy

Once the initial platform business is acquired, then the executive team builds out the core processes to allow for rapidly sharing and scaling best practices, processes, and people across multiple businesses within the network and within the roll-up.

X-Factor

Each roll-up should have an X-Factor. The X-Factor is the top level strategic brand, core competency, or cost advantage that provides a strategic competitive advantage to the roll-up by adding additional value for every business added into the roll-up. This can be a technology platform, media platform, franchise concept, or a similar roll-up multiplier that allows for the sum of the parts adding up to more than the individual businesses (cost structure advantage, network effect, …etc.).

Generally, 20%-40%+ growth can be achieved through a combination of organic growth, X-Factor development, and acquisitions of new small businesses.

With each acquisition in the roll-up, the risk is spread across more channels, localities, brands, and product lines. Also, each acquisition adds value to the platform business due to the X-Factor strategy so the collection of businesses are more valuable then any individual business.

Step 5: Holding Company Portfolio – Scalable Investments, Risk Reduction, and Competitive Advantage

The collection of roll-ups provide an increasingly diversified set of high return businesses creating an ideal, high return portfolio that we call the Holding Company Portfolio.

This beneficial fly wheel of high returns and decreasing risk comes together with a top level holding company. This holding company can be setup for an individual, a family office, an investing club, or a group of investors. The holding company becomes a network of sister business roll-ups that continually reduce the risk (measured by annualized return standard deviation) across the portfolio of investments to result in an increasingly diversified set of investments lining up with the original portfolio theses.

By planning the full set of small business theses and utilizing seed search funds, the different roll-ups can be identified and platforms modeled that will allow for a consistent pipeline of acquisitions and a beneficial set of core competencies cultivated by the network of sister of businesses.

For example, purchasing business service businesses allows us to develop an in-house cost advantage against companies that aren’t within our network of businesses. Although we will want to utilize our in-network business core competencies, we also keep the revenue from within our network for any individual business at a manageable 20% or less to prevent increasing correlation and risks from our Holding Company Portfolio.

Overwatch Insurance

While we develop a natural diversification through increasing our businesses and dividing our assets across 10+ roll-ups and multiple businesses within each roll-up, we can further manage the risk of the network of businesses by focusing our efforts on elevating our overwatch executive teams to providing an Overwatch Insurance for any business in the network of owned, or managed businesses.

Overwatch Insurance is a service provided by the holding company or management company to all the sister businesses in the network of owned, or co-owned businesses. Overwatch insurance allows for the individual business units to pay into a top-level insurance program that funds an eventually executive leadership team transition, and provides the capital to take-over and fix any business with management problems in the network of businesses. This buys down the management risk correlation between sister businesses within the holding company.

The correlation between assets and small businesses falls with each acquisition added to the set. Independent roll-ups and autonomously managed operators continue to diversify the management risk, while the holding company provides Overwatch Teams and Overwatch Insurance across the set of businesses to further decrease the risk of failure and maximize the chance of success.

The full strategy allows for managed risk, high return, and a scalable model of growth.

Step 6: Exiting and Rebalancing the Holding Company Portfolio

Each business roll-up and individual business will be developed as independent entities within successively larger entities (business>roll-up entity>Holding Company). This separation and loose coupling allows for a rebalancing of assets by selling shares of businesses to partnering investors as well as providing the ability to easily sell off entire businesses or a group of businesses when the portfolio manager decides to rebalance or target a new thesis for investing.

This provides a natural exit from any individual position within the larger collection of businesses. The loose-coupling and in-house acquisition of business services, X-factor platforms, and core competencies also allows for the individual businesses to keep running profitably if sold while still providing a network effect to the larger set of sister businesses.

Collecting multiple businesses within the roll-up allows for increasing the valuation multiple while generating cash-flow, offering high returns, and developing unique competitive advantages. The full strategy provides exceptional returns, managed risk, and the flexibility to transition between different portfolio positions to maximize success across the portfolio.

The Portfolio Incubator Strategy is the core methodology of our Fast FI Investing Club. If you’d like to learn more about the methodology that we employ, then check-out the the following articles and resources:

• De-Risk High Returns | Companion Spreadsheet
• 32% Return: The Strategy the Beats Billionaires
• Beating Buffett: Fast FI Portfolio Guide – Also found on our Resources Page.
• Search Fund Primer – See our Resources Page
• Beating Buffett Infographic
• Debunking Wall Street Wisdom
• Passive Money Machine: Fast FI Strategy of Investing