1. Sell offs, spin offs, carve outs and tracking stock
Corporate Restructuring
Tim Thompson
© Timothy A. Thompson, 2007

2. Defining divestitures
Selling assets, divisions, subsidiaries to another corporation or combination of corporations or individuals
© Timothy A. Thompson, 2007

3. Company A without Subsidiary B
Divestitures
Company A without Subsidiary B
Subsidiary B
Company C
© Timothy A. Thompson, 2007

4. Divestitures (2) © Timothy A. Thompson, 2007
Company A w/o subsidiary B
Cash, securities or assets as consideration
Old Sub B
Company C
© Timothy A. Thompson, 2007

5. Features of divestitures
Selling corporation typically receives consideration for the assets sold
cash
securities
other assets
Divestitures are typically taxable events for selling corporation (new basis for purchaser)
© Timothy A. Thompson, 2007

6. Spin offs
Typically parent corporation distributes on pro rata basis, all the shares it owns in subsidiary to its own shareholders.
No money generally changes hands
Non taxable event
as long as it jumps through substantial hoops
© Timothy A. Thompson, 2007

7. Company A without Subsidiary B
Spin offs
Company A without Subsidiary B
Subsidiary B
Shareholders own shares of combined company. Own the equity in subsidiary implicitly.
© Timothy A. Thompson, 2007

8. Company A after spinoff
Spin offs (2)
Company A after spinoff
New company B
Shareholders receive
Shares of company B
Old shareholders still own shares of company A, which now only represent ownership of A without B.
© Timothy A. Thompson, 2007

9. Equity carve outs Also called partial IPO
Parent company sells a percentage of the equity of a subsidiary to the public stock market
Receives cash for the percentage sold
Can sell any percentage, often just less than 20%, just less than 50%, are chosen.
Generally, if the parent sells more than 20% of the stock to the market, the parent loses the ability to subsequently spin off the remainder of the stock to their shareholders in a tax free transaction.
With dual class shares outstanding, where each class possesses identical attributes except in connection with voting power, and if the parent retains the high voting power relative to the shares sold to the market, the parent can sell more than 20% to the market and still retain the opportunity to subsequently spin off the rest of the shares to their shareholders in tax free spin off.
Requirement that mandates parent control the spunoff sub immediately prior to the spin off. 80 percent of the total combined voting power of all class of stock will do.
Abercrombie and Fitch, Limited. Limited can sell as much as 40% of A+F and still meet requirements.
© Timothy A. Thompson, 2007

10. Equity carve out (partial IPO)
Company A without subsidieary B
Subsidiary B
Shareholders implicitly own 100% of equity of subsidiary B through their Company A shares.
© Timothy A. Thompson, 2007

11. Equity carve out (partial IPO)
Company A without subsidieary B
Portion of
Sub B equity
Not sold
X % of sub B equity sold
To market for cash
In IPO
X % of
Company
B shares
Shareholders now own 100% of Company A (without B)
And (1-X)% of Company B implicitly
Through their company A shares
© Timothy A. Thompson, 2007

12. Motivations for transactions
Market for corporate control
Asset are more valuable to alternative management team
Divestiture, spin off, carve out, tracking stock
Unlocking hidden value
Stock market problem or management problem?
Improving management incentives
Agency costs
© Timothy A. Thompson, 2007

13. Moving assets to more highly valued user
Division no longer has a “strategic fit”
Returning to the core business (undiversifying)
Buyers might simply be willing to pay too much!
Spin off, carve out, may set up a subsequent control transaction
Or the threat may improve incentives
These sources of gains are not equally gains from divestitures/spin offs/carve outs. They are all offered as potential gains from separating the parent from the subsidiary and may not apply to all types of split ups.
© Timothy A. Thompson, 2007

14. Focus management Part of undiversification
Easier to run, more able to focus efforts
Superior performance measurement
Because you can use direct equity for compensation (divestiture?)
By the stock market?
Reduction in bureaucracy/Decision making authority
Internal capital markets/external cap markets
© Timothy A. Thompson, 2007

15. Unlocking hidden value
Creation of pure play
Stock market issue, spin off/carve out/tracking stock
Market can’t value tobacco/food, steel/oil
Makes a control play for sub easier later
Sell high!
Internet subs in
Biotech
Gold subs/Japanese subs in late ’80’s
© Timothy A. Thompson, 2007

16. Other reasons Reduction in agency costs Tax/regulatory factors
Bondholder wealth expropriation
© Timothy A. Thompson, 2007

17. Divestitures
© Timothy A. Thompson, 2007

18. Stock price reaction to sell off
Statistically positive response (Table 10.5 in Gaughn), but small
Pre-sell off performance is contradictory
Good performance, may be leakage
Poor performance, may be reason for restructuring
Post-sell off performance of parent
Contradictory (Jain vs. Klein in Kaiser)
© Timothy A. Thompson, 2007

19. Motives for divestiture
Kaplan and Weisbach
Change of focus or corporate strategy (43)
Unit unprofitable or mistake (22)
Sale to pay off leveraged finance (29)
Antitrust (2)
Need cash (3)
Defend against takeover (1)
Good price (3)
Total (103)
© Timothy A. Thompson, 2007

20. Defensive divestitures
Company is worried about being taken over
sells “crown jewels” so they’re not attractive anymore
does an leveraged recap and sells the dogs
More generally, divestitures follow leveraged acquisitions
pay down debt and restructure company to be most valuable going-forward
© Timothy A. Thompson, 2007

21. Divestitures: government requirements
An acquisition by company C of company A (which owns company B)
Company B and Company C may represent an antitrust problem
Buy company A agreeing to divest company B
Bally’s spin off of Bally’s Health and Tennis Corporation justified spin off business purpose due to reduction in regulation expenses -- had to license all its officers/directors, personal investigation, because of gaming.
© Timothy A. Thompson, 2007

22. Divesting business unit to managers
All the above reasons are possible
Less bureaucracy, may no longer fit corp strategy
Leveraged buyout benefits as well
Can you get this with spin offs?
© Timothy A. Thompson, 2007

23. Divestiture vs. other restructuring
In divestiture is that buyer pays cash (usually) for the whole sub.
Depends on price. If the price (after tax) is better than spin off results, then sell. (May depend on strategic interests).
In divestiture, parent no longer controls.
In divestiture, parent stuck with liabilities buyer doesn’t want.
Divestitures move with the M&A market
© Timothy A. Thompson, 2007

24. Bad bidders become good targets?
Kaplan and Weisbach
271 large acquisitions completed
44% divested by 1982
Diversification acquisitions four times more likely to be divested
Mitchell and Lehn
Companies with “negative” responses to acquisitions tend to divest more frequently
Become takeover targets more frequently
© Timothy A. Thompson, 2007

25. Analysis Is division worth more to you or to buyer?
Present value of operating free cash flows at divisional WACC
Less divisional “debt” liabilities going with buyer
Compare with the after-tax, after-fees divestiture proceeds
Strategy value of keeping/divesting?
© Timothy A. Thompson, 2007

26. Buyers of acquired units
In contrast to acquirers of public companies
Buyer’s stock price reaction to acquisitions of units is small positive.
Jain finds this temporary, but studies of many more acquired units contradicts this finding.
© Timothy A. Thompson, 2007

27. Spin offs
© Timothy A. Thompson, 2007

28. Central features of spin offs
Spin offs are a distribution of subsidiary shares to parent company shareholders
As such, no money (necessarily) comes into the parent company as a result
No shares (or assets) of the subsidiary are sold to the market (IPO) or to acquirer (divestiture)
Distribution in most instances is tax free
© Timothy A. Thompson, 2007

29. Requirements for Tax-free Distributions
Section 355 of IRC, “Distributions of stock and securities of a controlled corporation”
“transaction not used principally as device for distribution of earnings and profit…,” I.e. a valid business purpose
active business requirement is met
Parent must control and must distribute control*
80% of control, not nec. 80% of market value
Continuity of interest and control requirement
Sub cannot have been acquired in last five years by parent in taxable transaction
Divesting parent or spun-off sub cannot be acquired within two years of spin off, or spin off loses tax free status
Getty Petroleum breaks itself into a real estate company and a gasoline retailing operating, via a tax free spinoff. Does real estate operation qualify as an active trade or business?
The real estate, namely gas stations, will be owned by Getty Realty Corp, however the stations will be leased back to Getty Petroleum Marketing Inc.
Regulations now say that, with regard to real estate a corporation rents/leases to others, the corporation will only be viewed as active if it “performs significant servies” and “substantial management and operational functions directly.”
Frequently, active business requirement can only be satisfied if an investment banker certifies to IRS that the client’s business objective is attainable.
ITT spun off insurance from automotive and entertainment, then entertainment from automotive. I-Bankers argued that automotive and entertainment needed to raise debt capital (cheaper source) to finance growth opportunities, but this conflicted with insurance ratings. For 2nd spin off, argued that entertainment needed to raise equity in order to finance acquisitions (P/E multiples would expand if it was separated from automotive so that equity could be raised!)
© Timothy A. Thompson, 2007

30. IRS Guidelines for Spinoffs
Generally acceptable business purposes:
provide an equity interest to employees
facilitate primary stock offering
facilitate a borrowing
cost savings, fit and focus, competition
facilitate a tax free acquisition of the parent (Morris Trust transaction)
Risk reduction
© Timothy A. Thompson, 2007

31. What if the spin off is taxable?
Corporate level
Parent corporation recognizes a gain equal to the difference between the fair market value of property distributed less the parent’s tax basis in the net assets of the divested sub
Can be very large or small, depending on the size of the gain
Shareholder level
Dividend taxable at ordinary rates, equal to the fair market value of the property received, that is, the fair market value of the spun off sub
Spin offs that fail to qualify are generally, cancelled
© Timothy A. Thompson, 2007

32. What’s a Morris trust?
Essentially it was a way to turn a taxable divestiture into a tax free spin off with a subsequent tax free merger
Spin off assets you want to keep to your shareholders in tax free spin off
Remaining assets are a sub you wanted to divest
Acquirer buys the remaining assets in tax free merger and avoided taxable aspect of divestiture
Two-year no acquisition of parent intended to eliminate the “Monetizing Morris Trust” transaction
© Timothy A. Thompson, 2007

33. Spin off as takeover defense
Hostile suitor
Spin off a division with highly appreciated assets
Acquirer buys parent triggers prior spin off to be taxable
Tax “poison pill”
ITT threatened this in battle with Hilton
© Timothy A. Thompson, 2007

34. Spin offs in 1990’s 1991-mid 1996, $100 bn in tax-free spin offs
Probably another $100 bn since
Huge ones
AT&T/Lucent Technologies/NCR
GM/EDS
Most much smaller
Internet subsidiaries of “bricks and mortar” parents
© Timothy A. Thompson, 2007

35. Spin off studies Older studies (Kaiser)
Some evidence of pre-spin off postive performance (18%, Miles and Rosenfield)
Positive reaction on average (2%)
Not due to wealth redistribution from bondholders on average (Marriott?)
Larger spin offs – larger % price reaction
Cusatis, Miles and Woolridge
Post spinoff positive performance both for parent and subsidiary
Both more active in takeovers
© Timothy A. Thompson, 2007

36. Spun off entity performance
On average, very good performance
Just correcting for value losses from earlier acquisitions?
Not all spun off companies are stars
3M/Imation
Interco/Converse & Florsheim
Allen Group/TransPro Inc.
Ralston Purina/Ralcorp Holdings
© Timothy A. Thompson, 2007

37. Some recent spin offs Pepsi/Tricon Whitman Corporation/Hussman/Midas
Pepsi originally wanted to establish a captive channel for fountain beverage business, but found they needed to alleviate competitive barriers to expanding that business (many more restaurant chains)
Whitman Corporation/Hussman/Midas
Conglomerate discount, conflicts among management of divisions
No synergies between bottlers/heavy industry/auto service
RJR/Nabisco Holdings
Tobacco litigation, discounting food company
Carl Icahn, Bennet Lebow
© Timothy A. Thompson, 2007

38. How can spin offs generate money for parent?
Borrow at the sub level and dividend to parent pre spin off
Borrow money sole recourse to sub, proceeds go to parent
Fraudulent conveyance problem?
Do a carve out first: internet subs
© Timothy A. Thompson, 2007

39. Variants of spin offs Split offs
Divesting parent corporation distributes stock in sub to its shareholders in exchange for some of their parent stock
Exchange may or may not be pro rata
May avoid 355 entirely
© Timothy A. Thompson, 2007

40. Limited split off Abercrombie and Fitch
Dutch auction
Limited’s shareholders specify an exchange ratio, within a range, under which they would exchange a share of Limited for a fraction of a A&F share ( )
After tabulation, Limited finds the ratio for which they can distribute 90% of A&F stock, probably won’t be prorata
Exchanging shareholders probably get a premium, with no tax
Benefits
Shareholders can rearrange holdings in parent tax free
Also, because the split off effects a buyback, there is less EPS dilution than a spin off
© Timothy A. Thompson, 2007

41. Equity Carve Outs
© Timothy A. Thompson, 2007

42. Tax treatment of carve outs
No shareholder tax, usually
If selling newly issued sub shares, then non taxable
If selling shares owned by parent, then taxable on gain!
Why do the latter? Produce income?
Avon Japan (1987), USG?
© Timothy A. Thompson, 2007

43. Carve outs Why sell a partial stake? Pure play
Get the stock market to understand business
Once unit is revalued, the parent will be revalued as well (still owns the rest)
Setting up a sale later
Make it harder to pierce the veil
© Timothy A. Thompson, 2007

44. Other motives for carve outs
Divisional managers incentives
Kraft/Phillip Morris
Thermo Electron
Sell “hot” properties
Gold subs in mid ’80’s
Japanese subs in late ’80’s
Internet subs in ’97-’99
Why not sell all of it?
© Timothy A. Thompson, 2007

45. Targeted stock
Special class of common stock designed to provide equity return linked to operating performance of a distinct business unit (targeted business)
Splits company’s operations into two (or more) publicly traded equity claims, but allows businesses to remain as wholly owned segments of parent organization.
© Timothy A. Thompson, 2007

46. Target stock vs. spin off
Spin off creates equity of subsidiary, but
subsidiary is no longer owned by, or controlled by the management of parent company
new spun off stock has no equity claim on the assets or cash flows of the old parent company
© Timothy A. Thompson, 2007

47. Target stock vs. carve out
Like a carve out, payoff on target stock is a function of the performance of the target business
Like a carve out, parent company mgmt usually maintains control over business, but control is 100% w/ target stock
Unlike carve out, the target shares are not subsidiary shares
© Timothy A. Thompson, 2007

48. Target stock is not stock of the targeted business
Target stock is stock of the consolidated company, not the targeted business (sub)
Does not represent legal ownership interest in the assets of the sub
Receives dividend rights against computed earnings of sub
Voting rights (in decisions of corp) float as function of market value of the equity of sub
© Timothy A. Thompson, 2007

49. Features of target stock
Reduces, but does not eliminate, cross-subsidization of business units
No legal separation or transfer of assets from corporation to sub
Target stock structure does not alter board or director composition or mgmt control of the corp
© Timothy A. Thompson, 2007

50. Features of target common
Features in each target share have to be decided:
Notional allocation of debt, other assets and liabilities
How will joint costs be allocated?
Proxy statement describing amendments to corporate charter, shareholder vote req
Non taxable event
© Timothy A. Thompson, 2007

51. Distribution of target shares
Pro rata stock dividend paid to existing holders
Sell target shares to new public investors, with remainder held by parent
proceeds retained by sub
proceeds allocated elsewhere in company
Shares issued in acquisition of target company
© Timothy A. Thompson, 2007

52. Cash flow rights Dividend policy subject to discretion of board
“Available dividend amount” =
fixed dollar level adjusted over time to net income, dividends or other distributions
fixed as % of target business net income attributable to Targeted shareholders
Same limits on dividends as usual
© Timothy A. Thompson, 2007

53. Voting rights Floating voting rights
proportional to market value of underlying business
Asset disposition and liquidation rights
in liquidation of corporation, distribution to shares would be in proportion to market value
if the parent sells the sub, net proceeds can be paid to target, or can exchange for target shares
© Timothy A. Thompson, 2007