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© Timothy A. Thompson, Sell offs, spin offs, carve outs and tracking stock Corporate Restructuring Tim Thompson
© Timothy A. Thompson, Defining divestitures Selling assets, divisions, subsidiaries to another corporation or combination of corporations or individuals
© Timothy A. Thompson, Divestitures Subsidiary B Company A without Subsidiary B Company C
© Timothy A. Thompson, Divestitures (2) Company A w/o subsidiary B Old Sub B Company C Cash, securities or assets as consideration
© Timothy A. Thompson, 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, 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, Spin offs Company A without Subsidiary B Subsidiary B Shareholders own shares of combined company. Own the equity in subsidiary implicitly.
© Timothy A. Thompson, 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, 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.
© Timothy A. Thompson, 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, 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 Shareholders now own 100% of Company A (without B) And (1-X)% of Company B implicitly Through their company A shares X % of Company B shares
© Timothy A. Thompson, 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 Divestiture, spin off, carve out, tracking stock Agency costs Divestiture, spin off, carve out, tracking stock
© Timothy A. Thompson, 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
© Timothy A. Thompson, 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, 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, Other reasons Reduction in agency costs Tax/regulatory factors Bondholder wealth expropriation
© Timothy A. Thompson, Divestitures
© Timothy A. Thompson, 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, 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, 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, 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
© Timothy A. Thompson, 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, 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, Bad bidders become good targets? Kaplan and Weisbach 271 large acquisitions completed % 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, 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, 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, Spin offs
© Timothy A. Thompson, 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, 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
© Timothy A. Thompson, 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, 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, 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, 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, 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, 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, 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, Some recent spin offs Pepsi/Tricon 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, 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, 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, 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, Equity Carve Outs
© Timothy A. Thompson, 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, 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, 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, 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, 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, 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, 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, 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, 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, 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, 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, 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
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