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Sell offs, spin offs, carve outs and tracking stockCorporate Restructuring Tim Thompson © Timothy A. Thompson, 2007
Defining divestituresSelling assets, divisions, subsidiaries to another corporation or combination of corporations or individuals © Timothy A. Thompson, 2007
Company A without Subsidiary BDivestitures Company A without Subsidiary B Subsidiary B Company C © Timothy A. Thompson, 2007
Divestitures (2) © Timothy A. Thompson, 2007Company A w/o subsidiary B Cash, securities or assets as consideration Old Sub B Company C © Timothy A. Thompson, 2007
Features of divestituresSelling 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
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
Company A without Subsidiary BSpin offs Company A without Subsidiary B Subsidiary B Shareholders own shares of combined company. Own the equity in subsidiary implicitly. © Timothy A. Thompson, 2007
Company A after spinoffSpin 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
Equity carve outs Also called partial IPOParent 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
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
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
Motivations for transactionsMarket 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
Moving assets to more highly valued userDivision 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
Focus management Part of undiversificationEasier 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
Unlocking hidden valueCreation 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
Other reasons Reduction in agency costs Tax/regulatory factorsBondholder wealth expropriation © Timothy A. Thompson, 2007
Divestitures © Timothy A. Thompson, 2007
Stock price reaction to sell offStatistically 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
Motives for divestitureKaplan 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
Defensive divestituresCompany 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
Divestitures: government requirementsAn 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
Divesting business unit to managersAll 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
Divestiture vs. other restructuringIn 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
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
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
Buyers of acquired unitsIn 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
Spin offs © Timothy A. Thompson, 2007
Central features of spin offsSpin 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
Requirements for Tax-free DistributionsSection 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
IRS Guidelines for SpinoffsGenerally 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
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
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
Spin off as takeover defenseHostile 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
Spin offs in 1990’s 1991-mid 1996, $100 bn in tax-free spin offsProbably 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
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
Spun off entity performanceOn 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
Some recent spin offs Pepsi/Tricon Whitman Corporation/Hussman/MidasPepsi 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
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
Variants of spin offs Split offsDivesting 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
Limited split off Abercrombie and FitchDutch 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
Equity Carve Outs © Timothy A. Thompson, 2007
Tax treatment of carve outsNo 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
Carve outs Why sell a partial stake? Pure playGet 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
Other motives for carve outsDivisional 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
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
Target stock vs. spin offSpin 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
Target stock vs. carve outLike 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
Target stock is not stock of the targeted businessTarget 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
Features of target stockReduces, 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
Features of target commonFeatures 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
Distribution of target sharesPro 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
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
Voting rights Floating voting rightsproportional 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
Sell offs, spin offs, carve outs and tracking stock Corporate Restructuring Tim Thompson.
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