EQUITY CARVE-OUT (ECO) AS A FINANCIAL
INSTRUMENT FOR CORPORATE RESTRUCTURING, WILL IT
WORK FOR THE PULP AND PAPER INDUSTRY?
V.R. (PERRY) PARTHASARATHY, PhD
WEYERHAEUSER COMPANY
PORT WENTWORTH, GA 31407
2007 TAPPI Engineering, Pulping and Environmental Conference, Jacksonville, Florida, USA
October 21 to 24, 2007
BREAKING UP IS GOOD TO DO.
Restructuring through spin-offs and equity carve-outs can enhance
Shareholder Value Creation (SVC)
o
Restructuring usually eliminates diffusion of management goals, a
problem that goes hand in hand with big, diversified companies.
o
When the aim is to focus on being the best at one or two things,
restructuring make sense.
o
Spin-Offs (SO) and Equity Carve-Outs (ECO) are used by large
corporations for restructuring purposes. Used judiciously, SO and
ECO are important financial instruments that help corporations
increase value.
CORPORATE EQUITY CLAIMS
There are three types of corporate equity claims:
o
o
o
Tracking (or Targeted) Stock (TS),
Majority-owned Equity Carve-Out (ECO) and
Spin-offs (SO).
CORPORATE EQUITY CLAIMS
The Tracking Stock (TS) is a class of common stock that is linked to
the performance of a specific business group within the diversified firm.
Equity Carve-outs (ECO) are an IPO of a stake in a subsidiary. The
parent usually keeps majority ownership.
Spin-offs (SO) occur when the entire ownership of a subsidiary is
divested as a dividend to shareholders.
TRACKING STOCK (TS)
o
The financial reporting is separate for the TS from the parent but the
control remains in the hands of the parent company.
o
TS is typically distributed as a dividend to shareholders of the parent
company and can also take the form of an Initial Public Offering
(IPO).
o
Even during its hay day, only two Pulp and Paper Companies had
taken advantage of this instrument but that did not result in the
enhancement of their corporate value.
o
By 2006, the TS as a corporate restructuring tool had disappeared
altogether and none was issued between 2001 and 2006.
EQUITY CARVE-OUT (ECO)
o
The ECO is different from TS in that equity partition creates welldefined equity claims on assets.
o
ECO is the sale of a subsidiary by a publicly traded company by
carving out a portion of its outstanding shares through IPO.
o
While the parent firm usually retains a controlling interest in the
partitioned subsidiary, each ECO, however will have its own board,
operating CEO, and will issue its own financial statement.
o
Equity Carve-Outs (ECO) increase the access to capital markets,
enabling ECO subsidiary strong growth opportunities while avoiding
the negative signaling associated with a seasoned offering (SEO) of
parent equity.
EQUITY CARVE-OUT (ECO)
o
o
o
In a twelve-year period between 1988 and 1999, the US stock market has seen 50 Carveouts, or about 10% of the IPOs issued.
While the number of IPOs issued had increased at least three fold between the years
1997 and 2006, the IPOs for ECO were not that many (Exhibit 1).
Over the years, ECO as a corporate restructuring vehicle has shifted, for financial gain to
strategic realignment.
Strategic
Reasons
Percent
Financial
Reasons
SPIN--OFF
SPIN
OFF
EXHIBIT 1.
The Trend in Asset
Disaggregation
Number
of Events
Strategic
Reasons
Financial
Reasons
- OUT (ECO)
EQUITY
CARVE
-OUT
EQUITY
CARVE
(ECO)
17
26
83
10
15
7
88
50
42
80
44
25
12
50
58
80
20
44
56
25
75
1988-1993
1994-1996
1997-2006
1994-1996
1997-2006
100%
80%
60%
40%
20%
1988-1993
Source:Bloomberg,
Bloomberg,Financial
FinancialExecutives
ExecutivesResearch
ResearchFoundation
Foundation
, Compustat
Inc. Compustat
SDC, BDCI
Source:
Inc.,
SDC,Analysis
BDCI Analysis
EQUITY CARVE-OUT (ECO)
One thing sure about ECO is the inherent assumption that the asset that is being carved-out
could not derive its full asset value under the existing corporate structure and a carve-out will
accurately value the subsidiary if, part of the equity is carved out and sold in an IPO (Exhibit 2).
EXHIBIT 2.
Equity Carve-Out
(Pros and Cons)
EQUITY CARVE-OUT (ECO)
o
o
Common equity is the cheapest yet the largest value distribution in the Enterprise
Valuation of a company with multiple business segments.
ECO gives a corporate parent an opportunity to get equity and at the same time
increase its market capitalization by virtue of restructuring one of the units as a
carved-out entity
TOTAL = 2000
200
Convertible Securities
*all values in million US$
Corporate
250 Overhead
400
250
Operation D
Debt
1750
350
EXHIBIT 3.
Valuation of an
Enterprise with
Multi-Business
Segments
200 Preferred
Operation C
Stock
450
1150
Operation B
750*
Operation A
Value of the
Operating Units
Enterprise
Value
Value
Distribution
Source: “Valuation” – Measuring and Managing the Value of Companies: McKinsey & Company, Inc.,
Common
Equity Stock
EQUITY CARVE-OUT (ECO)
o
o
Thermo-Electron (TE) is the most successful company to leverage ECO to deliver
high returns to its shareholders.
In 1982, TE was just a US $200 million company. By 1997, its market value was
$5200 million (a whopping 2500%) through frequent equity partition of business
segments and owning controlled interest in the ECO subsidiaries
EXHIBIT 4.
Thermo Electron’s
ECO Examples
EQUITY CARVE-OUT (ECO)
Equity Carve-Outs (ECO) out performed SO on three financial metrics, Total Shareholder Return
(TSR), change in leading P/E ratio and Return on Invested Capital (ROIC).
EXHIBIT 5.
Comparison of
Performance
Metrics for ECO
and SO
EQUITY CARVE-OUT (ECO)
The Booz-Allen & Hamilton and SMU/The McKinsey Company studies which
compared 78 merger deals between 1997 and 1998 and between 2002 and
2003 and worth more than $1 billion each, concluded that
o
48% of the mergers failed to deliver the promised cost savings over
the two-year post-merger period.
o
52 percent of them had fallen short of achieving the revenue growth.
o
Almost one-third of the companies delivered less than 40% of
the cost-savings that were used as the basis for the mergers.
The previous pulp and paper industry mergers (and the premiums
paid to acquire the companies) had been justified under potential
cost savings rather than revenue growth put a big dent on their
chance for success which came out to be true.
EQUITY CARVE-OUT (ECO)
ECO on average has the strongest TSR or SVC performance of any restructuring vehicle and the track
record of ECO on ROIC are far superior to Spin-offs (SO).
Positive
4
Slow Down of
Solid Performers
Great Earners Unfazed
EXHIBIT 6.
Very Few
Companies
Achieved Success
Through Mergers
Pre-Merger Revenue Growth
3
2
1
-2
-1
2
1
0
3
0
-1
-2
Negative
Bad Remains Bad
Negative
-3
Very Few Players Perform
Post-Merger Revenue Growth
Positive
Sample of more than 160 acquisitions by 157 publicly traded companies across 11 industries. Revenue growth calculated for combined entity
5 years before and after mergers (1996-2005)
Source: The McKinsey Quarterly 2001, Number 4.
EQUITY CARVE-OUT (ECO)
o
To deliver superior shareholder return, P&P industry can use, ECO as a
corporate restructuring vehicle.
o
For ECO to be successful, the parent company should have multi-segmented
businesses and that the subsidiary can be separated easily from the parent
without creating huge transfer-pricing issues and also the subsidiary should
have good prospects.
o
Out of the eighteen large U.S. and Canadian pulp and paper companies, only
six are truly multi-segmented businesses and only these companies can do an
ECO or spin-off.
EQUITY CARVE-OUT (ECO)
The majority-owned ECO is the most appropriate for P&P industry
because:
Out of the six P&P companies that are truly multi-segmented businesses, five of them
have debt to equity ratio over 1.5 and therefore suffer huge capital constraints.
ECO will allow the parent companies to raise capital at a fair-price and to fund projects
that might otherwise depress earnings.
EQUITY CARVE-OUT (ECO)
The majority-owned ECO is the most appropriate for P&P industry
because:
Certain businesses in pulp and paper companies, woodlands or lumber, for example, can
readily be separated without involving transfer price problems.
Before the ECO, both the boards need to review contractual agreements, including those
establishing transfer prices, and agree on sharing other supports such as R&D, sales
and marketing, and certain manufacturing resources, etc.
EQUITY CARVE-OUT (ECO)
CONCLUSIONS
Restructuring of corporations is usually carried-out to improve
performance.
A majority-owned equity carve-out is one such equity claim that would
allow the carved-out business units to improve performance by
exposing them to the capital market and attracting new investors.
ECO brings a new management team into the organization. This usually
results in improvement in operating performance, providing
incentives for managers and increasing their strategic flexibility.
EQUITY CARVE-OUT (ECO)
CONCLUSIONS
While mergers can be used as one of the tools to improve the
performance of the pulp and paper industry, for companies with
multi-segmented businesses, the ECO offers the best valueenhancing proposition
If judiciously applied, ECO can help corporate management to increase
value of both the parent and the carved-out subsidiary.
Thanks.