Leveraged Recapitalizations &
Asset Restructuring
Chapter 13 Part 3
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Leveraged recapitalizations
• Same finance-driven reasons as financial acquisitions
• Deals produce leverage but co doesn’t go private
– See Interco in ch. 7, e.g. & Blasius deal in ch. 8
• Not always a good deal for s/h
• Increases risk of bankruptcy
• Even “scorched earth defense” can be well within BJR;
doesn’t necessarily even trigger Unocal review
– See Interco
• Simple deals – borrow money, pay dividend or buyback
stock
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Asset Restructuring
• M&A -like transactions that don’t fit definition
of merger or other fundamental corp change
• Legal: who decides?
• Financial: how is value created?
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Asset Restructuring Methods
• Divestitures/Asset Sales
– Sale of subsidiary, division or assets to third party usually
for cash
– Often sale of unrelated or geographically separate
– Divesting firms often have high leverage and/or are
experiencing losses
• Carve-outs
– Public offering of minority equity interest (e.g. 20%) in
subsidiary (IPO)
• Spin-offs
– Distribution of parent stockholdings in a subsidiary to
parent shareholders via dividend
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How Restructuring Creates Value: Seller
• A liquidity event (often, but not always)
– Taxes (tends to follow liquidity events; often, but not
always)
• Reducing costs via more precise management focus
– Harder to hide poor parent performance without
unrelated subsidiary
– Elimination of negative synergies e.g. lost sales because
competitors who won’t be subsidiary or parent customers
– Improved market-based capital allocation e.g. reduces
subsidies to weaker company
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How Restructuring Creates Value:
Seller
• Better monitoring by board/shareholders/market (i.e.
Improves firm transparency)
– Increases analysts coverage of “pure plays”
– Overcomes difficulty in valuing diversified firms
– Offers investors “pure plays” in parent & subsidiary stock
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How Restructuring Creates Value: Buyer
• Transfers assets to owners with higher valuation (e.g.
divestiture)
– Assets generally have synergies when combined with
buyer
• Improves subsidiary manager incentives (except divestitures)
– Stock-based compensation for subsidiary managers more
closely tied to specific operations
– More decentralized decision-making
• Improves board monitoring—a new board or more
independent subsidiary board of directors established
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How Restructuring Creates Value:
Buyer
• Improves market monitoring--Transparency
– Public disclosure of operations & financials reduces
information asymmetries - more accurate market
valuation of subsidiary
• Creates a market price for subsidiary equity increasing its
liquidity
– Makes it easier to sell remaining subsidiary stock (carveout)
– Improves subsidiary’s capital market access
– Managers able to sell stock in public market
– Subsidiary can use its stock as acquisition currency
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The Legal Dimension
• Who gets to decide?
– Divestiture
– Carve-out
– Spin-off
• So what legal review?
• Who is pushing restructuring?
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Empirical Evidence on divestiture
• Seller’s operations become more focused:
– Decrease in number of reported lines of business
– Divested assets are unrelated to seller’s main
operations in 75% of cases
– Seller’s remaining assets become more profitable
• negative synergies from divested assets
eliminated
• Performance gains related to improved focus
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Empirical Evidence on
divestiture
• Announcement returns to seller are positive (2%) overall and
more specifically reflect use of proceeds
– Positive for firms paying down debt (4.5%)
– Positive for firms expected to pay out proceeds
– Insignificant for firms expected to retain proceeds
– Stock price reactions are larger for firms in financial
distress (reduction of expected bankruptcy costs?)
– Stock price reactions increase as a fraction of assets sold
relative to a divesting firm’s total assets
– Announcement return higher if buyer has comparative
advantage in managing divested assets.
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Buyer motives
1. Assets with synergies when combined with a buyer operations—needs
transfer of control to realize gain
2. Assets are undervalued because managers or Target’s parent are not
efficiently using them
3. Target parent underestimates the expected future CFs
4. Buyer has large free cash flows and managers value growth above stock
value
First 3 hypotheses predict gains to buyers and fourth predicts a loss
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Buyer motives – evidence
• Empirical Evidence:
– Acquisitions of subsidiaries are much more
profitable than acquisitions of public companies larger buyer announcement effect
– Buyer stock prices fall back to pre-acquisition
announcement levels when proposed sales are
cancelled
– Firms with weak corporate governance generally
make less profitable acquisitions and more often
realize losses
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Divestitures follow M&A deals
• Strong correlation between merger & divestiture activity
– Number of divestitures averages 40% of number of M&A deals over
1979-1997
– Lower divestiture activity in years when stock market falls and higher
activity when stocks perform well
– LBOs lead to many divestitures
– Financial distress can trigger significant divestitures
– Antitrust or other regulatory authorities often force divestitures (e.g.
Exxon-Mobil $4 billion divested to get antitrust approval)
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Divestitures follow M&A deals
• What does close empirical relationship between M&A deals and
divestitures tell us?
– Buyer only wants part of Target and divests remainder
– Divestitures help pay for acquisitions
– Bust-up Takeover
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Equity Carve-Outs
• Initial public offering of stock in a wholly owned subsidiary
• Parent firm typically retains a controlling interest in the carved-out
subsidiary (median 80%); Assets of carved out subsidiary on
average represents 20% of pre-carve-out firm
• Means of raising funds (cash) in the capital market
• Reduces parent managers’ control over subsidiary; former
subsidiary managers have greater control, often more high-powered
incentives and report to their own board
• After the carve-out, the subsidiary subject to SEC disclosure
requirements and its board of directors subject to state law fiduciary
duties
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Carve-Out tax treatment
• Parent recognizes capital gains or loss recognition on the
cash raised in carve-out
• Sub can borrow cash and pay it to parent as a dividend,
before a spin-off of remaining 80% of stock without changing
tax treatment of the transaction
• If carve-out leaves behind 80% or more, then parent can
continue to benefit from tax consolidation of sub
• No tax consequence if sub keeps cash raised in sale of stock
– later sub could pay cash to parent – but to avoid an IRS
challenge to tax-free treatment of prior sale of stock, it must
be “old and cold”
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Evidence on carve-outs
•
Positive announcement stock return (2-3%)
– Positive returns when proceeds are paid out to creditors or
shareholders (7%)
– Insignificant returns when proceeds are retained for investment
purposes
•
Stock announcement return increases in its relative size
•
Prior to initiating a carve-out, parent firms have
– Higher leverage than industry norm
– Lower interest coverage ratios
– Poor operating performance compared to industry
 Consistent with managerial discretion hypothesis
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Carve-outs: What happens next?
• Most carve-outs are followed by a second ‘event’:
– Shares initially retained by parent are sold to another firm
or its management, or spun off (within 1-3 years)
– Subsequent tax-free spin-off of 80% ownership
– Subsequent public offering of parent’s remaining stock
– Parent reacquires subsidiary shares (within 4-5 years)
– Positive stock returns for parents and subsidiary on
announcement of second event
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Corporate spin-offs
• A distribution of shares in a subsidiary to shareholders of the
parent company as a dividend
• Distribution is usually pro-rata and does not change the
proportional ownership of parent and subsidiary
• No inflow of capital
• The spinoff separates the common stock of the parent and
subsidiary companies for subsequent trading
• Grants complete operational decision-making authority to the
subsidiary’s management team
• One way to divest assets on a tax-free basis
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Tax-free spin-offs
•
For a spinoff to be tax free (i.e., tax is deferred for shareholder until sale
of the subsidiary stock) Section 355 of Internal Revenue Code requires
that:
•
Spinoff is motivated by a valid “business purpose” (not a tax free
distribution of earnings)
•
Both subsidiary and parent actively conducts some business for at least
5 years prior to the spinoff
•
Parent owns at least 80 percent of subsidiary
•
Parent distributes all its securities in the subsidiary and retains no
‘practical control’
•
Beware of anti-Morris Trust provision of sec 355(e) IRC - makes spinoffs by Target within 2 years of a merger taxable to Target firm, even
retroactively
•
If taxable, shareholders are treated as receiving a dividend
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Why do spin-offs create value?
•
Added tax advantages – spin-off need not be a corporation
– REITS and some royalty trusts pay no taxes
•
Regulatory advantages
– Frees parent from regulations on a sub, such as a utility or bank
– Circumvents US restrictions on foreign subsidiaries
•
Wealth transfer from creditors to stockholders
– Due to transfer of too much or too little debt to the subsidiary being
spun-off
•
But …..
– Legal separation of entities is needed prior to spinoff
– Debt can be protected by change of control provision
– Tempered by threat of bondholder class action suits
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Empirical evidence on spin-offs
• Positive stock price announcement reaction (3%
return)
• Announcement returns increases with relative size
of spun-off subsidiary as a percent of parent assets
• Insignificant returns to bondholders at spin-off
announcement
• Significant improvements in performance & growth
(in sales, earnings and assets) for both parent and
subsidiary, when both are in different industries
• Increased probability of becoming a takeover target
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Asset restructuring variations
•
Spin-outs: Partial spin-off where parent retains some subsidiary shares
•
Split-offs: Exchange of subsidiary stock for some parent stock. Can be
tax-free & is used to breakup family-owned business facing divisiveness
•
Split-ups: Incorporate two new corporations from company assets.
Exchange stock in two new companies for all the outstanding old stock
of parent – reverse consolidation
•
Joint Venture: When one or both parents contribute a subsidiary to
establish JV
•
Eliminate Minority Interest: Dispose of parent’ non-controlling
shareholdings in another corporation
•
Asset Swap: Two companies exchange divisions or subsidiaries
•
Piecemeal Liquidation: Subsidiaries and divisions can be separately
sold off and proceeds distributed to shareholders
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