Spin-Offs and Other Forms of Restructuring
Slovin, Shusha, Ferraro (1995), Nanda (1991), Schipper and Smith (1986), Schipper and
Smith (1983),
In the last decades there has been a trend towards refocusing in the core business
of firms. This refocus involves restructuring activities by divesting units that do not fit in
the core business of corporations.
As future financial managers you need to be acquainted with the different
alternatives to divest an undesired productive unit, and the different valuation effects
associated with each alternative.
There are three major forms in which a firm can divest: Asset sale-off, spin-offs
and equity carve-outs. Empirical results indicate that these three events create value to
shareholders. We will analyze the sources of these gains.
1.
Equity carve-outs:
The parent firm issues equity of a subsidiary. The parent firm receives the cash,
and the buyers of the stock are new shareholders of the subsidiary firm. It is very
common to observe that the parent firm maintains a controlling interest in the subsidiary
that is being carved-out. These transactions create value for the shareholders of the
partner firm (increase in abnormal return on the announcement date).
What are the sources of these gains?
a) Better management of the now independent carved-out firm.
1
b) It is easier to set up better incentive based contracts in the independent unit.
Now there is publicly traded equity of the division and managers can be
compensated based on the stock performance (reduction of agency problems).
c) There is a greater monitoring and information production about the new firm
(analysts, rating agencies, and other firms in the industry.. etc), that should
reduce the cost of capital of the firm.
d) Financing motives (discussed later)
2.
Spin-offs:
Spin- offs are similar to equity carve-outs in that they involve an equity issuance
and a new firm is created. However, the parent firm does not receive cash in the
transaction because the new shares are distributed to the existing shareholders as a pro
rata dividend. This implies that the shareholders of the new independent firm will be the
same as the shareholder of the parent firm (this is not the case in equity-carve-outs).
These are usually tax-free transactions (if the parent firm distributes at least 80% of the
shares of the subsidiary), thus the parent firm does not control the subsidiary being spunoff.
These transactions also create value to shareholders. The reasons of the wealth
creation might be the same as in the case of an equity-carve-out. The difference is that
the parent firm does not receive financing in the transaction.
3.
Asset sell-offs:
The subsidiary is sold to a third party, so no new firm is created, and the parent
firm receives cash in the transaction.
2
Asset sell-offs also create value to shareholders of the parent firm (the selling part
in the transaction). Because no independent firm is created the sources of value are
different from those of spin-offs and equity carve outs.
The three types of transaction (spin-offs, equity carve outs and asset sell-offs)
should negatively affect the parent and subsidiary rival firms.
If you think about these transactions as financing alternatives to equity issuances,
how would you justify the selection of one of these transactions?
In an equity carve-out, the firm is issuing equity in a subsidiary, instead of issuing in the
parent firm. This can be justified if managers believe that the parent firms stock is
undervalued, and the subsidiary is overvalued. If this is the case, the equity carve out
should convey good news to the parent firm and bad news to the subsidiary. Empirical
studies show a positive reaction to the parent firm and a negative reaction to rivals of the
subsidiary firm. These results are consistent with the view by managers that the parent
firm is undervalued and the industry in which the subsidiary operates is overvalued.
These empirical findings suggest that equity carve-outs can be regarded as a
substitute to equity financing.
A spin-off involves no cash exchange and the wealth implications to rival firms
should be different.
Finally, the cash originated in an asset sell-offs can be regarded as the avoidance
to issue public equity. The sale is a private transaction and the gains might be derived
from the avoidance of negative implications of issuing public equity.
The empirical evidence indicates that rivals of subsidiaries of equity-carve outs
experience a loss of wealth at the announcement of the equity-carve out. However, rivals
3
of spin-offs experience positive returns, and there is no significant gains or losses of units
that have been sold in an asset sell-offs.
These results indicate that part of the gains of divestitures might result from the
existing asymmetries of information between managers and shareholders, and not from
efficiency considerations. If value is created because the new managers can improve the
efficiency of the subsidiary, then rivals to the divested subsidiaries should exhibit
negative returns. The study of rival firm in equity carve-outs is consistent with managers
conveying positive information about the parent firm and negative information about the
subsidiary because the price of a share of the parent firm increases and the price of the
rivals’ equity decreases. Announcements of spin-offs create value for rival firms, which
is inconsistent with the efficiency hypothesis. Parent firms can choose a spin off instead
of an equity carve out if they do not have negative private information about the
subsidiary, which would cause the price of rivals of the subsidiary to increase.
Finally, an asset sale can create value for the parent firm because managers are
avoiding issuing equity, which signals that the price per share can be too low
(undervalued).
4
Tacking Stocks (TS)
This is not a divestiture per se, but in some cases it may be an alternative to
divestitures. The following paragraphs are taken from the paper “Rearranging residual
claims: a case for targeted stock”, Dennis E. Logue, James K. Seward, James P. Walsh
Financial Management, Spring 1996 v25 n1 p43(19)
I. What is Targeted Stock?
Targeted Stock is a special class of a corporation's common stock or possibly
preferred designed to provide an equity return linked to the operating performance of a
distinct business unit, sometimes referred to as the targeted business. A Targeted Stock
transaction typically splits a company's business operations into two (or more) publiclytraded common equity claims but allows the businesses to remain as wholly-owned
segments of a common parent organization.(1) Thus, rather than a single class of
common stock, which reflects the aggregate value of all of the business units of the firm,
the value of each targeted business is reflected in its own class of common stock, the
Targeted Stock.
It is important to recognize that Targeted Stock is common stock of the consolidated
company and not of the subsidiary itself. As a result, Targeted Stock does not represent a
legal ownership interest in the assets of the targeted business and subsidiary. Targeted
Stock owners receive dividend rights against the computed earnings of the targeted
business division, thus reducing, though not eliminating, the prospects of one business
cross-subsidizing another over a prolonged period. However, there is no legal separation
or transfer of assets from the corporation to the targeted business. The total value of the
5
common stock of the firm is equal to the aggregate value of all of the firm's Targeted
Stock, which is, presumably, equal to or greater than the value of the common equity if
no Targeted Stock arrangement had been adopted. From a corporate governance and
control perspective, the Targeted Stock structure does not alter board of director
composition or management control of the corporation
Overall, Targeted Stock is an equity-based method of restructuring that provides many of
the benefits associated with the creation of separate public equity securities, while
preserving certain advantages of remaining a single, consolidated entity.
II Among the benefits of creating separate public equity securities, Targeted
Stock
1) Allows the financial markets the opportunity to value disparate businesses
according to their relevant individual operating fundamentals,
2) Provides for a choice of acquisition currency; this is the parent firm can pay with
different classes of stock (currency)
3) Allows dividends to be set on the basis of performance in each targeted business
unit.
4) Allows stock-based management incentive programs to be designed for each
targeted business unit.
Targeted Stock also preserves the following features associated with remaining a
consolidated entity:
1) No change in management or the board of directors,
6
2) Preservation of tax consolidation,
3) Retention of operating synergies that would be lost if integrated businesses
became independent, and
Retention of consolidated debt capacity and existing lending arrangements.
III Potential Disadvantages and Implementation Impediments
1) The targeted business retains continued exposure to the liabilities of the
consolidated entity;
2) The board of directors may find itself challenged to meet the fiduciary
responsibilities to the shareholders of all classes of common stock, hence not
favor one or the other group in deciding certain cost allocations, particularly when
there is conflict,
Costly conflicts among managers of different target businesses may arise as a
consequence of cost allocations or any other internal transfer transaction that could
potentially reduce their target business notional earnings, the typical basis of actual
dividends and management
7