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Restructuring Organization and
Ownership Relationships
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• Company owns or creates a subsidiary whose shares are distributed on a pro rata basis to shareholders of parent company
• Subsidiary becomes publicly owned corporation
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• Parent company often will retain from
10% to under 20% of shares of the new subsidiary
• Spin-off often follows the initial sale of up to 20% of the shares in an initial public offering (IPO) — transaction known as an equity carve-out
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• Event return studies of spin-offs
– Significant positive 3-5% abnormal return to parent shareholders
– Size of announcement effect positively related to size of spin-off
– Spin-offs to avoid regulation experienced abnormal returns of 5-6% as compared to
2-3% for the remainder of the sample
– No adverse effect on bondholders
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– Tax effects
• No positive abnormal returns for taxable spin-offs
• Positive abnormal returns for nontaxable
• Controlling for size, tax effects disappear
– Both spin-offs and their parents are more frequently involved in subsequent takeovers
• Firms which engage in no further restructuring activity earn only normal returns
• Firms which engage in subsequent takeovers account for positive abnormal returns
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• Performance studies of spin-offs
– Bregman
• Annualized returns were 31.8%, 18 points better than S&P 500
– Karen and Eric Wruck
• Spin-offs outperformed overall stock market
• Few spectacular performances dominated results
– Forbes study
• Combined stock performance of parent and spinoff
– 40% did better than S&P 500
– 60% underperformed
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– Anslinger, Klepper, and Subramaniam (1999)
• Sample of 12 spin-offs achieved returns over a two-year period of 26.9% compared to 17.2% for the S&P 500
• 8 spin-offs underpeformed index
– Mixed results may reflect characteristics of industries
– Firms in industries with excess capacity or low sales growth underperform broader indexes
– Results should be related to industry peers
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• Tax aspects of spin-offs
– Spin-off qualify for tax-exempt status if parent company own 80% of voting subsidiary stock
– Spin-off transactions
• Companies spin off with two classes of stock
– Parent sells nonvoting class of stock in public offering and then spins off voting stock tax free
– Parent can do an equity carve-out of 20% of the voting stock, spin off remainder and entire spin-off transaction is tax free
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• Companies create new subsidiary
– Parent company creates subsidiary
– Subsidiary has two classes of shares: Class A nonvoting, Class B voting
– Parent company owns all B shares
– Parent company distribute A shares to its shareholders
– Parent company may have option to buy back proportion of subsidiary's stock it does not now own
– Parent company is not required to buy back shares or to put more money into subsidiary
– Creation of subsidiary allows parent to separate risk of subsidiary business from its core operations — shareholders decide whether to increase or decrease their own risk
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• Equity carve-out is an IPO of some portion of the common stock of a wholly owned subsidiary
• Also referred as "split-off IPOs"
• Resembles seasoned equity offering of the parent in that cash is received from a public sale of equity
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• Other changes when subsidiary equity is
"carved out"
– IPO of common stock of subsidiary initiates public trading in a new and distinct set of equity claims on assets of subsidiary
– Management system for operating the assets is likely to be restructured
– Public market value for operations of subsidiary becomes established
– Financial reports are issued on the subsidiary operations
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• Equity carve-outs can be used by a firm to raise equity funds directly related to the operation of a particular segment or industry
• Equity carve-outs also used as first step in spin-off and split-ups
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• Comparison to spin-off
– Similar to voluntary spin-off in that it results in subsidiary's equity claims traded separately from the equity claims on the parent entity
– Differences
• In spin-off a distribution is made pro rata to shareholders of parent firm as dividend; in equitycarve-out, stock of subsidiary is sold in public markets for cash which is received by parent
• In spin-off, parent firm no longer has control over subsidiary assets; in carve-out, parent generally sells only minority interest in subsidiary and maintains control over subsidiary assets and operations
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• Comparison to divestitures
– Similar in that cash is received
– Differences
• Divestiture is usually to another company
• Control over assets sold is relinquished by parent-seller and trading of subsidiary is not initiated
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• Transaction examples
– GM-Delphi
• In August 1998, the GM board of directors voted to separate Delphi from GM
• In February 1999, Delphi completed its IPO of 100,000,000 shares of common (17.7% equity carve-out) while GM held remaining 465,000,000 (82.3%) of Delphi's outstanding stock
• In April 1999, board of directors approved spin-off of
452,565,000 of GM's Delphi shares through a dividend of
0.7 shares of Delphi for one share of GM common stock
• Remaining 12,435,000 of GM's shares were contributed to the General Motors Welfare Benefit Trust
• Delphi became a fully independent, publicly traded company (split-up) after the spin-off
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– DuPont-Conoco
• DuPont bought Conoco in 1981
• On May 12, 1998, DuPont announced it would divest itself of
20% of its Conoco oil subsidiary and subsequently spin-off remainder
• In initial IPO, DuPont sold 150 million A shares which carried one vote
• Spin-off of remainder of Conoco was accomplished by a share exchange in which for each share of DuPont stock, holder could receive 2.95 shares of class B stock of Conoco
• Class B stock was identical to class A stock except that each share carried 5 votes
• GM paid Delphi's shares as a dividend; to obtain Conoco shares,
DuPont shareholders had to exchange their DuPont shares
• Share exchange method allowed DuPont's shareholders to choose whether they wanted to invest in the chemical industry versus petroleum industry
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• Carve-out event returns
– Market reaction not easily predictable since equity carve-outs have characteristics in common with spin-offs, divestitures, and seasoned equity issues
• Spin-offs — abnormal returns to parent firm of 2-
3% on average
• Divestitures — gains to selling firm of 1-2% on average
• Seasoned equity issues — negative residuals of
2-3% on announcement
– Event returns +2 - +5%
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• Performance studies of carve-outs
– Vijh (1999)
• Compared performance of carve-outs to several benchmarks — carve-outs did not underperform benchmarks
• Carve-outs earned an annual raw return of
14.3% during first three years — contrast to poor performance of IPOs which have annual return of 3.4%
• Average initial listing-day returns for carve-outs of 6.2%, with median of 2.5% — much smaller than 15.4% for IPOs
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• Possible performance explanations
– Parent firms tend to be relatively unfocused — carveouts are an opportunity to improve focus
– Subsidiaries gain partial freedom to pursue own activities
– Allen (1998)
• Examined performance of equity carve-outs at
Thermo Electron
• Thermo Electron has performed well since program implementation
– $100 invested in firm in 1983 would have appreciated to $1,667 by end of 1995
– Contrast to industry index which grew to $524, and
S&P 500 which grew to $381
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• Tracking stocks are separate classes of common stock of parent corporation
• First issued in 1984 by GM in connection with its acquisition of EDS
• Also known as letter stock, targeted stock, and designer stocks
©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20

• Company's business operations are split into two or more common equity claims, but businesses remain as wholly owned segments of single parent
• Each tracking stock is regarded as common stock of consolidated company and not of subsidiary
• Tracking stock company is usually assigned its own distinctive name
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• Tracking stock trades separately from parent company so that dividends paid to shareholders can be based on cash flows of tracking company alone
• Compensation of tracking company's managers can be based on financial results and stock price of tracking stock
• 80% of firms issuing tracking stocks use a dividend process but some firms use the issuance of tracking stock as a source of cash
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• Comparison to dual-class stock and spinoffs
– Dual-class stocks
• In dual-class stocks, class A generally has one vote per share versus five or more per share for class B, but class A has higher allocations of dividends
• Tracking stock has same voting rights as shareholders who hold stock in parent
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– Spin-off
• Similar to spin-off in that financial results of parent and subsidiary are reported separately
• Different in that spin-off is a separate entity with its own board of directors and shareholders who can vote for board of their separate company but not for the parent
• In spin-off, initial assignment of assets and other relationships are defined, thereafter they are independent entities
• In tracking stock, board of parent continues to control activities of tracking segment
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• Benefits and limitations
– Benefits
• Tax-free issuance
• Financial markets can value different businesses based on their own performance
• Analysts' coverage likely to be improved
• Stock-based management incentive programs can be related to each tracking business unit
• Investors are provided with quasi-pure play opportunities
• Increase flexibility in raising equity capital
• Provides alternative types of acquisition currency
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– Limitations
• Tracking stock subsidiary is generally subject to will of parent
• Potential conflict of interest over cost allocations or other internal transfer transactions
• Tracking stock subsidiary may command less takeover interest because of blurred relationship with parent
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• Price performance
– Main determinant is economic characteristics of businesses in which tracking stock subsidiary have been established
– Combined parent/tracking stock performance has been, with exceptions, superior to performance of their peer groups
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• Companies split into two or more parts
• Accomplished usually by initial carveouts, followed by spin-offs of individual parts
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• Examples
– Hewlett-Packard and Agilent
• Bring more focus
• Avoid overlap of capabilities
– AT&T restructuring
• Avoid conflicts from AT&T’s role as supplier and competitor in long distance business
• Improve valuation multiples for core business
– ITT Corp
• Attempt to improve share price
• Separate poor performers
• Resulted in takeover
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• Information
– Subsidiary true value hidden
– Preference for pure-play (single-industry) securities
– Increased availability of information
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• Managerial efficiency
– Management's inability to manage complex organizations
– Sell-offs sharpen focus, get rid of poor fit subsidiaries, eliminate negative synergy
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• Management incentives
– Bureaucracy and consolidation of financial statements stifle entrepreneurial spirit — hide good (bad) performance
– Conflict of objectives between parent and subsidiary
– Tie compensation directly to subsidiary performance
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• Tax and/or regulatory factors
– Subsample of spin-offs citing tax benefits have higher abnormal returns
– Tax motives — subsidiaries can take forms that shelter income
– Regulatory motives — spin-offs can free parent from regulatory scrutiny
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• Bondholder expropriation
– Spin-off reduces bondholder collateral
– Unsupported by evidence
• Bondholders can anticipate spin-offs and write protective covenants
• Subsidiaries have their own debt or take on a pro rata share of parent debt
• Bondholders may benefit if junior debt of parent becomes senior debt of subsidiary
• No evidence of bond price or ratings decline at spin-off announcements
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• Changing economic environment
– Major shifts in economic environment alter parent and subsidiary opportunity sets such that separate operations become optimal
• Avoiding conflicts with customers
– Spin-off can deal more effectively with customers
– Spin-off can avoid conflict if customer is a competitor of parent firm
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• Provide investors with pure winners
– Separate segments that lower valuation multiple on overall company
• Option creation
– Common stock is an option on underlying technology of firm
– Spin-off creates two options on same assets, therefore more value
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• Increase market spanning
– Expanded opportunity sets to appeal to different investor clienteles
– Improve completeness of markets — increased number of securities for given number of possible states of the world
• Enable more focused mergers
– Facilitate more focused mergers where bidder is interested in only a subset of target assets
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• Spin-offs
– Parent's potential position to create value through skills, systems, or synergies is weak
– Parents and subsidiaries have conflicts of interest
©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38

• Equity carve-outs
– Firms can easily separate subsidiaries
– Bring added attention to subsidiaries with high margins and growth
– Provide capital for acquisitions or other investments
– Allow division managers to take primary responsibility for financing and investment decisions
©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39

– Subsidiaries may have better access to capital
• Take advantage of parent's debt rating
• Seek funding from capital markets instead of overstating budgeting needs to parent
– Fund projects that otherwise would depress parent's earnings
©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40

• Tracking stocks
– Provide capital for acquisition or other investment programs
– Bring attention to subsidiaries with high growth or margins
– Subsidiaries can take advantage of capital structure of parent
– Reduce taxes — net operating losses of parent or subsidiary can be used to reduce overall corporate taxes
– Useful for firms with divisions that share significant synergies so full separation not desirable
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– Limitations
• Parent still controls
• Potential conflicts of interest with parent
• Value depends on its performance
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