Increasing Corporate Focus

Managing diverse and complex business portfolios is time consuming and may result in funding those businesses with relatively unattractive investment opportunities with cash flows generated by units offering more favorable opportunities. Firms often choose to simplify their business portfolio by focusing on those units with the highest growth potential and by exiting those businesses that are not germane to the firm’s core business strategy. Such firms often are able to reduce cost substantially by eliminating layers of management that existed at the corporate level. Increasing focus often improves firm value by allocating limited resources better and by reducing competition for such resources within multidivisional firms.² CEOs managing firms with numerous diverse businesses are more likely to exit those businesses in industries in which they have less experience.³ Moreover, new CEOs are more likely to engage in restructuring but the scale and scope of the change tends to differ if the new CEO comes from within the firm rather than is an outsider. While new inside CEOs tend to sell more businesses (usually those not meeting the firm’s profit targets), they often refrain from radically altering the firm’s current business strategy, perhaps because they played a key role in developing the strategy. In contrast, new outside CEOs sell fewer businesses and tend to exit those that are unrelated.⁴

Regulatory Concerns

A firm with substantial market share purchasing a direct competitor may create antitrust concerns. The combination of such firms may be viewed as anticompetitive if the combined firms’ market share exceeds some threshold. Regulatory agencies still may approve the merger if the acquirer divests some of its operations, the target’s, or some combination of the two, in order to establish other competitors in the industry.

Lack of Fit

Synergies anticipated by the parent among its businesses may not materialize. TRW’s decision to sell its commercial and consumer information services businesses came after years of trying to find a significant fit with its space and defense businesses.

Tax Considerations

Tax benefits may be realized through a restructuring of the business. Nursing home operator Sun Healthcare Systems (Sun) contributed its nursing home real estate operations to a Real Estate Investment Trust (REIT) in 2010 through a spin-off. Because REITs do not pay taxes on income that is distributed to shareholders, Sun was able to enhance shareholder value by eliminating the double taxation of income, once by the parent and again by investors when dividends are paid. Similarly, shareholders celebrated retailer Sears Holdings by driving up its share price by 31% in late 2014 when the firm announced the creation of a REIT to hold its real estate assets.

Raising Funds

Parent firms may choose to fund new initiatives or reduce leverage or other financial obligations through the sale or partial sale of units no longer considered strategic. Tobacco giant Reynolds American acquired its smaller rival Lorillard in late 2014 for $27.4 billion, selling specific product lines at closing for $7.1 billion to the Imperial Tobacco Group to help finance the deal. Pressured by activist shareholders, Chesapeake Energy Group announced in 2012 its intention to sell $11.5 billion to $14 billion in assets to reduce its leverage.

Worth More to Others

Others may view a firm’s operating assets as more valuable than the parent firm. In early 2017, tool maker Stanley Black & Decker acquired financially ailing retailer Sears’ Craftsman tool trademark for $900 million (including $250 million in future payments). Sears expects to use the proceeds to augment working capital and reduce indebtedness while Stanley intends to expand sales in the United States under the widely recognized Craftsman brand.

Rupert Murdoch, 88, after having spent decades building his media empire 21st Century Fox reached a deal to divest the firm’s entertainment assets to Disney Corporation in December 2017 for $51 billion. The remaining 21st Century’s assets were to be spun off to its shareholders. His eldest son, Lachlan Murdoch, would become CEO and Chairman of a new business containing Fox Television Network, Fox News, and most all of Fox Sports. However, Comcast Cable Company entered with a more attractive offer immediately following the announcement of 21st Century’s agreement with Disney. It would be another 7 months before Disney was able to close the deal in mid-2018 with a stunning $71.3 billion, 40% higher than what it had offered 7 months earlier.

Risk Reduction

A firm may reduce risk associated with a unit by selling or spinning-off the business. For example, major tobacco companies have been under pressure for years to divest or spin off their food businesses because of the litigation risk associated with their tobacco subsidiaries. Altria bowed to such pressure with the spin-off of its Kraft Food operations.

Discarding Unwanted Businesses From Prior Acquisitions

Acquirers often find themselves with certain target firm assets that do not fit their primary strategy. These redundant assets may be divested to raise funds to help pay for the acquisition and to enable management to focus on integrating the remaining businesses into the parent without the distraction of having to manage nonstrategic assets. When Northrop Grumman acquired TRW, it announced it would retain TRW’s space and defense businesses and divest operations not germane to Northrop’s core defense business. Nestlé acquired Adams, Pfizer’s chewing gum and confectionery business, for $4.6 billion, which Pfizer viewed as a noncore business acquired as part of its acquisition of Warner-Lambert.

Avoiding Conflicts With Customers

For years, many of the regional Bell operating companies (i.e., RBOCs) that AT&T spun off in 1984 have been interested in competing in the long-distance market, which would put them in direct competition with their former parent. Similarly, AT&T sought to penetrate the regional telephone markets by gaining access to millions of households by acquiring cable TV companies. In preparation for the implementation of these plans, AT&T announced in 1995 that it would divide the company into three publicly traded global companies to avoid conflicts between AT&T’s former equipment manufacturer and its main customers, the RBOCs.

Increasing Transparency

Firms may be opaque to investors due to their diverse operations. General Electric is an example, operating dozens of separate and unrelated businesses in many countries. Even with access to financial and competitive information on each business, it is challenging for any analyst or investor to value properly such a diversified firm. By reducing its complexity, a firm may make it easier for investors to assess accurately its true value. In an effort to restore profitability and achieve greater focus, GE announced a series of far reaching restructuring programs in 2018.

Motives for Divestitures

Divestitures often represent a way of raising cash. A firm may choose to sell an undervalued or underperforming operation that it determined to be nonstrategic or unrelated to the core business and to use the proceeds of the sale to fund investments in potentially higher-return opportunities, including paying off debt. Alternatively, the firm may choose to divest the undervalued business and return the cash to shareholders through either a liquidating dividend⁵ or share repurchase. Moreover, an operating unit may simply be worth more if sold than if retained by the parent.

Corporate Portfolio Reviews

Parent firms often conduct strategic and financial analyses to determine if its businesses are worth more to shareholders if sold and the proceeds returned to the shareholders or reinvested in more profitable opportunities. This process is best done at the corporate level without involvement of personnel from the firm’s business units in order to ensure that decision making is objective and fact based. Once the decision to divest is made, involving business unit level managers is critical to a successful selling process because of their intimate knowledge of the business and their involvement in providing information during buyer due diligence.⁶

To Sell or Not to Sell

An analysis undertaken to determine if a business should be sold involves a multistep process. These steps include determining the after-tax cash flows generated by the unit, an appropriate discount rate reflecting the risk of the business, the after-tax market value of the business, and the after-tax value of the business to the parent. The decision to sell or retain the business depends on a comparison of the after-tax value of the business to the parent with the after-tax proceeds from the sale of the business. These steps are outlined in more detail next.

Timing of the Sale

Obviously, the best time to sell a business is when the owner does not need to sell or the demand for the business is greatest. The decision to sell also should reflect the broader financial environment. Selling when business confidence is high, stock prices are rising, and interest rates are low is likely to fetch a higher price for the unit. If the business to be sold is highly cyclical, the sale should be timed, if possible, to coincide with the firm’s peak-year earnings.

The Selling Process

Selling firms choose that process best serving their objectives and influences the types of buyers that are attracted (e.g., strategic versus private equity).⁹ The selling process may be reactive or proactive (Fig. 16.1). Reactive sales occur when the parent is unexpectedly approached by a buyer, either for the entire firm or for a portion of the firm such as a product line or subsidiary. If the bid is sufficiently attractive, the parent firm may choose to reach a negotiated settlement with the bidder without investigating other options. This may occur if the parent is concerned about potential degradation of its business, or that of a subsidiary, if its interest in selling becomes public knowledge. In contrast, proactive sales may be characterized as public or private solicitations. In a public sale or auction, a firm announces publicly that it is putting itself, a subsidiary, or a product line up for sale. In this instance, potential buyers contact the seller. This is a way to identify easily interested parties; however, this approach can also attract unqualified bidders (i.e., those lacking the resources necessary to complete the deal) or those seeking to obtain proprietary information through the due diligence process. In a private or controlled sale, the parent firm may hire an investment banker or undertake on its own to identify potential buyers to be contacted. Once a preferred potential buyer or list of what are believed to be qualified buyers has been compiled, contact is made.¹⁰

In either a public or a private sale, interested parties sign confidentiality agreements before being given access to proprietary information, which can include a financial forecast provided by the selling firm. Experienced buyers know that such forecasts tend to be overly optimistic and often will discount them by 25%–30%. The challenge for the selling firm is to manage efficiently this information, which can grow into thousands of pages of documents and spreadsheets, and to provide easy and secure access to all interested parties. Such information frequently is offered online through so-called virtual data rooms (VDRs), particularly when the seller is represented by an investment bank.¹¹ Because so much data is released to interested parties including competitors, there is a significant cost to the selling firm if a sale does not take place. That is, even though they are required according to the confidentiality agreement to return any proprietary information in their positions and not to use it for competitive purposes, competitors have knowledge that they can (and often do) use to gain a competitive advantage.

In private sales, bidders may be asked to sign a standstill agreement requiring them not to make an unsolicited bid. Parties signing these agreements then submit preliminary, nonbinding “indications of interest” (i.e., a single number or a bid within a range). Those parties submitting such bids are ranked by the selling company by bid size, form of payment, the ability of the bidder to finance the transaction, form of acquisition, and anticipated ease of doing the deal. A small number of those submitting preliminary bids are then asked to submit a legally binding best and final offer. At this point, the seller may choose to initiate an auction among the most attractive bids or to go directly into negotiating a purchase agreement with a single party.

Choosing the Right Selling Process

Early board involvement in developing a divestiture strategy tends to result in higher premiums paid to selling firm shareholders because the board actively contributes to the selection of the appropriate selling process and monitors the actions of the CEO throughout the process.¹² Selling firms attempt to manage the process to realize the highest possible purchase price while maintaining the interest of potential acquirers. Selling firms may choose to negotiate with a single firm, to control the number of potential bidders, or to engage in a public auction (Table 16.1). Large firms often choose to sell themselves, major product lines, or subsidiaries through “one-on-one” negotiations with a single bidder deemed to have the greatest synergy with the selling firm. Sellers are concerned about the deleterious effects of making the sale public and the disruptive effects of allowing many firms to perform due diligence and to receive proprietary information even though it is “protected” by confidentiality agreements. This approach also may be adopted to limit the potential for losing bidders who may also be competitors from obtaining proprietary information as a result of due diligence.

An auction may be undertaken to elicit the highest offer when selling smaller firms¹³ that are more difficult to value and because there may be more bidders. Moreover, money-losing startups that are perceived as potential threats to current competitors may initiate an auction because an existing competitor may bid for the startup to prevent others from acquiring the firm. The winning bidder may substantially overpay fully aware that the startup is likely to continue to lose money. Examples include Newscorp’s purchase of Myspace for $580 million, Facebook’s $1 billion takeover of Instagram, Yahoo’s $1.1 billion purchase of Tumblir, Google’s $1.65 billion investment in YouTube, and eBay’s $2.6 billion buyout of Skype.¹⁴

The mix of bidders (strategic versus financial) in an auction can significantly impact premiums paid for the target firm. Bids made by strategic buyers reflect their perceived synergy with the target firm; in contrast, financial buyers base their bids on a desired target rate of return. Financial buyers often cannot pay as much as a strategic buyer since they generally do not rely on synergy for value creation. Premiums paid by strategic buyers in auctions average about 28% of the current value of the target while financial buyers’ premiums paid average about 19%.¹⁵ However, for large divisional buyouts where information about the unit is widely known, private equity firms often outbid strategic buyers. Why? Private equity firms having access to the necessary information base their bids on their perceived ability to restructure the division, improve operating efficiency, and increase revenue.¹⁶

When public auctions fail to produce a bid acceptable to the seller, negotiating leverage often shifts to buyers willing to enter into direct negotiations with the seller after the auction has been completed. These negotiations frequently result in the acquirer paying lower premiums and earning higher financial returns compared with both successful auctions and negotiations with a single bidder that could have been undertaken at the outset.¹⁷

Public auctions may discourage some firms from bidding due to the potential for overly aggressive bidding by relatively uninformed bidders boosting the price to excessive levels. The private or controlled sale among a small number of carefully selected bidders may spark competition to boost the selling price while minimizing the deleterious effects of public auctions. Pfizer’s 2012 auction of its baby food business is an example of a controlled auction. Pfizer sought bids from those it knew could benefit from the unit’s exposure to emerging markets and had the financial wherewithal to pay a substantial premium. The auction process involving Swiss-based Nestlé and France’s Groupe Danone went through several rounds before Nestlé’s $11.85 billion bid was accepted by Pfizer. At 19.8 times EBITDA, the bid was considerably higher than that of the 15.7 multiple Nestlé paid for Gerber’s baby food operations in 2007.

Approximately one-half of corporate M&A transactions involve “one-on-one” negotiations. The remaining transactions involve public or controlled auctions in which the sellers contacted an average of 10 potential bidders, with some contacting as many as 150. The financial returns to the selling firm’s shareholders appear to be about the same regardless of the way in which the business is sold. However, for larger target firms, one-on-one negotiation is more common.¹⁸ One-on-one negotiation may be superior to auctions when the target is large, because there are likely to be fewer potential buyers, which may result in a higher purchase price because the selling firm is able to share more proprietary information with the potential buyer. In an auction involving many bidders, the likelihood that such information could leak to competitors and be used to the competitive disadvantage of the selling firm is much higher.¹⁹

These findings seem at odds with the conventional wisdom that auctions should result, on average, in higher returns for selling-company shareholders assuming that more bidders are usually better than fewer bidders.²⁰ Conventional wisdom presumes all bidders have access to the same information and have the financial ability to finance their bids. As previously noted, some qualified bidders may choose to refrain from bidding in an auction, concerned about overpaying for the target firm. Another risk to a seller of an auction is that it may attract a single viable bidder. If the potential buyer becomes aware that there are no other interested parties, negotiating leverage shifts from the seller to the buyer. This usually results in a lower premium paid for the target firm than may have been achieved had the seller undertaken a one-on-one negotiation.²¹

The mere fact that most transactions involve relatively few bidders does not suggest that the bidding process is not competitive.²² The seller must maintain the perception throughout a one-on-one negotiation that other potential bidders exist but were not included in the process for reasons ranging from their exhibiting less potential synergy to concerns about loss of competitive information to the possibility of not receiving regulatory approval. In most cases, simply the threat of rival bids is sufficient to increase bids. Such latent competition influences bid prices the most when market liquidity is greatest such that potential bidders have relatively inexpensive access to funds through borrowing or new equity issues. Ultimately, the premium a target firm receives is influenced by a variety of factors relating to the deal and industry characteristics.

The purchase premium is usually defined in the popular press as the excess of the offer price over the target firm’s share price immediately prior to the deal announcement date. A more accurate estimate of the purchase premium includes the sum of the increase in the target firm’s share price prior to the announcement (i.e., the run-up) plus the excess of the offer price over the run-up (i.e., the mark-up). The run-up reflects anticipated synergy resulting from the combination of the target and acquiring firms. The bidder may be willing to mark-up the offer price above the run-up if it believes the preannouncement date target price increase did not fully reflect anticipated synergies. Table 16.2 provides a summary of those factors that have been found to be significant determinants of the magnitude of purchase price premiums grouped by financial market considerations as well as target and acquirer characteristics.

The results shown in this table are based on deals initiated by outside bidders, but in fact about 15%–20% of sales are initiated by the selling company. Seller initiated deals are highly correlated with CEO equity ownership. A combination of lucrative stock, stock option grants, and golden parachutes can motivate CEOs to promote deal negotiations. Such deals are correlated with higher takeover premiums.²³

Tax and Accounting Considerations for Divestitures

The divesting firm recognizes a gain or loss for financial-reporting purposes equal to the difference between the fair value of the payment received for the divested operation and its book value. For tax purposes, the gain or loss is the difference between the proceeds and the parent’s tax basis in the stock or assets. Capital gains are taxed at the same rate as other business income.

Motives for Spin-Offs

In addition to the motives for exiting businesses discussed earlier, spin-offs reward shareholders with a nontaxable dividend (if properly structured). Parent firms with a low tax basis in a business may choose to spin off a unit as a tax-free distribution to shareholders rather than sell the business and incur a substantial tax liability. Independent of the parent, the unit has its own stock for possible acquisitions without interference from the parent’s board. The managers of the business that is to be spun off have a greater incentive to improve the unit’s performance if they own stock in the unit. Now more focused and transparent to investors than when it was part of a larger diversified firm, the unit can become an attractive takeover opportunity. Spin-offs also represent an easy alternative to divesting a difficult to sell business.

Disadvantages of spin-offs include the loss of both revenue and synergies associated with the unit spun off by the parent. For publicly traded firms, the elimination of a large portion of a firm through a spin-off to shareholders can result in less stock analyst coverage, removal from stock indices, and an increased likelihood of takeover of the former parent if the spin-off substantially reduces the size of the parent. Finally, the costs associated with separating a unit from the parent can become substantial if the unit is well integrated into other parts of the firm.

Tax and Accounting Considerations for Spin-Offs

If properly structured, a corporation can make a tax-free distribution to its shareholders of stock in a subsidiary in which it holds a controlling interest. Neither the parent nor its shareholders recognize any taxable gain or loss on the distribution. Such distributions can involve a spin-off, a split-up (a series of corporate spin-offs often resulting in the dissolution of the firm), or a split-off (an exchange offer of subsidiary stock for parent stock). Split-ups and split-offs are explained in more detail later in this chapter.

To be tax-free to both the parent and its shareholders, spin-offs must satisfy certain conditions stipulated in Section 355 of the Internal Revenue Tax Code. These conditions apply to the separation of two operating businesses and not to transactions involving the distribution of cash or liquid assets or those resembling sales (a spin-off followed by an immediate acquisition of the unit). These conditions include the following:

1. 1. The parent must control the subsidiary(ies) to be spun off, split up, or split off by owning at least 80% of each class of the unit’s voting and nonvoting stock²⁴;
2. 2. The distributing firm must distribute all of the stock of the controlled subsidiary;
3. 3. The transaction must be for a sound business purpose, such as to improve profitability, increase access to the capital markets for either the parent or the unit to be spun off, or enhance management focus by reducing the number of lines of business, and not for tax avoidance²⁵; and
4. 4. Both the parent and the controlled subsidiary must remain in the same business following the distribution in which they were actively engaged for the 5 years prior to the distribution. Any acquisition either 2 years prior or following the spin-off may trigger an IRS determination that the spin-off was actually a “disguised sale” intended to avoid taxes with the IRS removing the tax free status of the spin-off.

For financial-reporting purposes, the parent firm should account for the spin-off of a subsidiary’s stock to its shareholders at book value, with no gain or loss recognized, other than any reduction in value due to impairment.²⁶ The reason for this treatment is that the ownership interests are essentially the same before and after the spin-off.

Motives for Equity Carve-Outs

Like divestitures, equity carve-outs provide an opportunity to raise funds for reinvestment in the subsidiary, paying off debt, or paying a dividend to the parent firm. Carve-outs also may be used if the parent has significant contractual obligations, such as supply agreements, with its subsidiary.²⁷ Moreover, a carve-out frequently is a prelude to a divestiture, since it provides an opportunity to value the business by selling stock on a public stock exchange. The stock created for purposes of the carve-out often is used in incentive programs for the unit’s management and as an acquisition currency (i.e., form of payment) if the parent later decides to grow the subsidiary. By creating a market for the formerly largely illiquid subsidiary shares, the carve-out also provides a market in which shareholders can more easily sell their shares. The two basic forms of an equity carve-out are the initial public offering and the subsidiary equity carve-out.

Initial Public Offerings and Subsidiary Equity Carve-Outs

An initial public offering is the first offering to the public of common stock of a formerly privately held firm. The sale of the stock provides cash to the parent and an opportunity for pre-IPO shareholders to convert their shares to cash. The cash proceeds from the IPO may be retained by the parent or returned to shareholders. Alibaba, the Chinese e-commerce giant, went public in a record setting IPO in late 2014 raising more than $25 billion and valuing the firm at more than $200 billion. The proceeds of the Alibaba IPO will be used to allow investors to cash out, to make acquisitions, and to build brand awareness outside of China. In 2018, Japanese technology conglomerate Softbank agreed to invest $1 billion in newly issued shares of the ride hailing giant Uber valuing the firm at about $70 billion. With the goal of reaching a 14% ownership stake in the firm, Softbank agreed to buy shares from investors and employees enabling them to liquidate their holdings.

How an IPO is structured and their post-IPO share performance can be predictive of whether a firm will become an acquirer, a target, or not engage in any M&A activity.²⁸ For example, firms with particularly large cash infusions are more likely to grow through acquisition. Furthermore, firms that go public and significantly underprice²⁹ their securities are also more likely to be acquirers. Why? Because these firms attract a broader array of investors, issue extra shares via the overallotment option,³⁰ create dispersed ownership, and a liquid acquisition currency. The diffuse ownership can also be part of a defensive strategy by minimizing large institutional owners who are more inclined to sell to potential acquirers. Post-IPO share performance reduces uncertainty concerning what the firm is worth and allows the firm to have more confidence in share for share exchanges as part of its M&A strategy. Finally, firms with a dual ownership structure are less likely to become targets because of the concentration of ownership.

Table 16.3 illustrates a timeline associated with a typical IPO which involves the hiring of one or more investment banks in an advisory and marketing capacity to guide the firm through the entire process of selling an initial stock issue to the public. Alternatively, the investment bank can buy the entire issue from the firm and subsequently resell it to the public. The bank buys the shares at a substantial discount from fair value to compensate for the risk that they will not be able to resell the shares to the public at a profit. As discussed below, a less common practice is for the issuing firm to directly list their shares on a public exchange.

Before issuing shares to the public, the parent usually estimates the size of the post-IPO public or free float. Float represents shares trading on exchanges that can be bought and sold without restrictions, consisting of those held both by institutions and individuals. Free float excludes restricted shares or those issued by a firm that cannot be bought or sold for a certain period of time without permission by the SEC. Restricted stock is a type of stock given to insiders as part of their compensation. Why is free float important? Because the size of the float affects the degree of the parent’s post-IPO control, its ability to consolidate the unit for tax purposes, the cost to the parent to reacquire its subsidiary at a later date if it chooses to do so, and the accuracy of the valuation of the shares issued.

While investment banks are normally hired to advise and manage the IPO process, some firms have chosen to minimize issuance costs by directly listing their shares on a public exchange. Music streaming service Spotify filed for a direct listing on the New York Stock Exchange (NYSE) on April 3, 2018, allowing early investors and employees to sell shares without the firm raising new capital or hiring an investment bank to underwrite the offering. Because the firm was not issuing new shares, it did not specify a listing (or reference) price before the IPO. The NYSE did establish a listing price when trading opened of $135 per share based on how Spotify shares had traded previously on private exchanges. Unlike a conventional IPO, a direct listing does not dilute ownership because the firm is not issuing new shares and potentially saves hundreds of millions of dollars in underwriting fees.³¹ Furthermore, existing shareholders are not subject to lockup periods restricting them the sale of their shares following the listing. Direct listings can result in more volatile share price activity immediately following the IPO because underwriters do not purchase shares to provide price stability.

The subsidiary carve-out is a transaction in which the parent creates a wholly owned, independent subsidiary, with stock and a management team that are different from the parent’s, and issues a portion of the subsidiary’s stock to the public. Usually, only a minority share of the parent’s ownership in the subsidiary is issued to the public. Although the parent retains control, the subsidiary’s shareholder base may be different than that of the parent due to the public sale of equity. The cash raised may be retained in the subsidiary or transferred to the parent as a dividend, a stock repurchase, or an intercompany loan. An example of a subsidiary carve-out is the sale to the public by Phillip Morris in 2001 of 15% of its wholly owned Kraft subsidiary. Phillip Morris’ voting power over Kraft was reduced only to 97.7% because Kraft had a dual-class share structure in which only low-voting shares were issued in the public stock offering.

Tax and Accounting Considerations for Equity Carve-Outs

Retention of at least 80% of the unit enables consolidation for tax purposes, and retention of more than 50% enables consolidation for financial-reporting purposes.³² If the parent owns less than 50% but more than 20%, it must use the equity method for financial reporting. Below 20%, it must use the cost method.³³

For a spin-off of the remaining stock following an IPO to be tax-free, the parent must have retained at least 80% of the voting power of the shares of the subsidiary. Why? Because tax rules require the parent to distribute control of the subsidiary, where control for tax purposes is defined as 80% of the voting stock. The proceeds of an IPO distributed to the parent are tax free to the parent if the amount of the cash distributed is less than the value of the parent’s investment in the stock of the controlled subsidiary (i.e., its basis) as it is considered a return of capital.

Motives for Split-Offs

A split-off is most appropriate when the parent firm owns less than 100% of a subsidiary’s stock. This may occur when the parent acquires less than 100% of the outstanding shares of another firm or when the parent undertakes an IPO of a portion of the stock of a controlled subsidiary. Divestiture may not be an option for disposing of businesses in which the parent owns less than 100% of outstanding shares, because potential buyers often want to acquire all of a firm’s outstanding stock. By acquiring only a portion of another firm’s shares, a buyer inherits minority shareholders, who may disagree with the new owner’s future business decisions.

Split-offs are commonly undertaken after a portion of the shares in a controlled subsidiary has been issued to the public in an IPO so that the value of the subsidiary’s shares can be determined. Once their trading value has been established, it is used in determining the exchange ratio between subsidiary and parent shares (i.e., the split-off exchange ratio). That is, the number of subsidiary shares (which could be less than one if the trading value of the subsidiary shares exceeds that of the parent’s shares) to be exchanged for each parent share. Typically, the parent offers to purchase parent stock at a premium compared to the subsidiary’s trading price established following the IPO of a portion of the subsidiary’s stock as an incentive for parent shareholders to exchange their shares for subsidiary shares. Split-offs are most successful when parent shareholders show a preference for the subsidiary’s stock over the parent’s stock. Any subsidiary shares not tendered during the exchange offer period may be distributed to parent shareholders through a spin-off, resulting in the subsidiary becoming totally independent.

A split-off reduces the pressure on the spun-off firm’s share price because shareholders who exchange their stock are less likely to sell the new stock. Presumably, a shareholder willing to make the exchange believes the stock in the subsidiary has greater appreciation potential than the parent’s. The exchange also increases the earnings per share of the parent firm by reducing the number of its shares outstanding, as long as the impact of the reduction in the number of shares outstanding exceeds the loss of the subsidiary’s earnings. A split-off is generally tax-free to shareholders as long as it conforms to the IRS requirements previously described for spin-offs. Finally, the split-off gives the parent shareholder the option to decide whether the shareholder wants to hold parent stock, split-off company stock, or a combination.

Cash-Rich Split-Offs

As variations of conventional split-offs, cash-rich split-offs commonly occur when a firm wants to reacquire stock from a large shareholder, often another firm. In this type of transaction, the parent firm creates a new subsidiary and contributes an operating business that the parent has owned and operated for at least 5 years to the subsidiary as well as cash. The business must comprise at least 5%–10% of the subsidiary’s enterprise value and the subsidiary cannot contain more than 66% cash or other investment securities. Assuming the there is a valid business purpose for the deal, the parent can then exchange stock in the new subsidiary for the parent’s stock held by the large investor in a deal that is tax-free.

How a cash-rich split-off may be structured is illustrated in Fig. 16.2. Assume Buyer Corp owns stock in Seller Corp and Seller Corp wishes to buy back its stock. To do so in a tax-free transaction, Seller Corp forms a new subsidiary (Split-Co) and transfers operating assets and liabilities and cash into the subsidiary in exchange for subsidiary stock. The subsidiary’s assets can consist of up to 66% cash and 34% operating assets. The fair market value of the subsidiary must be approximately equal to the market value of Seller Corp’s stock held by Buyer Corp. Seller Corp enters into a split-off in which it exchanges Split-Co stock for Seller stock held by Buyer Corp. Following the transaction, Split-Co becomes a wholly owned subsidiary of Buyer Corp. The transaction is tax-free to both Seller Corp shareholders and Buyer Corp shareholders. The disadvantages of this deal are that it is complicated to execute and Buyer Corp must operate the acquired business for at least 2 years following closing.

In 2015, Warren Buffett’s Berkshire Hathaway bought Proctor & Gamble’s Duracell battery business in a deal valued at about $3 billion and structured as a tax-free cash rich split-off. P&G received shares of its own stock held by Berkshire Hathaway with a market value of $4.7 billion. To make the fair market value of the P&G stock and the Duracell business equal, P&G contributed $1.7 billion in cash to the Duracell business prior to closing. News Corp. also employed a tax-free cash-rich split-off in reaching an agreement in early 2007 to buy Liberty Media’s 19%—or $11 billion—stake in the media giant in exchange for News Corp.’s 38.6% stake in satellite TV firm DirecTV Group, $550 million in cash, and three sports TV channels. The cash and media assets were added to ensure that Liberty Media was exchanging its stake in News Corp. for “like-kind” assets of an equivalent or higher value to qualify as a tax-free exchange. Had the assets been divested, the two firms would have had to pay $4.5 billion in taxes due to likely gains on the sale. Other recent “cash-rich” split-offs include Comcast/Time Warner Cable, Comcast/Liberty, KeySpanG/Houston Exploration, Cox/Discovery Communications, and DST Systems/Janus Capital Group.

Spin-Offs Combined With M&A Transactions

Spin-offs may be combined with a concurrent merger deal. Called “Morris Trust” and “Reverse Morris Trusts,” these structures allow the parent to transfer a business to another firm (i.e., merger partner) in a stock deal that is tax-free. In a Morris Trust deal, all of the parent’s assets, except those to be combined with the merger partner, are spun off or split off into a new public company and then the parent merges with the merger partner. In a Reverse Morris Trust, all assets to be combined with the merger partner are spun off or split off into a new public company, with the new company combining with the merger partner.³⁴

To be tax-free, the Morris and Reverse Morris Trust structures require the merger partner to be smaller than the business to be combined with the merger partner resulting in the shareholders of the parent owning a majority of the stock of the combined firms. That is, the spun-off subsidiary is the “buyer” if its shareholders (the original parent company shareholders who received the stock spun off by the parent) own more than 50% the merged firms. The former subsidiary will usually have a bigger market value than the target firm into which it is merged. This effectively reduces the number of potential merger partners. This limitation was imposed by the IRS to make such structures less attractive.

An advantage the Reverse Morris Trust is that it does not require approval by the parent shareholders for the spin-off or merger. This is so because the spin-off firm is merging or combining with the merger partner and the parent approves this merger at the time the parent is the sole shareholder of the subsidiary to be spun off. In contrast, the Morris Trust requires approval by the parent’s shareholders because the merging party (i.e., the parent) is already a public firm owned by its public shareholders at the time the merger is proposed. The major drawback of these types of deals is their complexity as each deal is dependent of the completion of the other. In addition, such transactions require lengthy predeal negotiation so that both parties understand which assets and liabilities will be spun-off in the parent’s subsidiary and which will be retained.

In April 2017, Hewlett Packard Enterprises completed the spin-off its call center and networks business to its shareholders which was then merged with Computer Sciences Corporation in an all-stock deal creating a new firm (to be named Computer Sciences Corp.) valued at more than $13.5 billion. The deal is tax-free to both Hewlett Packard Enterprise and Computer Sciences shareholders. See the case study at the end of this chapter for a detailed discussion of both the mechanics and implications of a recent reverse Morris Trust deal involving CBS and Entercom.

Motives for Tracking Stocks

Tracking stock enables investors to value the different operations within a corporation based on their own performance. There is little empirical evidence that issuing a tracking stock for a subsidiary creates pure-play investment opportunities for investors, since the tracking stock tends to be correlated more with the parent’s other outstanding stocks than with the stocks in the industry in which the subsidiary competes.³⁵ Tracking stocks provide the parent with another way of raising capital for a specific operation by selling a portion of the stock to the public and an alternative “currency” for making acquisitions. Stock-based incentive programs to attract and retain key managers also can be implemented for each operation with its own tracking stock.

Firms that have created disparate asset structures sometimes use a combination of spin-offs and tracking stocks in an effort to deliver shareholder value. In 2016, Liberty Interactive Corporation, known for its digital commerce businesses spun off two units: Commerce Hub, a service provider to e-commerce firms, and Liberty Expedia Holdings, which includes the firm’s 18% stake in the travel booking site and Bodybuilding.com, a fitness site. The firm also reclassified its common stock into three tracking stocks: The Liberty Braves Group, which owns the Atlanta Braves baseball team; the Liberty Sirius group, which includes the satellite radio provider Sirius XM Holdings; and the Liberty Media Group, which includes the firm’s remaining assets. The transactions were tax-free to the firm’s shareholders and were intended to give investors greater choice in which assets they wanted to invest.

Tax and Accounting Considerations for Tracking Stocks

For financial-reporting purposes, a distribution of tracking stock divides the parent firm’s equity structure into separate classes of stock without a legal split-up of the firm. Unlike spin-offs, the IRS currently does not require that the business for which the tracking stock is created be at least 5 years old and that the parent retain a controlling interest in the business for the stock to be exempt from capital gains taxes. Unlike a spin-off or a carve-out, the parent retains complete ownership of the business. In general, a proportionate distribution by a company to its shareholders of the company’s stock is tax-free to shareholders.

Problems With Tracking Stocks

Few tracking stocks have been issued in recent years, due to inherent governance issues and poor long-term performance. Conflicts among the parent’s operating units arise in determining how the parent’s overhead expenses are allocated to business units and what price one business unit is paid for selling products to other units. Tracking stocks can stimulate shareholder lawsuits. The parent’s board approves overall operating unit and capital budgets. Decisions made in support of one operating unit may appear to be unfair to those holding a tracking stock in another unit. Thus, tracking stocks can pit classes of shareholders against one another and lead to lawsuits. Tracking stocks also may not have voting rights. Further, the chances of a hostile takeover of a firm with a tracking stock are virtually zero because the firm is controlled by the parent.

In addition, tracking stocks often have inferior voting rights or none at all when compared to a firm’s other common stock outstanding. Also, holders of tracking stock usually do not receive dividends and in liquidation typically do not have a legal claim on the parent firm’s assets. Tracking stocks can be particularly problematic when issued by private firms such as Dell Inc.’s use of tracking shares as part of the compensation paid to shareholders in its 2016 takeover of storage company EMC. Why? Because governance issues can be greater when ownership is heavily concentrated and financial reporting may be more opaque.

What Stays and What Goes

For a subsidiary operated as a standalone unit, separating the business from the parent may be relatively straight-forward as the assets and liabilities associated with the business are easily identified. Complexities arise when the unit has formal relationships with the parent or other operating units owned by the parent including sharing common support functions such as finance, human resources, and accounting and intracompany purchase or sale arrangements. These will have to be divided, reproduced or provided by the parent to the spin-off company on an interim or transitional basis before the unit will be ready to operate as a standalone, publicly traded company. Spinning off a portion of business through an equity carve-out having operations that are to remain with the parent may be far more complicated as the assets to be retained by the parent must be clearly identified and a mechanism established for transferring them from the spin-off company to the parent. Such mechanisms could include a merger with or sale of assets to another business owned by the parent or an internal spin-off of selected spin-off company assets to other parent operating units.

Target Capital Structure

In this context, target capital structure refers to the spin-off company’s and parent’s mix of debt and equity immediately following the spin-off. The parent generally wants to reallocate its existing cash and debt between itself and the spin-off company and to raise additional cash if possible. A common strategy is for the spin-off company to issue new debt prior to the spin-off with the cash proceeds distributed to the parent. The parent may then use the cash to retire its outstanding debt. For example, Hewlett-Packard Enterprise raised $14.6 billion just prior to its being spun off by its parent Hewlett-Packard Co. in late 2015, with the cash transferred to the parent. The parent used the proceeds to redeem $8.85 billion in debt and the remainder to refinance other obligations at lower interest rates.

The mechanism for transferring the cash to the parent may involve the spin-off company making a cash distribution to the parent, buying back some of its own shares held by the parent for cash, paying off intercompany loans owed to the parent, or buying assets owned by the parent for cash. Alternatively, the spin-off company may assume some of the parent’s outstanding debt. Care must be taken in selecting the right mechanism for transferring cash in order not to trigger taxable gains to the extent the cash payment for stock or assets or the assumption of debt exceeds the parent’s book value in the spin-off company’s stock or assets or the parent’s long-term debt.

Allocation of Nonlong-Term Debt Liabilities

Which liabilities belong with the parent or the spin-off company? Warranty claims relating to spin-off company sales and pension fund obligations would be liabilities of the spin-off company. General corporate liabilities not relating specifically to the parent or the spin-off company such as shareholder litigation could remain with the parent. It is customary to include indemnification clauses in the separation and distribution agreement defining the rights and obligations of the parties to the separation. Such clauses require that the party assuming responsibility for a liability is to be reimbursed by the other party if the future actual cash cost of the liability exceeds the amount of the liability at the time it was assumed.

Solvency

If a spin-off quickly proves not to be financially viable, the parent may be compelled to cover the firm’s liabilities because of possible fraudulent conveyance or transfer. That is, the parent may be accused of attempting to avoid the payment of debt or other obligations. In 2013, a judge ruled that Kerr-McGee had fraudulently transferred profitable oil and gas assets from its Tronox subsidiary to the parent in 2004, leaving the subsidiary unable to pay outstanding environmental claims. In 2014, Andarko which had acquired Kerr-McGee’s oil and gas assets had to pay $5.2 billion to settle these claims.

Board Governance

In structuring a spin-off transaction, directors of a solvent corporation have a fiduciary responsibility to the shareholders of the pre-spin company (not to the spin-off company) and may structure the transaction to maximize value for the parent shareholders. The parent board may unilaterally allocate assets and liabilities between the parent and spin-off company prior to executing the spin-off subject to insolvency and tax considerations. Such decisions often are honored by the courts as long as the board’s decision was made for legitimate business purposes.

Human Resource Management

When a subsidiary has been operated as a standalone business, its current management usually becomes the management team after the spin-off and its employees remain with the spin-off company. In spin-offs of divisions operated on a standalone basis, management issues are more challenging. Existing managers of the spin-off company often have responsibilities that overlap with businesses to be retained by the parent or are valuable to both the parent and the spin-off company. In determining the roles of such managers, it is critical to consider their desires in assigning them to the parent or to the spin-off company. Other challenges in separating employee populations involve the division of pension and benefit plans and assets funding such plans, the treatment of stock options, and the impact of union contracts, which may restrict how employees and benefit plan assets are assigned between the parent and the spin-off company.

Separation and Distribution Agreement

Outlining how the separation of the spin-off unit from the parent will be implemented, this agreement identifies assets to be transferred, liabilities to be assumed and contracts to be assigned to the spin-off firm and the parent. It also explains how and when transfers, liability assignments, and contract assignments will occur and governs the rights and obligations of the parent and the spin-off company regarding the distribution of the spin-off company’s shares.

Transition Agreement

This agreement covers services shared by the parent and the spin-off unit, which may include legal, payroll, accounting, information technology or benefits. These may have to be continued on an interim basis following separation. The services may be provided by the parent to the spin-off company, the spin-off company to the parent, or by both.

Tax Matters Agreement

This agreement defines the rights and obligations of the parent and the spin-off company if tax liabilities are created due to transactions undertaken to implement the spin-off (e.g., sale of specific spin-off company assets to other parent subsidiaries). This agreement also allocates tax liabilities between the parent and the spin-off company often by making the parent responsible for all taxes incurred before closing and the spin-off company responsible for taxes after closing. To protect the tax-free status of the transaction, the agreement usually contains restrictions on the spin-off’s ability to take actions during the 2 year period following closing without obtaining either the parent’s consent or an IRS ruling or opinion of legal counsel that the action will not impact the tax treatment of the spin-off. Such restrictions include limitations on any transaction that would result in a significant change in ownership of the spin-off company (e.g., via merger), a liquidation of the spin-off firm, a sale of a major percentage of the spin-off company’s assets, and certain repurchases of stock of the spin-off company.

Preannouncement Abnormal Returns

Studies indicate that the alternative restructure strategies discussed in this chapter generally provide positive abnormal returns to the shareholders of the company implementing the strategy prior to and including the announcement date of such strategies. Why? Because such actions are undertaken to correct many of the problems associated with highly diversified firms, such as having invested in underperforming businesses, having failed to link executive compensation to the performance of the operations directly under their control, and being too difficult for investors and analysts to evaluate. In addition, restructuring strategies involving divisional or asset sales may create value simply because the asset is worth more to another investor. Table 16.6 provides a summary of the results of selected empirical studies of restructuring activities.

Divestitures

Positive abnormal returns around the announcement date of the restructure strategy average 1.5% for sellers. Buyers average positive abnormal returns of about 0.5%.³⁸ While both sellers and buyers gain from a divestiture, most of the gain appears to accrue to the seller. How the total gain is divided depends on the relative bargaining strength and negotiating skills of the seller and the buyer. Selling firm CEOs are less likely to divest businesses with which they are most familiar. When they do, their greater familiarity seems to give them an edge in negotiating with buyers, as they tend to earn above average positive abnormal financial returns for seller shareholders.³⁹

When domestic capital markets are illiquid, domestic firms may find selling assets to foreign firms more lucrative than selling them to domestic firms. Foreign firms often pay a higher price if they have access to cheaper financing, a stronger currency, or view the purchase as a means of entering the domestic market. Financial returns to firms selling domestic assets can be .6% higher than domestic firms selling foreign assets. Why? News of the pending sale is more likely to leak domestically thereby attracting more potential bidders than it is with assets held in foreign countries.⁴⁰ The magnitude of the difference tends to decline for larger asset sales as such divestitures tend to attract more domestic and international attention.

Spin-Offs

At 3.8%, the average excess return to parent shareholders associated with spin-off announcements is double the average excess return on divestitures. The gap between abnormal returns to shareholders from spin-offs versus divestitures may be attributable to tax considerations. Spin-offs generally are tax free, while any gains on divested assets can be subject to double taxation. With spin-offs, shareholder value is created by increasing the focus of the parent by spinning off unrelated units, providing greater transparency, and transferring wealth from bondholders to shareholders.

Equity Carve-Outs

Investors view the announcement of a carve-out as the beginning of a series of restructuring activities, such as a reacquisition of the unit by the parent, a spin-off, a secondary offering, or an M&A. The sizeable announcement-date abnormal returns to parent firm shareholders averaging 3.9% reflect investor anticipated profit from these subsequent events. These abnormal positive returns are realized when the parent firm retains a controlling interest after a carve-out announcement, allowing the parent to initiate these secondary actions.⁵⁷ Furthermore, these returns tend to increase with the size of the carve-out.⁵⁸ Announcement-date returns are significant for both parent firm stock⁵⁹ and bond⁶⁰ investors when the parent indicates that the majority of the proceeds resulting from the carve-out will be used to redeem debt.

While most studies of equity carve-outs have focused on the United States, a recent study of European equity carve-outs was generally consistent with the performance of American equity carve-outs. The magnitude of the positive abnormal announcement-date financial returns for the parent and the subsidiary undergoing a carve-out was greatest in those countries with the highest shareholder protections, especially for minority shareholders.⁶¹

Value is created through equity carve-outs by increased parent focus, providing a source of financing, and resolving agency issues. These are discussed next.

Tracking Stocks

Reflecting initial investor enthusiasm, a number of studies show that tracking stocks experience significant positive abnormal returns around their announcement date. Studies addressing the issue of whether the existence of publicly listed tracking shares increases the demand for other stock issued by the parent give mixed results.⁶³ However, there is some evidence that investors become disenchanted with tracking stocks over time, with excess shareholder returns averaging 13.9% around the date of the announcement that firms would eliminate their target stock issues.⁶⁴

Post Carve-Out, Spin-Off, and Tracking Stock Returns to Shareholders

It is unclear if operating performance improves following equity carve-outs.⁶⁵ There is some evidence that both parents and carved-out subsidiaries tend to improve their operating performance relative to their industry peers in the year following the carve-out.⁶⁶ However, other studies have shown that operating performance deteriorates.⁶⁷ Carve-outs and spin-offs are more likely to outperform stock market indices as their share prices reflect speculation that they will be acquired rather than an improvement in the operating performance. One-third of spin-offs are acquired within 3 years after the unit is spun off by the parent. Once those spin-offs that have been acquired are removed from the sample, the remaining spin-offs generally perform no better than their peers.⁶⁸ Spin-offs may create value by simply providing an efficient method of transferring assets to acquiring companies.⁶⁹

The wealth gain accruing to holders of stock in the unit spun off by the parent is higher in countries where takeover activity is high, reflecting the likelihood that the spun-off units will become takeover targets.⁷⁰ There is evidence that spun-off units show productivity gains due to a reduction in total wage costs and employment, perhaps reflecting improved management attention and discipline. Such gains start immediately following the spin-off and tend to persist for as much as 5 years.⁷¹ Carve-outs that are largely independent of the parent (i.e., in which the parent tended to own less than 50% of the equity) tended to outperform the S&P 500 significantly.⁷² The evidence for the long-term performance of tracking stocks is mixed.⁷³

Discussion Questions

1. 1. The merger of CBS Radio and Entercom could have been achieved as a result of a CBS spin-off of CBS Radio. Explain the details of how this might happen.
2. 2. Speculate as to why CBS chose to split-off rather than spin-off CBS Radio as part of its plan to merge CBS Radio with Entercom. Be specific.
3. 3. What are the Morris Trust tax regulations? How did they affect how this deal was structured? Why was the final ownership distribution of Entercom important?
4. 4. How is value created for CBS and Entercom Shareholders in this type of a transaction?
5. 5. What are the advantages and disadvantages of a Reverse Morris Trust structure?

Solutions to this case study are found in the Online Instructors Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).