Many corporations, particularly large, highly diversified organizations, are reviewing constantly ways in which they can enhance shareholder value by changing the composition of their assets, liabilities, equity, and operations. These activities generally are referred to as restructuring strategies. Restructuring may embody both growth and exit strategies. Growth strategies have been discussed elsewhere in this book. The focus in this chapter is on those strategic options allowing the firm to maximize shareholder value by redeploying assets through downsizing or refocusing the parent company. As such, this chapter discusses the myriad motives for exiting businesses, the various restructuring strategies for doing so, and why firms select one strategy over other options. In this context, equity carve-outs, spin-offs, divestitures, and split-offs are discussed separately rather than as a specialized form of a carve-out. The chapter concludes with a review of what empirical studies say are the primary determinants of financial returns to shareholders resulting from undertaking the various restructuring strategies.
Corporate restructuring; Restructuring; Exit strategies; Divestitures; Sell-offs; Spin-offs; Carve-outs; Split-ups; Split-offs; Tracking stocks; Letter stocks; Selling process; Purchase price; Letter stocks; Wealth transfer; Agency issues; Corporate focus; Portfolio reviews
Experience is the name everyone gives to their mistakes.
Oscar Wilde
The comparative stability in global energy prices and diminishing cost cutting opportunities have encouraged consolidation among large oil and gas exploration and development companies. The need to achieve economies of scale to spread fixed costs and new extraction technologies encourages additional industry mergers and acquisitions. The historical route of using business alliances to defray the cost and associated risk of exploiting new oil and gas discoveries has given way to growth by acquiring known energy fields.
A.P. Moller-Maersk Group (Maersk), the world’s largest shipping firm, initiated the process of divesting its energy operations to focus on its transport business in 2016 and return to the firm’s historical roots: logistics and transportation. As part of its restructuring plan, the firm announced on August 21, 2017 that it had agreed to sell its oil and gas business, Maersk Oil, to France’s energy giant Total for $7.45 billion. Total will pay Maersk a combination of $4.95 billion worth of its shares resulting in the Danish conglomerate having a 3.76% stake in Total. In addition, Total will assume responsibility for $2.5 billion in Maersk Oil debt.
Total will assume control over Maersk Oil’s entire operation, including reserve portfolio, obligations, and rights. Denmark will become the regional hub for all of Total’s operations in Denmark, Norway, and the Netherlands due to Maersk Oil’s strong position in the North Sea. Maersk intends to issue a special dividend consisting of a portion of the Total shares it received as a result of the sale of Maersk Oil.
On a per barrel basis, Total is paying $13.40 per barrel of reserves. This is consistent with what Royal Dutch Shell paid to acquire competitor BG Group Plc in 2015. In undertaking this deal, Total is reducing its exposure to higher risk regions such as Iran and Qatar and toward OECD regions. Total will be adding about one million barrels of output to its current two million barrels pumped per day in the North Sea region. Total expects to realize $400 million in annual cost savings by combining its North Sea operations with Maersk Oil’s. Total is using its healthy balance sheet to buy attractive assets from competitors as it emerged from the downturn in energy prices stronger than many of its rivals. Implicit in Total’s strategy is that it should replenish its reserves in view of its expectation that oil and gas prices will rise.
But is Total too early in acquiring these oil and gas reserves? The risk is clear: Will oil and gas prices remain in their current trading range or slide further if global economic growth slows? Will the 2016 Paris Climate Accord have the intended effect on slowing (or even reducing) the world’s demand for carbon based fuels? Different energy companies have different answers to these questions. It is these differences that motivate buyers and sellers in the global takeover market. Maersk attempts to manage risk by refocusing the firm on its core logistics and transportation capabilities. Total manages its perceived risk by shifting its geographic focus of oil and gas reserves from the Middle East to the North Sea and by replenishing reserves when they are believed to be relatively cheap.
In recent years, many firms have moved away from managing a complex, diverse set of businesses to a coherent business portfolio more easily understood by investors and more easily managed by those tasked with the responsibility to do so. Most businesses, particularly large, highly diversified organizations, are constantly looking for ways in which they can enhance shareholder value by changing the composition of their assets, liabilities, equity, and operations. These activities generally are referred to as restructuring strategies. Restructuring may embody both growth strategies and exit strategies. Growth strategies have been discussed elsewhere in this book. The focus in this chapter is on those strategic options allowing the firm to maximize shareholder value by redeploying assets through downsizing or refocusing the parent company. As such, this chapter discusses the myriad motives for exiting businesses, the various restructuring strategies for doing so, and why firms select one strategy over other options.
In this context, equity carve-outs, spin-offs, divestitures, and split-offs are discussed separately rather than as a specialized form of a carve-out.1 The chapter concludes with a discussion of what empirical studies say are the primary determinants of financial returns to shareholders resulting from undertaking the various restructuring strategies. Voluntary and involuntary restructuring and reorganization (both inside and outside the protection of bankruptcy court) also represent exit strategies for firms and are discussed in detail in Chapter 17. A review of this chapter (including practice questions with answers) is available in the file folder entitled “Student Study Guide” on the companion website to this book (https://www.elsevier.com/books-and-journals/book-companion/9780128150757).
Theories abound as to why corporations choose to exit certain businesses. While not an exhaustive list, some of the most common are discussed next.
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
Parent firms often exit businesses failing to meet or exceed the parent’s hurdle-rate requirements. Amid plummeting readership and advertising revenues, Gannet, Tribune Company, and E.W. Scripps, firms that had historically grown as print newspapers but which had expanded into other forms of media, dumped their print businesses in 2015 through spin-offs. That same year, in the wake of softening commodity prices, global metals and mining company BHP Billion spun off underperforming assets that contributed only 4% of the consolidated firm’s profitability. The spinoff essentially undid the 2001 merger that created the global commodities firm.
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.
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 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.
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.
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.
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.
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.
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.
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.
A divestiture is the sale of a portion of a firm’s assets to an outside party, generally resulting in a cash infusion to the parent. Such assets may include a product line, a subsidiary, or a division.
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.
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
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.
To decide if a business is worth more to the shareholder if sold, the parent must first estimate the after-tax cash flows of the business viewed on a stand-alone basis. This requires adjusting the cash flows for intercompany sales and the cost of services (e.g., legal, treasury, and audit) provided by the parent. Intercompany sales refer to operating unit revenue generated by selling products or services to another unit owned by the same parent. Intercompany sales should be restated to ensure they are valued at market prices.7 Moreover, services provided by the parent to the business may be subsidized or at a markup over actual cost. Operating profits should be reduced by the amount of any subsidies and increased by any markup over what the business would have to pay if it purchased comparable services outside of the parent firm.
Once cash flows have been determined, a discount rate should be estimated that reflects the risk characteristics of the industry in which the business competes. The cost of capital of other firms in the same industry (or firms in other industries exhibiting similar profitability, growth, and risk characteristics) is often a good proxy for the discount rate of the business being analyzed.
The discount rate from Step 2 then is used to estimate the market value of the projected after-tax cash flows of the business determined in Step 1. Step 3 also requires the estimation of an appropriate terminal value for the business (see Chapter 7).
The after-tax equity value (EV) of the business as part of the parent is estimated by subtracting the market value of the business’s liabilities (L) from its after-tax market value (MV) as a stand-alone operation. This relationship can be expressed as follows:
EV is a measure of the after-tax market value of the shareholder equity of the business, where the shareholder is the parent firm.
The decision to sell or retain the business is made by comparing the EV with the after-tax sale value (SV) of the business. Assuming other considerations do not outweigh any after-tax gain on the sale of the business, the decision to sell or retain can be summarized as follows:
Although the sale value may exceed the equity value of the business, the parent may choose to retain the business for strategic reasons. The parent may believe that the business’s products facilitate the sale of other products the firm offers. Amazon.com breaks even on the sale of Kindle e-book readers while expecting to make money on electronic books that will be downloaded via the Kindle. In another instance, the divestiture of one subsidiary of a diversified parent may increase operating expenses for other parent operations. In 2011, one reason given for Hewlett-Packard’s decision not to sell its PC unit after publicly announcing its intention to do so was the potential for a one-time increase in expenses following the selloff of the unit.8
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.
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.
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.
Table 16.1
Selling process | Advantages/disadvantages |
---|---|
One-on-one negotiations (single bidder) | Enables seller to select the buyer with the greatest synergy. Minimizes disruptive due diligence. Limits the potential for loss of proprietary information to competitors. May exclude potentially attractive bidders. |
Public auction (no limit on number of bidders) | Most appropriate for small, private, or hard-to-value firms. May discourage bidders concerned about undisciplined bidding by uninformed bidders. Potentially disruptive due to multiple due diligence activities. |
Controlled auction (limited number of bidders) | Enables seller to select potential buyers with the greatest synergy. Sparks competition without the disruptive effects of public auctions. May exclude potentially attractive bidders. |
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.
Table 16.2
Financial market considerations | |
Run-up in preannouncement target share price | While the run-up may cause bidders unsure of having adequate information to increase their offer price, there is little evidence that bidders pay for anticipated synergies twice. That is, when the target’s share price increases in advance of the deal’s announcement plus the excess of the offer price over the run-up.a |
Credit rating | Rated firms on average pay a 3.3% higher premium reflecting their lower cost of capital than nonrated acquirers. Bidders tend to pay lower premiums when the target firm has bonds that are rated as the target is more transparent and more easily valued.b |
Investor consensus around target share price | Acquisition premiums tend to be higher whenever there is considerable disagreement among bidders as to the value of the target, possibly reflecting more active bidding for the target firm.c |
Target characteristics | |
Net synergy potential | Purchase premiums are likely to increase the greater the magnitude of perceived net synergy. Net synergy often is greatest in related firms.a Moreover, premiums are likely larger if most of the synergy is provided by the target. |
Growth potential | Targets displaying greater growth potential relative to competitors generally command higher premiums.d |
Target size | Buyers pay more for smaller targets due to potential ease of integration.e |
Target’s eagerness to sell | Targets with a strong desire to sell typically receive lower premiums due to their relatively weak negotiating positions.f |
Industry growth prospects | The magnitude of premiums varies substantially across industries, reflecting differences in expected growth rates.g |
Industry structure | Targets in industries undergoing consolidation command higher premiums than other industries as acquirers attempt to eliminate industry excess capacity.h |
Acquirer characteristics | |
Desire for control | Buyers pay more for control of firms with weak financial performance because of potential gains from making better business decisions. |
Hubris | Excessive confidence may lead bidders to overpay.i |
Information asymmetry (i.e., one bidder has more information than others) | Informed bidders are likely to pay lower premiums because less informed bidders fear overpaying and either withdraw from or do not participate in the bidding process.j |
Type of purchase | Hostile transactions (or the credible threat of such transactions) tend to command higher premiums than friendly transactions.k |
Type of payment | Cash purchases usually require an increased premium to compensate target shareholders for the immediate tax liability they incur.d Bidders using overvalued shares often overpay for target firms. |
Financial leverage (debt/equity) | Highly leveraged buyers are disciplined by their lenders not to overpay; relatively unleveraged buyers often are prone to pay excessive premiums.l However, overlevered acquirers are willing to pay higher premiums for targets that would increase their debt capacity.m |
Customer-supplier relationships | In vertical mergers, buyers substantially reliant on a target that is either a customer or a supplier and that has few alternatives will be forced to pay higher premiums than otherwise.n |
Board connections | Acquirers realize higher announcement-date returns in transactions in which the target and the acquirer’s boards share a common director, perhaps reflecting more consistent and candid communication.o |
Value of potential target tax attributes (e.g., NOLs) | Acquirers are willing to pay more for target tax attributes if they believe the potential tax savings can be realized relatively quickly.p |
Preemption concerns | Acquirers willing to pay more for a target at an earlier stage of development to prevent others from acquiring it.q |
i Hayward and Hambrick (1997).
k Calcagno and Falconieri (2014) and Moeller (2005).
l Gondhalekar et al. (2004) argue that highly levered buyers are monitored closely by their lenders and are less likely to overpay. Hackbarth and Morellec (2008) find that relatively unleveraged buyers often pay more for targets.
o Cai and Sevilir (2012). Having a board connection often improves the information flow such that the acquirer is less likely to overpay for the target firm.
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
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.
A spin-off is a stock dividend paid by a firm to its current shareholders consisting of shares in an existing or newly created subsidiary. No shareholder approval is required since only the board of directors may decide the amount, type and timing of dividends. Such distributions are made in direct proportion to the shareholders’ current holdings of the parent’s stock. As such, the proportional ownership of shares in the subsidiary is the same as the stockholders’ proportional ownership of shares in the parent firm. The new entity has its own management and operates independent of the parent company. Unlike the divestiture or equity carve-out (explained later in this chapter), the spin-off does not result in a cash infusion to the parent. Following the spin-off, shareholders own both parent company shares and shares in the unit involved in the spin-off.
While spin-offs may be less cumbersome than divestitures, they are by no means simple to execute. The parent firm must make sure that the unit to be spun off is viable on a standalone basis, legally disentangled from other parent operations, and that the parent has no ongoing liabilities associated with the spun-off unit. If the spun-off unit goes into bankruptcy shortly after having been separated from the parent, the parent may be held responsible for the unit’s liabilities. Once the spin-off has been implemented, the former parent often continues to provide “transitional” services. More than 1 year after Baxter International completed its spin-off of biopharmaceutical business Baxalta, Inc. the parent was still managing many of Baxalta’s back office operations such as finance and IT. While receiving $100 million annually for such services, the former parent is limited in its ability to make other changes in its ongoing operations since it needs to maintain this support infrastructure.
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.
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:
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.
Equity carve-outs exhibit characteristics similar to spin-offs. Both result in the subsidiary’s stock’s being traded separately from the parent’s stock. They also are similar to divestitures and IPOs, in that they provide cash to the parent. However, unlike the spin-off or the divestiture, the parent generally retains control of the subsidiary in a carve-out transaction. A potentially significant drawback to the carve-out is the creation of minority shareholders.
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.
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.
Table 16.3
Steps | Comments |
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Step 1: Decide to go public | Why? To raise money to grow the firm, allow early investors to cash out, reduce indebtedness, make acquisitions, to recruit talented managers, etc. |
Step 2: Hire an investment bank(s) to guide and to market the equity issue | Investment banks: • Create legal documents and satisfy regulatory requirements • Advise the client through the process of marketing, pricing, and conducting IPOs • Stand ready to buy IPO shares if they fall postissue to limit volatility |
Step 3: Register with the Securities and Exchange Commission (SEC) | Requires filing an S-1 form with the SEC which entails listing the company’s plans for the funds raised, its business model, the competition, its corporate governance, and executive compensation.a |
Step 4: “Road show” | The offering is promoted to potential investors, as soon as 21 days after the S-1 is approved. Prior to the “road show,” the number of shares offered and the price per share (often within a narrow range) are announced.b “Road show” attendees include hedge funds, mutual funds, banks, pension funds, endowments, and individuals.c |
Step 5: Issue equity | Based on precommitments to buy shares made during the “road show,” a final price (or reference price) and deal size are announced. Investors having submitted final bids find out if they can buy the stock. |
a Many firms are uncomfortable with a public filing since it makes sensitive data available to their competition. Now, under the JOBS Act of 2012, many firms can file confidentially. See Chapter 2 for more detail.
b Firms often issue 10%–25% of their stock to ensure a liquid market for the stock.
c Investment bankers conducting the “road show” record preissue offers made for the stock at various prices and adjust the price up or down depending on demand prior to the sale of the stock.
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.
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.
A split-off involves the parent firm making an offer to shareholders to exchange their parent stock for all or a portion of the shares of the firm’s subsidiary. It is equivalent to a share repurchase by the parent of its stock using stock in the subsidiary instead of cash. Like a spin-off, the split-off results in the parent’s subsidiary becoming an independent firm; the parent does not generate any new cash. Unlike spin-offs, which result in the same proportionate ownership distribution before and after the spin-off, split-offs generally result in disproportionate changes in the ownership of parent shares. Split-offs normally are non-pro rata stock distributions, in contrast to spin-offs, which generally are pro rata (or proportional) distributions of shares. In a pro rata distribution, a shareholder owning 10% of the outstanding parent company stock would receive 10% of the subsidiary shares. A non-pro rata distribution takes the form of a tender or exchange offer in which shareholders can accept or reject the distribution generally resulting in a disproportionate change in the ownership of parent shares outstanding. For example, if 50% of the parent shareholders exchange their parent shares for subsidiary shares the remaining half of parent shareholders will hold 100% of whatever parent shares remain outstanding.
A split-up is a restructuring strategy in which a single company splits into two or more separately managed firms. Through a series of split-offs or spin-offs, shareholders of the original or parent firm may choose to exchange their shares in the parent firm for shares in the new companies. Following the split, the original firm’s shares are cancelled, and it ceases to exist.
Recent examples include industrial conglomerate Pentair Plc., US aluminum company, Alcoa Inc., and business services firm Xerox Corp. In an admission of a lack of synergy between their business units, Pentair split into two parts in mid-2018: one that provides fluid-processing and water-filtration technologies while retaining the businesses selling protective enclosures for electrical equipment. Alcoa split the firm into separate entities in late 2016 to isolate the firm’s more profitable “value added” upstream fabrication operations from its floundering downstream raw aluminum operations. The upstream company consists of rolled sheet products, engineered products, and transportation and construction businesses. The downstream business includes the firm’s bauxite-mining and aluminum ingot production operations. The decision was made to give investors the opportunity to invest in companies with a narrower product focus in an effort to boost shareholder value. Xerox reversed its effort to combine business services with copiers and printers when it split into two publicly traded companies in 2017: one contained its office machines and another contained its services operations.
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.
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 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.
Such stocks are separate classes of common stock of the parent firm. The parent divides its operations into two or more subsidiaries and assigns a common stock to each. Tracking stock is a class of common stock that links the shareholders’ return to the subsidiary’s operating performance. Tracking stock dividends rise or fall with the subsidiary’s performance. Such stock represents an ownership interest in the parent rather than an ownership interest in the subsidiary. For voting purposes, holders of tracking stock with voting rights may vote their shares on issues related to the parent and not the subsidiary. The parent’s board of directors and top management retain control of the subsidiary for which a tracking stock has been issued, since it is still legally part of the parent. Tracking stocks may be issued to current parent shareholders as a dividend, used as payment for an acquisition, or issued in a public offering.
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.
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.
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 follows is a partial list of some of the more important issues that should be addressed early in the process in the context of a spin-off to illustrate how they are commonly resolved. The unit to be separated from the parent will be referred to as the “spin-off company.”
Once a unit has been identified for separation, the parent must determine what assets will be retained and what will go with the unit. Finance-related issues include determining the desired debt-to-total capital ratio, deciding which nonlong-term debt related liabilities will go with the spin-off company and which will be retained, and how to maintain the solvency of the spin-off unit. Other critical execution issues are determining the appropriate governance mechanism for the new unit and how best to address human resource issues. These issues are discussed next.
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.
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.
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.
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.
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.
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.
Key documents include a separation and distribution agreement, a transition agreement, and a tax matters agreement negotiated between the parent and spin-off companies. Additional agreements may include patent, trademark and other intellectual property license arrangements.
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.
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.
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.
Table 16.4 summarizes the primary characteristics of the restructuring strategies discussed in this chapter. Note that divestitures and carve-outs provide cash to the parent, whereas spin-offs and split-ups do not. The parent remains in existence in all restructuring strategies. A new legal entity generally is created with each restructuring strategy. With the exception of the carve-out, the parent generally loses control of the division involved in the restructuring strategy. Only spin-offs, split-ups, and split-offs are generally not taxable to shareholders, if properly structured.
Table 16.4
Alternative strategies | ||||||
---|---|---|---|---|---|---|
Characteristics | Divestitures | Equity carve-outs/IPOs | Spin-offs | Split-ups | Split-offs | Tracking stocks |
Cash infusion to parent | Yes | Yes | No | No | No | Yes |
Parent ceases to exist | No | No | No | Yes | No | No |
New legal entity created | Sometimes | Yes | Yes | Yes | No | No |
New shares issued | Sometimes | Yes | Yes | Yes | Yes | Yes |
Parent remains in control | No | Generally | No | No | No | Yes |
Taxable to shareholders | Yes | Yes | No | No | No | No |
Parent firms undertaking divestitures often are diversified in unrelated businesses and desire to achieve greater focus or to raise cash.36 Those using carve-out strategies operate businesses with some synergy, have contractual obligations to the business, and want to raise cash. The parent may pursue a carve-out rather than a divestiture or spin-off to retain synergy. The timing of the carve-out is influenced by when management sees its subsidiary’s assets as overvalued.37 Firms engaging in spin-offs often are diversified, but less so than those that are prone to pursue divestiture strategies and have little need to raise cash. Table 16.5 identifies characteristics of parent firm operating units that are subject to certain types of restructuring activities.
Table 16.5
Sources: Kang, J., Shivdasani, A., 1997. Corporate restructuring during performance declines in Japan. J. Financ. Econ. 46, 29–65, Powers, E., 2003. Deciphering the motives for equity carve-outs. J. Financ. Res. 26, 31–50, Chen, H.L., Guo, R.J., 2005. On corporate divestitures. Rev. Quant. Finan. Acc. 25, 399–421, Bergh, D., Johnson, R., Dewitt, R.L., 2007. Restructuring through spin-off or sell-off: transforming information asymmetries into financial gain. Strateg. Manag. J. 29, 133–148, and Prezas, A., Simmonyan, K., 2015. Corporate divestitures: spin-offs v. sell-offs. J. Corp. Finan. 34, 83–107.
Divestitures, carve-outs, and spin-offs are commonly used when a parent corporation is considering exiting a business partially or entirely. Which strategy to use is influenced by the parent firm’s need for cash, the degree of synergy between the business to be divested or spun off and the parent’s other operating units, and the potential selling price of the division. However, these factors are not independent. Parent firms needing cash are more likely to divest or engage in an equity carve-out for operations exhibiting high selling prices relative to their synergy value. Parent firms not needing cash are more likely to spin off units exhibiting low selling prices and synergy with the parent. Parent firms with moderate cash needs are likely to engage in equity carve-outs when the unit’s selling price is low relative to perceived synergy.
Unlike a spin-off, a divestiture or carve-out generates a cash infusion to the firm. However, a spin-off may create greater shareholder wealth, for several reasons. First, a spin-off is tax-free to the shareholders if it is properly structured. The cash proceeds from an outright sale may be taxable to the parent if a gain is realized. Also, management must be able to reinvest the after-tax proceeds at or above the firm’s cost of capital. If management chooses to return the cash proceeds to shareholders, the shareholders incur a tax liability. Second, a spin-off enables the shareholders to decide when to sell their shares. Third, a spin-off may be less traumatic than a divestiture for an operating unit. The divestiture process can degrade value if it is lengthy: employees leave, worker productivity suffers, and customers may not renew contracts.
Restructuring strategies can create value by increasing parent firm focus, transferring assets to those who can operate them more efficiently, and mitigating agency conflicts and financial distress. The empirical support for this statement is discussed next in terms of pre- and postannouncement financial returns to shareholders by type of restructuring strategy.
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.
Table 16.6
Restructuring strategy | Average preannouncement abnormal returns (%) |
---|---|
Divestituresa | 1.5 |
Spin-offsb | 3.8 |
Tracking stocksc | 3.0 |
Equity carve-outsd | 3.9 |
a Allen (2000), Clubb and Stouraitis (2002), Bates (2005), Slovin et al. (2005), Kengelbach et al. (2014), Prezas and Simmonyan (2015).
b Loh et al. (1995), Maxwell and Rao (2003), Veld and Veld-Merkoulova (2004), McNeil and Moore (2005), Harris and Glegg (2007), Kengelbach et al. (2014), Prezas and Simmonyan (2015).
c Logue et al. (1996), D’Souza and Jacob (2000), Elder and Westra (2000), Chemmanur and Paeglis (2001), and Billett et al. (2004a,b).
d Vijh (1999), Prezas et al. (2000), Hulburt et al. (2002), Hogan and Olson (2004), and Kengelbach et al. (2014).
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.
In late 2015, Google Inc. unveiled a sweeping reorganization separating its highly profitable search and advertising business from its fledgling research and development investments including robotics and self-driving cars. The resulting holding company was named Alphabet Inc. The search and advertising operations contribute almost 90% of the firm’s total revenue and all of its profits. The so-called “moon-shot” investments are intended to identify the “next big thing” to propel the firm’s future growth. While billed as an effort to give investors greater visibility into the cost of these investments and to facilitate managing the increasingly complex firm, the new structure allows the firm to divest or spin-off the noncore businesses in the future.
Google is not alone in its effort to manage complexity. The difficulty in managing diverse portfolios of businesses and in valuing accurately these portfolios contributed to the breakup of conglomerates in the 1970s and 1980s. Of the acquisitions made between 1970 and 1982 by companies in industries unrelated to the acquirer’s primary industry focus, 60% were divested by 1989. Abnormal returns to shareholders of a firm divesting a business result largely from improved management of the assets that remain after the divestiture.41 Divesting firms often improve their investment decisions in their remaining businesses following divestitures by achieving levels of investment in core businesses comparable to those of their more focused peers.42 However, poorly managed firms may be inclined to misuse the proceeds received from asset sales. Firms experiencing cash windfalls are prone to make value destroying acquisitions after experiencing the cash inflow as they are more likely to overpay for the target firm.43
Some firms seem to prosper despite the growing complexity of their business portfolio. Berkshire Hathaway is a prime example. The firm has successfully managed for decades a highly diverse portfolio ranging from cowboy boots, floor enamel and Ginsu knives to ear-piercing tools, diamond rings, encyclopedias, candelabras, and refrigerated trailers. The firm also owns a variety of insurance businesses and ketchup and other condiments products. Demonstrating the firm’s ongoing commitment to managing a diverse business portfolio, Berkshire Hathaway made its largest acquisition in 2015 taking control of Precision Castparts, an aerospace equipment supplier, for $32 billion. The firm’s success is perhaps a testimony more to the superb investment and management skills of Warren Buffett and the firm’s management culture than to the conglomerate as a sustainable business organization. Few have been able to even come close to Berkshire Hathaway’s success in managing highly diverse firms. General Electric after years of superior stock market performance under the guidance of CEO Jack Welch floundered shortly after he retired in the early 2000s. In the last decade, the firm has sold off hundreds of billions of dollars in underperforming assets.
Divestitures result in productivity gains by transferring assets from poorly managed sellers to acquirers that are on average better managed. Investors thus have a reasonable expectation that the acquirer can generate a higher financial return and bid up its share price.44
Conflicts arise when management and shareholders disagree about major corporate decisions. What to do with the proceeds of the sale of assets can result in such a conflict, since they can be reinvested in the seller’s remaining operations, distributed to shareholders, or used to reduce the firm’s outstanding debt. Abnormal returns on divestiture announcement dates tend to be positive when the proceeds are used to pay off debt45 or are distributed to the shareholders.46 Such results suggest shareholders mistrust management’s ability to invest intelligently.
Not surprisingly, empirical studies indicate that firms sell assets when they need cash. The period before a firm announces asset sales often is characterized by deteriorating operating performance. Firms that divest assets often have lower cash balances, cash flow, and bond credit ratings than firms exhibiting similar growth, risk, and profitability characteristics.47 Firms experiencing financial distress are more likely to utilize divestitures as part of their restructuring programs than other options, because they generate cash.48
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.
Spin-offs that increase parent focus improve excess financial returns more than spin-offs that do not increase focus.49 There is also a reduction in the diversification discount when a spin-off increases corporate focus, but not for those that do not.50 Spin-offs of subsidiaries that are in the same industry as the parent firm do not result in positive announcement-date returns because they do little to enhance corporate focus.51 Like divestitures, spin-offs contribute to better investment decisions by eliminating the tendency to use the cash flows of efficient businesses to finance investment in less efficient business units; parent firms also are more likely to invest in their attractive businesses after the spin-off.52
Divestitures and spin-offs tending to reduce a firm’s complexity help to improve investors’ ability to evaluate the firm’s operating performance. By reducing complexity, financial analysts are better able to forecast earnings accurately.53 Analysts tend to revise upward their earnings forecasts of the parent in response to a spin-off.54
Evidence shows that spin-offs transfer wealth from bondholders to parent stockholders, for several reasons.55 First, spin-offs reduce the assets available for liquidation in the event of business failure: investors may view the firm’s existing debt as riskier.56 Second, the loss of the cash flow generated by the spin-off may result in less total parent cash flow to cover interest and principal repayments on the parent’s current debt. In contrast, stockholders benefit from holding shares in the parent firm and shares in the unit spun off by the parent, with the latter now separate from the parent, having the potential to appreciate in value.
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.
Parents and subsidiaries involved in carve-outs often are in different industries. Positive announcement-date returns tend to be higher for carve-outs of unrelated subsidiaries. This is consistent with the common observation that carve-outs are undertaken for businesses that do not fit with the parent’s business strategy.
Equity carve-outs can help to finance the needs of the parent or the subsidiary. Firms choose equity carve-outs and divestitures over spin-offs when the ratio of market value to book value and revenue growth of the carved-out unit are high to maximize the amount of cash raised.62
Investor reaction to a carve-out announcement is determined by how the proceeds are used. Firms announcing that the proceeds will be used to repay debt or pay dividends earn a 7% abnormal return, compared to minimal returns for those announcing that the proceeds will be reinvested in the firm.
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
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
Divestitures, spin-offs, equity carve-outs, split-ups, and split-offs are commonly used restructuring strategies to redeploy assets by returning cash or noncash assets through a special dividend to shareholders or to use cash proceeds to pay off debt. On average, these restructuring strategies create positive abnormal financial returns for shareholders around the announcement date but the longer-term performance of spin-offs, carve-outs, and tracking stocks is problematic.
Answers to these Chapter Discussion Questions are found in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).
In early 2016, CBS Inc. (CBS) considered “strategic options” for its radio business, CBS Radio. The unit’s operating performance had been deteriorating in recent years due to declining ad revenues and profit pressures due to internet competition. While radio reaches more Americans than any other medium and offers advertisers the ability to target local markets, CBS Radio simply did not have the geographic coverage and content to achieve sustained profitability.
The range of options considered included retaining the business, undertaking an IPO followed by a split-off, exiting the business through a Reverse Morris Trust transaction, and selling the business for cash. Unable to find a buyer and finding the other options unattractive, CBS announced on February 20, 2017 that it would exit CBS radio in a two-step strategy involving initially splitting off the business to its shareholders through an exchange offer and immediately merging with Entercom Communications Corp (Entercom) through a Reverse Morris Trust transaction.74 Entercom is a publicly traded American broadcasting company and the fourth largest radio network in the United States owning 127 radio stations in 28 major media markets.
It was no secret that CBS wanted any deal for its radio operations to be tax-free. A Reverse Morris Trust is a tax-optimization strategy in which a company wishing to spin off and subsequently sell assets (CBS) to another party (Entercom) can do so and avoid taxes on any gains that would have been incurred had the assets been sold outright. The deal if properly structured would also be tax-free to CBS shareholders. The Reverse Morris Trust acquisition combines a divisive reorganization (e.g., a spin-off or split-off) with an acquisitive reorganization (e.g., a statutory merger) to allow a tax-free transfer of a subsidiary.75
The deal would create the largest US radio network consisting of 244 stations, including 23 of the 25 top markets. The combined firms will have the rights to broadcast 45 professional sports teams, a leadership position in news and talk formats, a diverse array of music and entertainment formats, a growing portfolio of digital content, and the ability to distribute dozens of major market radio shows across multiple media platforms.76 The merger also allows the combined firms to achieve the scale necessary to achieve the cost savings through the elimination of duplicate functions to compete profitably with other media. On a proforma basis, the combined firms will have $1.7 billion in annual revenue, making it the second largest radio station owner in the United States, and an annual EBITDA of almost $500 million, including an expected $25 million in annual cost savings related synergies.
According to SEC filings, Entercom would issue about 101, 497, 494 shares of its Class A common stock to complete the merger, along with another 4,004,451 Entercom restricted stock units and options to CBS Radio employees who have unvested equity awards. This brings total new Entercom stock issued to 105, 501, 945. Based on its average stock price of $13.50, the enterprise value of the deal is $2.794 billion, consisting of $1.424 billion of CBS Radio equity plus the assumption of $1.370 billion in CBS Radio debt.
Entercom chairman Joe Field, the firm’s controlling shareholder, agreed to vote in favor of the transaction and recommended that the other shareholders vote for the merger. The firm’s board unanimously approved the merger and related agreements just prior to the deal’s public announcement. Progress in the deal was slowed by a “second request” for data by the Justice Department. Fig. 16.3 illustrates the three stages of the deal. These include the following: (1) the creation of the CBS Radio subsidiary directly owned by CBS, (2) the exchange offer, and (3) the reverse merger of CBS Radio into Entercom’s Merger Sub with CBS Radio surviving.
Prior to the exchange offer, Westinghouse directly owned 100% of CBS Broadcasting, and CBS Broadcasting directly owned 100% of the equity of CBS Radio. As a result of an internal CBS reorganization, CBS Broadcasting would distribute all of the outstanding equity of CBS Radio to Westinghouse, which then would distribute all of its equity in CBS Radio to CBS, making CBS Radio a directly owned subsidiary of CBS.77
In the exchange proposal, CBS shareholders could buy all, some, or none of the 105, 501, 945 CBS Radios shares offered by tendering their CBS shares. Any CBS Radio shares not exchanged would be distributed in a spin-off on a pro rata basis to the remaining holders of CBS Class B stock. The final share exchange ratio used to determine the number of shares of Radio common stock offered for each share of CBS Class B common stock accepted in the exchange offer (as well as the upper limit on the number of shares that can be received for each share of CBS Class B common stock tendered) would be announced by press release at the end of the second day of trading day immediately preceding the expiration date of the exchange offer. The exchange offer does not provide for a minimum exchange ratio.
Immediately following the final distribution (split-off plus any spin-off shares if necessary) of CBS Radio shares, Entercom’s Merger Sub would merge with CBS Radio, with the latter surviving as a subsidiary of Entercom. Each share of CBS Radio common would be converted into the right to receive one share of Entercom Class A common stock. Following the merger, Entercom would contribute all the outstanding equity interests in Entercom Radio to CBS Radio such that Entercom Radio would become a wholly owned subsidiary of CBS Radio.
Entercom’s share price had fallen by more than 40% since the merger announcement date. Since CBS Radio is classified by CBS as held for sale, accounting practices dictate that its carrying (book) value continued to fluctuate based on the trading price of Entercom’s stock raising the possibility that either party could back out of the deal. The deal terms call for a party withdrawing from the deal to pay the other a “breakup” fee of $30 million.
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).