Chapter 15
Alternative Exit and Restructuring Strategies
Divestitures, Spin-Offs, Carve-Outs, Split-Ups, Split-Offs, and Tracking Stocks
Experience is the name everyone gives to their mistakes.
—Oscar Wilde
Inside M&A: Bristol-Myers Squibb Splits off the Rest of Mead Johnson
Facing the loss of patent protection for its blockbuster drug Plavix, a blood thinner, in 2012, Bristol-Myers Squibb Company decided to split off its 83% ownership stake in Mead Johnson Nutrition Company in late 2009 through an offer to its shareholders to exchange their Bristol-Myers shares for Mead Johnson shares. The decision was part of a longer-term restructuring strategy that included the sale of assets to raise money for acquisitions of biotechnology drug companies and the elimination of jobs to reduce annual operating expenses by $2.5 billion by the end of 2012.
Bristol-Myers anticipated a significant decline in operating profit following the loss of patent protection as increased competition from lower-priced generics would force sizeable reductions in the price of Plavix. Furthermore, Bristol-Myers considered Mead Johnson, a baby formula manufacturer, as a noncore business that was pursuing a focus on biotechnology drugs. Bristol-Myers shareholders greeted the announcement positively, with the firm's shares showing the largest one-day increase in eight months.
In the exchange offer, Bristol-Myers shareholders were able to exchange some, none, or all of their shares of Bristol-Myers common stock for shares of Mead Johnson common stock at a discount. The discount was intended to provide an incentive for Bristol-Myers shareholders to tender their shares. Also, the rapid appreciation of the Mead Johnson shares in the months leading up to the announced split-off suggested that these shares could have attractive long-term appreciation potential.
While the transaction did not provide any cash directly to the firm, it did indirectly augment Bristol-Myer's operating cash flow by $214 million annually. This represented the difference between the $350 million that Bristol-Myers paid in dividends to Mead Johnson shareholders and the $136 million it received in dividends from Mead Johnson each year. By reducing the number of Bristol-Myers shares outstanding, the transaction also improved Bristol-Myers' earnings per share by 4% in 2011. Finally, by splitting-off a noncore business, Bristol-Myers was increasing its attractiveness to investors interested in a “pure play” in biotechnology pharmaceuticals.
The exchange was tax free to Bristol-Myers shareholders participating in the exchange offer, who also stood to gain if the now independent Mead Johnson Corporation were acquired at a later date. The newly independent Mead Johnson had a poison pill in place to discourage any takeover within six months to a year following the split-off. The tax-free status of the transaction could have been disallowed by the IRS if the transaction were viewed as a “disguised sale” intended to allow Bristol-Myers to avoid paying taxes on gains incurred if it had chosen to sell Mead Johnson.
Chapter Overview
Many corporations, particularly large, highly diversified organizations, are constantly reviewing 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.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 16. A review of this chapter (including practice questions with answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
Commonly Stated Motives for Exiting Businesses
Theories abound as to why corporations choose to exit certain businesses, including increasing corporate focus, a desire to exit underperforming businesses, a lack of fit, regulatory concerns, and tax considerations. Other motives include a need to raise funds, reduce risk, discard unwanted businesses from prior acquisitions, avoid conflicts with customers, and increase financial transparency (i.e., the ease with which investors can understand a firm's true financial performance).
Increasing Corporate Focus
Managing highly diverse and complex portfolios of businesses is both time consuming and distracting and may result in funding those businesses with relatively unattractive investment opportunities with cash flows generated by units offering more favorable opportunities. This is particularly true when the businesses are in largely unrelated industries and senior managers lack sufficient understanding of such businesses to make appropriate investment decisions. Consequently, 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.
In 2005, Agilent announced that it had reached an agreement to sell its semiconductor unit and its stake in a lighting technology company for $3.6 billion to emphasize its core measurement products business. Similarly, Sara Lee announced in early 2006 that it would divest or spin off businesses accounting for as much as 40% of its current revenue to concentrate its resources on its food and beverage business (see Case Study 15.6 for more details). In 2010, Fiat announced that it would spin off its trucking operations to focus on its core car operations and to enable investors to more easily value the firm.
Underperforming Businesses
Parent firms often exit businesses that consistently fail to meet or exceed the parent's hurdle rate requirements. In 2004, IBM announced the sale of its ailing PC business to China's Lenovo Group. In May 2007, General Electric announced the sale of its plastics operations for $11.6 billion to Saudi Basic Industries Corporation as part of the firm's strategy to sell lower-return businesses and move into faster-growing and potentially higher-return businesses such as healthcare and water processing. In late 2007, Daimler announced it was divesting its Chrysler operations to private equity investor firm Cerberus in exchange for Cerberus's willingness to pay off $18 billion in future retirement and healthcare liabilities. Daimler had acquired Chrysler in 1998 for $36 billion.
Regulatory Concerns
A firm with substantial market share purchasing a direct competitor may create concerns about violations of antitrust laws. Regulatory agencies still may approve the merger if the acquiring firm is willing to divest certain operations that, in combination with similar units in the acquiring company, are deemed to be anticompetitive. As a result of an antitrust suit filed by the Department of Justice, the government and AT&T reached an agreement effective January 1, 1984, to break up AT&T's 22 operating companies into 7 regional Bell operating companies (RBOCs). The RBOCs became responsible for local telephone service, and AT&T kept responsibility for long-distance service and certain telecommunications equipment manufacturing operations. In another instance, the Justice Department required AlliedSignal and Honeywell to divest overlapping businesses before approving their merger in 1999.
Lack of Fit
Perceived synergies associated with certain businesses may be insufficient to offset the overhead expenses that come with their being part of the parent company. This may have been a factor in AT&T's choice to break up its business in the mid-1990s into three entities, each with its own stock traded on the public exchanges. In late 1999, a failed attempt to redirect the business into more lucrative telecommunications industry segments, such as broadband and wireless, caused AT&T to again undertake a strategy to spin off or divest some portions of the firm.
Companies may divest units after they have had time to learn more about the business. Raytheon sold its D.C. Heath textbook publishing company to Houghton Mifflin Company in 1995. Although largely operated as a stand-alone, D.C. Heath did not fit with the other three larger core Raytheon businesses, which included defense electronics, engineering, and avionics. Similarly, TRW's decision to sell its commercial and consumer information services businesses in 1997 came after years of trying to find a significant fit with its space and defense businesses.
Tax Considerations
Restructuring actions may provide tax benefits that cannot be realized without a restructuring of the business. Marriott Corporation contributed its hotel real estate operations to a Real Estate Investment Trust (REIT) in 1989 through a spin-off. Because REITs do not pay taxes on income that is distributed to shareholders, Marriott was able to enhance shareholder value by eliminating the double taxation of income, once by the parent and again when paid as dividends.
Raising Funds or Worth More to Others
Parent firms may choose to fund new initiatives or reduce leverage through the sale or partial sale of units no longer considered strategic or that underperform corporate expectations. Sales may also result from a financially failing firm's need to raise capital. Examples include Andarko's announcement in late 2006 of the sale of its Canadian gas properties to Canadian Natural Resources for $4.1 billion to help finance its purchase of two smaller competitors earlier in the year and Chrysler's sale of its highly profitable tank division to avoid bankruptcy in the early 1980s. Similarly, Navistar, formerly International Harvester, sold its profitable Solar Turbines operation to Caterpillar Tractor to reduce its indebtedness.
Others may view a firm's operating units as much more valuable than the parent itself and be willing to pay a “premium” price for such businesses. In early 2010, GE completed its sale of its fire alarm and security systems unit at a substantial profit to United Technologies for $1.82 billion to eliminate what it considered a noncore business. In contrast, United Technologies desired to increase its focus in the security business and had acquired a series of home security firms. In late 2010, British Petroleum completed a sale of “mature” oil and gas properties to Apache Corporation for $7 billion in order to finance a portion of the costs associated with the Gulf of Mexico oil well “blowout” (see Case Study 15.1).
Case Study 15.1
British Petroleum Sells Oil and Gas Assets to Apache Corporation
In the months that followed the oil spill in the Gulf of Mexico, British Petroleum agreed to create a $20 billion fund to help cover the damages and cleanup costs associated with the spill. The firm had agreed to contribute $5 billion to the fund before the end of 2010. To help meet this obligation and to help finance the more than $4 billion already spent on the spill, the firm announced on July 20, 2010, that it had reached an agreement to sell Apache Corporation its oil and gas fields in Texas and southeast New Mexico worth $3.1 billion; gas fields in Western Canada for $3.25 billion; and oil and gas properties in Egypt for $650 million. All of these properties had been in production for years, and their output rates were declining.
Apache is a Houston-based independent oil and gas exploration firm with a reputation for being able to extract additional oil and gas from older properties. Also, Apache had operations near each of the BP properties, enabling them to take control of the acquired assets with existing personnel.
In what appears to have been a premature move, Apache agreed to acquire Mariner Energy's and Devon Energy's offshore assets in the Gulf of Mexico for a total of $3.75 billion just days before the BP oil rig explosion in the Gulf. The acquisitions made Apache a major player in the Gulf just weeks before the United States banned temporarily deepwater drilling exploration in federal waters.
The announcement of the sale of these properties came as a surprise because BP had been rumored to be attempting to sell its stake in the oil fields of Prudhoe Bay, Alaska. The sale had been expected to fetch as much as $10 billion. The sale failed to materialize because of lingering concerns that BP might at some point seek bankruptcy protection and because the firm's creditors could seek to reverse an out-of-court asset sale as a fraudulent conveyance of assets. Fraudulent conveyance refers to the illegal transfer of assets to another party in order to defer, hinder, or defraud creditors. Under U.S. bankruptcy laws, courts might order that any asset sold by a company in distress, such as BP, must be encumbered with some of the liabilities of the seller if it can be shown that the distressed firm undertook the sale with the full knowledge that it would be filing for bankruptcy protection at a later date.
Ideally, buyers would like to purchase assets “free and clear” of the environmental liabilities associated with the Gulf oil spill. Consequently, a buyer of BP assets would have to incorporate such risks in determining the purchase price for such assets. In some instances, buyers will buy assets only after the seller has gone through the bankruptcy process in order to limit fraudulent conveyance risks.
Discussion Questions
1. In what sense were the BP properties strategically more valuable to Apache than to British Petroleum?
2. How could Apache have protected itself from risks that they might be required at some point in the future to be liable for some portion of the BP Gulf–related liabilities? What are some of the ways Apache could have estimated the potential costs of such liabilities? Be specific.
Risk Reduction
A firm may reduce its perceived risk associated with a particular unit by selling a portion of the business to the public. 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. RJR Nabisco bowed to such pressure in 1998 with the spin-off of Nabisco Foods. For similar reasons, Altria spun off its Kraft food operations in 2007. Parent firms may attempt to dump debt or other liabilities by assigning them to a subsidiary and later exiting those businesses. In early 2002, Citigroup sold 21% of its Travelers Property Casualty unit in a $3.9 billion initial public offering (IPO), announcing that the remainder would be sold off later. The parent's motivation for this exit strategy could have been to distance itself from the potential costs of asbestos-related claims by Travelers' policyholders. Similarly, Goodrich passed on its asbestos liabilities to EnPro Industries, its diversified industrial products subsidiary, which it spun off in mid-2002.
Discarding Unwanted Businesses from Prior Acquisitions
Acquirers often find themselves with certain assets and operations of the acquired company that do not fit their primary strategy. These redundant assets may be divested to raise funds to help pay for the acquisition and enable management to focus on integrating the remaining businesses into the parent without the distraction of having to manage nonstrategic assets. In 2002, Northrop Grumman Corporation announced that it would acquire TRW. Northrop stated that it would retain TRW's space and defense businesses and divest its automotive operations, which were not germane to Northrop's core defense business. Nestlé acquired Adams, Pfizer's chewing gum and confectionery business, in early 2003 for $4.6 billion. Pfizer viewed Adams as a noncore business it had acquired as part of its $84 billion acquisition of Warner-Lambert in 2000.
Avoiding Conflicts with Customers
For years, many of the regional Bell operating companies (i.e., RBOCs) that AT&T spun off in 1984 had 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. The primary reason for the breakup was to avoid conflicts between AT&T's former equipment manufacturer and its main customers, the RBOCs.
Increasing Transparency
Firms may be opaque to investors due to their diverse business and product offerings. General Electric is an example of such a corporation, operating dozens of separate 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 the complexity of its operations and making information more readily available, a firm may increase the likelihood that investors will value the corporation accurately.
Divestitures
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, subsidiary, or division. Between 1970 and 2009, divestitures averaged about one-third of total M&A transactions.2 The number of divestitures as a percentage of M&A volume surged in the early to mid-1970s (reaching a peak of 54% in 1975), in the early 1990s (reaching a high of 42% in 1992), in the early 2000s (hitting 40% in 2002), and again between 2008 and 2010 (topping out at 50% in 2010). These peak activity levels followed the merger and acquisition boom periods of the late 1960s, the 1980s, the second half of the 1990s, and from 2003 to 2007.
Motives for Divestitures
Divestitures often represent a way of raising cash. A firm may choose to sell an undervalued or underperforming operation that it determines to be nonstrategic or unrelated to the core business and 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 dividend3 or share repurchase. Moreover, an operating unit may simply be worth more if sold than if retained by the parent. Some firms try to identify operating units that are worth more if sold by periodically conducting business portfolio reviews.
Corporate Portfolio Reviews
The parent conducts a financial analysis to determine if the business is worth more to shareholders if it is sold and the proceeds either returned to the shareholders or reinvested in opportunities offering higher returns. Weighing the future of certain current businesses with other perceived opportunities, General Electric announced in late 2006 that it was selling its silicone and quartz business for $3.4 billion to private equity firm Apollo Management. GE's portfolio of companies has been undergoing change since the current CEO, Jeffrey Immelt, took control in September 2001. Since then, GE has completed transactions valued at more than $110 billion in buying and selling various operating units.
To Sell or Not to Sell
An analysis undertaken to determine if a business should be sold involves a multistep process. These steps include determining the after-tax cash flows generated by the unit, an appropriate discount rate reflecting the risk of the business, the after-tax market value of the business, and the after-tax value of the business to the parent. The decision to sell or retain the business depends on a comparison of the after-tax value of the business to the parent with the after-tax proceeds from the sale of the business. These steps are outlined next.
Step 1: Calculating After-Tax Cash Flows
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.4 Moreover, services provided by the parent to the business may be subsidized (i.e., provided at below actual cost) or at a markup over actual cost. To reflect these factors, 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 from sources outside of the parent firm.
Step 2: Estimating the Discount Rate
Once the after-tax stand-alone 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.
Step 3: Estimating the After-Tax Market Value of the Business
The discount rate then is used to estimate the present or market value of the projected after-tax cash flows of the business as if it were a stand-alone business. The valuation is based on the cash flows determined in Step 1.
Step 4: Estimating the Value of the Business to the Parent
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.
Step 5: Deciding to Sell
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. For example, the parent may believe that the business's products (e.g., ties) may facilitate the sale of other products the firm offers (e.g., custom shirts). The firm may lose money on the sale of ties but make enough money on the sale of custom shirts to earn a profit on the combined sales of the two products. In another instance, one subsidiary of a diversified parent may provide highly complex components critical to the assembly of finished products produced by other subsidiaries of the parent firm. The parent may incur a loss on the components to ensure the continued high quality of its highly profitable finished products.
Timing of the Sale
Obviously, the best time to sell a business is when the owner does not need to sell or the demand for the business to be divested 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 to coincide with the firm's peak year earnings. Businesses also can be timed to sell when they are considered most popular.5
The Selling Process
The selling process may be reactive or proactive (Figure 15.1). 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.
Figure 15.1 The selling process.
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; unfortunately, 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 has been identified or list of what are believed to be qualified buyers has been compiled, contact is made.6
In either a public or private sale, interested parties are asked to sign confidentiality agreements before they are given access to proprietary information. 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. Increasingly, such information is offered online through so-called virtual data rooms (VDR).7
In a private sale, bidders may be asked to sign a standstill agreement requiring them not to make an unsolicited bid. Parties willing to sign these agreements are then asked to submit preliminary, nonbinding “indications of interest” (i.e., a single number or a bid within a range). Those parties submitting preliminary bids are then ranked by the selling company in terms of the size of the bid, form of payment, the ability of the bidder to finance the transaction, form of acquisition, and ease of doing the deal. The last factor involves an assessment of the difficulty in obtaining regulatory approval, if required, and the integrity of the bidder. A small number of those submitting preliminary bids are then asked to submit a best and final offer. Such offers must be legally binding on the bidder. At this point, the seller may choose to initiate an auction among the most attractive bids or go directly into negotiating a purchase agreement with a single party.
Choosing the Right Selling Process
Firms may choose to negotiate with a single firm, to control the number of potential bidders, or to engage in a public auction (Table 15.1). 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. Such firms' sellers are concerned about the potential deleterious effects of making the sale public and the disruptive effects of allowing many firms to perform due diligence. This approach also may be adopted to limit the potential for losing bidders who may also be competitors from obtaining proprietary information as a result of due diligence. An auction among a number of bidders may be undertaken to elicit the highest offer when selling smaller, more difficult to value firms. 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. Paradoxically, public auctions may actually discourage some firms from bidding due to the potential for overly aggressive bidding by relatively uninformed bidders to boost the bid price to excessive levels.
Table 15.1. Choosing the Right Selling Process
| Selling Process | Advantages/Disadvantages |
| One on One Negotiations (single bidder) | Enables seller to select buyer with greatest synergy Minimizes disruptive due diligence Limits 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 diligences |
| Controlled Auction (limited number of bidders) | Enables seller to select a number of potential buyers with greatest synergy Sparks competition without disruptive effects of public auctions May exclude potentially attractive bidders |
Approximately one-half of corporate M&A transactions involve “one on one” negotiations. The remaining transactions include deals in which the sellers contacted an average of 10 potential bidders, with some contacting as many as 150. The number of bidders actually signing confidentiality agreements averages 4, with some deals involving as many as 60. About one-third of the time, sellers receive more than one legally binding bid, and about 12% of sellers receive additional bids once a formal merger agreement has been announced. The average length of time from the start of the solicitation process to completion is about a year, with about 90% of deals involving a breakup fee averaging about 3% of the value of the deal.8
The mere fact that most transactions involve relatively few bidders does not suggest that the bidding process is not competitive.9 In most cases, simply the threat of rival bids is sufficient to increase bids even in “one on one” negotiations. Such latent competition tends to influence 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 over its current share price is influenced by a variety of factors. Table 15.2 provides a summary of those factors that have been found to be significant determinants of the magnitude of purchase price premiums.
Table 15.2. Factors Affecting Purchase Price Premiums
| Factor | Explanation |
| Net Synergy Potential | Purchase premiums are likely to increase the greater the magnitude of perceived net synergy (see Chapter 9). Net synergy often is the greatest in highly related firms (Betton et al., 2009). Moreover, premiums are likely to be larger if most of the synergy is provided by the target. |
| Desire for Control | Buyers may pay more to gain control of firms exhibiting weak financial performance because of potential gains from making better business decisions (see Chapter 10). |
| Growth Potential | Targets displaying greater growth potential relative to competitors generally command higher premiums (Betton et al., 2008). |
| Information Asymmetry (i.e., one bidder has more information than other bidders) | 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 (Dionne et al., 2010). |
| Target Size | Buyers pay more for smaller targets due to the anticipated ease of integration (Moeller, 2005). |
| Target's Eagerness to Sell | Targets with a strong desire to sell typically receive lower premiums due to their relatively weak negotiating positions (Aktas et al., 2010). |
| Run-up in Preannouncement Target Share Price | Share price run-up causes bidders unsure of having adequate information to revalue their bids upward (Betton et al., 2009). |
| Type of Purchase | Hostile transactions tend to command higher premiums than friendly transactions (Moeller, 2005). |
| Hubris | Excessive confidence may lead bidders to overpay (Hayward et al., 1997). |
| Type of Payment | Cash purchases usually require an increased premium to compensate target shareholders for the immediate tax liability they incur (Hayward et al., 1997). Conversely, target shareholders receiving acquirer stock often receive lower premiums because of the deferred tax liability in such situations. |
| Leverage | Highly leveraged buyers are disciplined by their lenders not to overpay; relatively unleveraged buyers often are prone to pay excessive premiums.a |
a Gondhaleker et al. (2004) argue that highly leveraged buyers are monitored closely by their lenders and are less likely to overpay. Morellec and Zhdanov (2008) find that relatively unleveraged buyers often pay more for target firms.
Tax and Accounting Considerations for Divestitures
The divesting firm is required to recognize a gain or loss for financial reporting purposes equal to the difference between the fair value of the consideration received for the divested operation and its book value. However, if the transaction is an exchange of similar assets or an equivalent interest in similar productive assets, the company should not recognize a gain or loss other than a loss resulting from the impairment of value.10 For tax purposes, the gain or loss is the difference between the proceeds and the parent's tax (i.e., cost) basis in the stock or assets. Capital gains are taxed at the same rate as other business income.
Spin-Offs
A spin-off is a transaction in which a parent creates a new legal subsidiary and distributes shares it owns in the subsidiary to its current shareholders as a stock dividend. Such distributions are made in direct proportion to the shareholders' current holdings of the parent's stock. Consequently, the proportional ownership of shares in the new legal subsidiary is the same as the stockholders' proportional ownership of shares in the parent firm. The new entity has its own management and operates independently from the parent company.
Unlike the divestiture or equity carve-out (explained later in this chapter), the spin-off does not result in an infusion of cash to the parent company. Some of the more notable spin-offs include the spin-off of Medco by Merck, Allstate by Sears, Payless by May Department Stores, Dean Witter/Discover by Sears, CBS by Westinghouse, and Pizza Hut, KFC, and Taco Bell by PepsiCo. In early 2011, Motorola Inc. completed its ongoing restructuring effort by spinning off Motorola Mobility to its shareholders and renaming the remaining business Motorola Solutions (see Case Study 15.2).
Case Study 15.2
Motorola Bows to Activist Pressure
Under pressure from a proxy battle with activist investor Carl Icahn (who owned a 6.4% stake in the firm), Motorola felt compelled to make a dramatic move before its May 2008 shareholders' meeting. Icahn had submitted a slate of four directors to replace those that were up for reelection and demanded that the wireless handset and network manufacturer take actions to improve profitability. Shares of Motorola, which had a market value of $22 billion, had fallen more than 60% since October 2006, making the firm's board vulnerable in the proxy contest.
Signaling its willingness to take dramatic action, Motorola announced on March 26, 2008, its intention to create two independent, publicly traded companies. The two new companies would consist of the firm's former Mobile Devices operation (including its Home Devices businesses consisting of modems and set-top boxes) and its Enterprise Mobility Solutions & Wireless Networks business. In addition to the planned spin-off, Motorola agreed to nominate two people supported by Carl Icahn to the firm's board.
Originally scheduled for 2009, the breakup was postponed due to the upheaval in the financial markets that year. The breakup would result in a tax-free distribution to Motorola's shareholders, with shareholders receiving shares of the two independent and publicly traded firms.
Mobile Devices designs, manufactures, and sells mobile handsets globally, and it has lost more than $5 billion during the last three years. The Enterprise Mobility Solutions & Wireless Networks business manufactures, designs, and services public safety radios, handheld scanners and telecommunications network gear for businesses and government agencies, and generates nearly all of Motorola's current cash flow. This business also makes network equipment for wireless carriers such as Spring Nextel and Verizon Wireless.
By dividing the company in this manner, Motorola would separate its loss-generating Mobility Devices division from its other businesses. Although it is the third largest handset manufacturer globally, its handset business had been losing market share to Nokia and Samsung Electronics for years. Following the breakup, the Mobility Devices unit will be renamed Motorola Mobility, and the Enterprise Mobility Solutions & Networks operation will be called Motorola Solutions.
Motorola's board is seeking to ensure the financial viability of Motorola Mobility by eliminating its outstanding debt and through a cash infusion. To do so, Motorola intends to buy back nearly all of its outstanding $3.9 billion debt and to transfer as much as its $4 billion in cash to Motorola Mobility.
Furthermore, Motorola Solutions would assume responsibility for the pension obligations of Motorola Mobility. If Motorola Mobility were to be forced into bankruptcy shortly after the breakup, Motorola Solutions may be held legally responsible for some of the business's liabilities. The court would have to prove that Motorola had conveyed the Mobility Devices unit (renamed Motorola Mobility following the breakup) to its shareholders, fraudulently knowing that the unit's financial viability was problematic.
Once free of debt and other obligations and when it is flush with cash, Motorola Mobility would be in a better position to make acquisitions and to develop new phones. It would also be more attractive as a takeover target. A stand-alone firm is unencumbered by intercompany relationships, including such things as administrative support or parts and services supplied by other areas of Motorola. Moreover, all of the liabilities and assets associated with the handset business already would have been identified, making it easier for a potential partner to value the business.
In mid-2010, Motorola Inc. announced that it had reached an agreement with Nokia Siemens Networks, a Finnish–German joint venture, had reached an agreement with Motorola Inc. to buy its wireless networks operations, formerly part of Motorola's Enterprise Mobility Solutions and Wireless Network Devices business. On January 4, 2011, Motorola Inc. spun off the common shares of Motorola Mobility it held as a tax-free dividend to its shareholders and renamed the firm Motorola Solutions. Each shareholder of record as of December 21, 2010, would receive one share of Motorola Mobility common for every eight shares of Motorola Inc. common stock they held. Table 15.3 shows the timeline of Motorola's restructuring effort.
Table 15.3. Motorola Restructuring Timeline
| Motorola (Beginning 2010) | Motorola (Mid-2010) | Motorola (Beginning 2011) |
| Mobility Devices | Mobility Devices | Motorola Mobility spin-off |
| Enterprise Mobility Solutions & Wireless Networks | Enterprise Mobility Solutions* | Motorola Inc. renamed Motorola Solutions |
* Wireless Networks sold to Nokia-Siemens.
Motives for Spin-Offs
In addition to the motives for exiting businesses discussed earlier, spin-offs provide a means of rewarding shareholders with a nontaxable dividend (if properly structured). Parent firms with a low tax basis in a business may choose to spin off the unit as a tax-free distribution to shareholders rather than sell the business and incur a substantial tax liability. In addition, the unit, now independent of the parent, has its own stock to use for possible acquisitions. Finally, 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.
Tax and Accounting Considerations for Spin-Offs
If properly structured, spin-offs are generally not taxable to shareholders. According to the Internal Revenue Service Code Section 355, a spin-off must be undertaken for reasons other than tax avoidance such as to increase management focus or improve profitability. The parent must control the subsidiary to be spun off by owning at least 80% of each class of the unit's voting and nonvoting stock, and parent firm shareholders must maintain a continuity of interest in both the parent firm and the subsidiary. Finally, both the parent and the spun-off subsidiary must remain in operation during the five years following the spin-off.11
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. The reason for this treatment is that the ownership interests are essentially the same before and after the spin-off. See Case Study 15.3 for a description of how a spin-off may be structured.
Case Study 15.3
Anatomy of a Spin-Off
On October 18, 2006, Verizon Communications' board of directors declared a dividend to the firm's shareholders consisting of shares in a company comprising the firm's domestic print and Internet yellow pages directories publishing operations (Idearc Inc.). The dividend consisted of 1 share of Idearc stock for every 20 shares of Verizon common stock. Idearc shares were valued at $34.47 per share. On the dividend payment date, Verizon shares were valued at $36.42 per share. The 1-to-20 ratio constituted a 4.73% yield—that is, $34.47/($36.42 × 20)—approximately equal to Verizon's then current cash dividend yield.
Because of the spin-off, Verizon would contribute to Idearc all its ownership interest in Idearc Information Services and other assets, liabilities, businesses, and employees currently employed in these operations. In exchange for the contribution, Idearc would issue to Verizon shares of Idearc common stock to be distributed to the Verizon shareholders. In addition, Idearc would issue senior unsecured notes to Verizon in an amount approximately equal to the $9 billion in debt that Verizon incurred in financing Idearc's operations historically. Idearc would also transfer $2.5 billion in excess cash to Verizon. Verizon believed it owned such cash balances, since they were generated while Idearc was part of the parent.
Verizon announced that the spin-off company would enable the parent and Idearc to focus on their core businesses, which might facilitate expansion and growth of each firm. The spin-off would also allow each company to determine its own capital structure, enable Idearc to pursue an acquisition strategy using its own stock, and permit Idearc to enhance its equity-based compensation programs offered to its employees. Because of the spin-off, Idearc would become an independent public company. Moreover, no vote of Verizon shareholders was required to approve the spin-off, since it constituted the payment of a dividend permissible by the board of directors according to the bylaws of the firm. Finally, Verizon shareholders had no appraisal rights in connection with the spin-off.
In late 2009, Idearc entered Chapter 11 bankruptcy because it was unable to meet its outstanding debt obligations. In September 2010, a trustee for Idearc's creditors filed a lawsuit against Verizon, alleging that the firm breached its fiduciary responsibility by knowingly spinning off a business that was not financially viable. The lawsuit further contends that Verizon benefited from the spin-off at the expense of the creditors by transferring $9 billion in debt from its books to Idearc and receiving $2.5 billion in cash from Idearc.
Discussion Questions
1. How do you believe the Idearc shares were valued for purposes of the spin-off? Be specific.
2. Do you believe that it is fair for Idearc to repay a portion of the debt incurred by Verizon relating to Idearc's operations even though Verizon included Idearc's earnings in its consolidated income statement? Is the transfer of excess cash to the parent fair? Explain your answer.
3. Do you believe shareholders should have the right to approve a spin-off? Explain your answer?
4. To what extent do you believe that Verizon's activities could be viewed as fraudulent? Explain your answer.
Equity Carve-Outs
Equity carve-outs exhibit characteristics similar to spin-offs. Both result in the subsidiary's stock 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 divestiture, the parent generally retains control of the subsidiary in a carve-out transaction. 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.12 A potentially significant drawback to the carve-out is the creation of minority shareholders. General Motors 2006's sale of a 51% stake in its then profitable GMAC finance unit to private investor group Cerberus for $14 billion is a recent example of an equity carve-out. In this transaction, GM retained the right (i.e., a call option) to buy back GMAC during the ten-year period following the close of the transaction.
Motives for Equity Carve-Outs
As is true of a divestiture, equity carve-outs provide an opportunity to raise funds for reinvestment in the subsidiary, to pay off debt, or to pay a dividend to the parent firm. Moreover, a carve-out frequently is a prelude to a divestiture, since it provides an opportunity to value the business by selling stock in 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. The two basic forms of an equity carve-out are the initial public offering and the subsidiary equity carve-out. These are discussed in the following sections.
Initial Public Offerings
An initial public offering is the first offering to the public of the common stock of a formerly privately held firm. The sale of the stock provides an infusion of cash to the parent. The cash may be retained by the parent or returned to shareholders. United Parcel Service's IPO of 5 percent of its stock in 1999 is an example of an IPO.
Subsidiary Equity Carve-Outs
The subsidiary carve-out is a transaction in which the parent creates a wholly-owned independent legal 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 from 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.
Equity Carve-Outs as Staged Transactions
Equity may be sold to the public in several stages. A partial sale of equity either in a wholly-owned subsidiary (a subsidiary equity carve-out) or in the consolidated business (an IPO) may be designed to raise capital and establish a market price for the stock. Later, once a market has been established for the stock, the remainder of the subsidiary's stock may be issued to the public. Alternatively, the parent may choose to spin off its remaining shares in the subsidiary to the parent's shareholders as a dividend. Few carve-outs remain under the parent's control in the long term. In a study of more than 200 carve-outs, only 8% of the firms held more than 50% of the equity of their carve-outs after five years, 31% of the parents held less than 25% of the equity, and 39% of the carve-outs had been acquired or merged with third parties.13 Hewlett-Packard's staged spin-off of its Agilent Technologies subsidiary is an example of a staged transaction. It began with an equity carve-out of a minority position in its wholly-owned Agilent subsidiary in late 1999. The remainder of the unit's stock was sold in 2000.
Split-Offs and Split-Ups
A split-off is similar to a spin-off in that a firm's subsidiary becomes an independent firm and the parent firm does not generate any new cash. However, unlike a spin-off, the split-off involves an offer to exchange parent stock for stock in the parent firm's subsidiary. For example, in 2004, Viacom spun off its movie rental chain by exchanging shares in its 81%–owned Blockbuster Inc. subsidiary for Viacom common shares. Split-offs tend to be less common than spin-offs because they most often arise when a portion of the parent firm's shareholders prefer to own the shares of a subsidiary of the parent rather than the parent's shares.
A split-up refers to a restructuring strategy in which a single company splits into two or more separately managed firms. Through a series of split-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 canceled, and it ceases to exist.
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 whose shares were distributed. A non–pro rata distribution takes the form of a tender or exchange offer in which shareholders can accept or reject the distribution. Case Study 15.4 describes how such a non–pro rata distribution took place for the Bristol-Myers Squibb split-off discussed in the Inside M&A case study at the beginning of this chapter.
Case Study 15.4
Anatomy of a Split-Off
Under the Bristol-Myers Squibb exchange offer of Mead Johnson shares for shares of its common stock, announced on November 16, 2009, each BMS shareholder would receive $1.11 for each $1 of BMS stock tendered and accepted in the exchange offer. The exchange was subject to an upper limit of 0.6027 shares of MJ common stock per share of BMS common.
On December 4, 2009, BMS amended the offer by increasing the maximum share exchange ratio to 0.6313, indicating it would accept for exchange a maximum of 269,281,601 shares of its stock and that if the exchange offer were oversubscribed, all shares tendered would be subject to proration. The proration formula was determined by dividing the maximum number of MJ shares BMS was willing to exchange by the number of BMS shares actually tendered.
The actual ratio at which shares of Bristol-Myers' common stock and shares of Mead Johnson's common stock were exchanged was determined by computing a simple three-day average of the shares of the two firms during December 8–10, 2009, subject to the 0.6313 upper limit. On December 16, 2009, Bristol-Myers announced it would exchange up to 170 million shares of Mead Johnson common stock (i.e., all that it owned) for outstanding shares of its stock at an exchange ratio of 0.6313 shares of Mead Johnson common stock for each share of Bristol-Myers common stock tendered and accepted in the exchange offer.
Assuming that the three-day average of the BMS and MJ share prices was $24.30 and $43.75, respectively. BMS shareholders whose tendered shares were accepted in the exchange offer received the higher of $26.97 (i.e., $24.30 × 1.11) or $27.62 (i.e., 0.6313 × $43.75). Therefore, a BMS shareholder tendering 100 shares of BMS stock would have received the share equivalent of $2,762 ($27.62 × 100) or 63.13 MJ shares at $43.75 per share (i.e., $2,762 ÷ $43.75). Fractional shares were paid in cash.
The actual number of BMS shares tendered totaled 500,547,697, resulting in a proration ratio of 53.80% (i.e., 269,281,601 ÷ 500,547,697). Each shareholder tendering BMS shares would only have 53.80% of their tendered shares accepted for the exchange.
Answers to these questions are provided in the Online Instructors Manual for instructors using this textbook.
Motives for Split-Offs
Divestiture may not be an option for disposing of a business in which the parent owns less than 100% of the stock because potential buyers often want to acquire all of a firm's outstanding stock. By acquiring less than 100%, a buyer inherits minority shareholders who may disagree with the new owner's future business decisions. Consequently, split-offs are best suited for disposing of a less than a 100% investment stake in a subsidiary. Moreover, the 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, those shareholders willing to make the exchange believe the stock in the subsidiary has greater appreciation potential than the parent's stock. 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. Finally, split-offs are generally tax free to shareholders as long as they conform to the IRS requirements previously described for spin-offs.
Tracking, Targeted, and Letter Stocks
Such stocks are separate classes of common stock of the parent corporation. The parent firm divides its operations into two or more operating units and assigns a common stock to each operation. Tracking stock is a class of common stock that links the shareholders' return to the operating performance of a particular business segment or unit. Dividends paid on the tracking stock rise or fall with the performance of the business segment. Tracking stock represents an ownership interest in the company as a whole, rather than a direct ownership interest in the targeted business segment. 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 the subsidiary is still legally a part of the parent. Tracking stocks may be issued to current parent company shareholders as a dividend, used as payment for an acquisition, or, more commonly, issued in a public offering. Once the tracking stock is listed on a public exchange, the subsidiary must file separate financial statements with the Securities and Exchange Commission.
Thirty-two U.S. firms had issued 50 tracking stocks as of the end of 2009. The concept was introduced in 1984 when General Motors issued a class of stock identified as E stock, often referred to as letter stock at that time, to buy Electronic Data Systems (EDS). In 1985, GM issued another class of stock called H stock when it acquired Hughes Corporation. In 1991, U.S. Steel Company created a USX-Marathon stock for its oil business and a USX stock for its steel operations. The next year, USX created a third tracking stock when it sold shares of the USX-Delhi group in an IPO. Few tracking stocks have been issued in recent years, perhaps due to inherent governance issues and their poor long-term performance. Relatively recent issues include AT&T Wireless, Alcatel, and Disney in 2000, as well as Sony, Sprint PCS, and CarMax in 2001.
Motives for Tracking Stocks
The purpose in creating tracking stock is to enable the financial markets to value the different operations within a corporation based on their own performance. Such stocks represent pure plays to the extent that they give investors an opportunity to invest in a single operating unit of a diversified parent firm. Moreover, the operating unit files financial statements with the SEC separate from those of the parent's, even though its financial performance is included in the parent's consolidated financial statements. However, there is little empirical evidence that issuing a tracking stock for a subsidiary creates pure-play investment opportunities, 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.14 Tracking or targeted stocks provide the parent company with an alternative means of raising capital for a specific operation by selling a portion of the stock to the public and an alternative “currency” for making acquisitions. In addition, stock-based incentive programs to attract and retain key managers can be implemented for each operation with its own tracking stock.
Tax and Accounting Considerations for Tracking Stocks
For financial reporting purposes, a distribution of tracking stock divides the parent firm's equity structure into separate classes of stock without a legal split-up of the firm. Tracking stocks may be issued as dividends to the parent's current shareholders. Unlike the case with spin-offs, the IRS currently does not require that the business for which the tracking stock is created be at least five 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 carve-out, the parent retains complete ownership of the business. In general, a proportionate distribution by a company to its shareholders in the company's stock is tax free to shareholders.
Problems with Tracking Stocks
Conflicts among the parent's operating units often arise in determining how the parent's overhead expenses are allocated to the business units and what price one business unit is paid for selling products to other business units. Tracking stocks also can stimulate shareholder lawsuits. Although the unit for which a tracking stock has been created may be largely autonomous, the potential for conflict of interest is substantial because the parent's board and the target stock's board are the same. 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.15 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. Hence, there is no takeover premium built into the stock price.
Voluntary Liquidations (Bust-Ups)
Chapter 16 includes a detailed discussion of involuntary bankruptcy-related liquidations. Such transactions occur when creditors and the bankruptcy court concur that they will realize more value through liquidation than by reorganizing the firm. Voluntary liquidations or bust-ups reflect the judgment that the sale of individual parts of the firm could realize greater value than the value created by a continuation of the combined corporation. This may occur when management views the firm's growth prospects as limited.16 This option generally is pursued only after other restructuring strategies have failed to improve the firm's overall market value. Unlike spin-offs and divestitures, which may be viewed as discrete events, the liquidation process generally represents a series of individual transactions during which the firm's assets are sold.
Comparing Alternative Exit and Restructuring Strategies
Table 15.4 summarizes the primary characteristics of each of the restructuring strategies discussed in this chapter. Note that divestitures and carve-outs provide cash to the parent, whereas spin-offs, split-ups, and bust-ups do not. The parent remains in existence in all restructuring strategies except split-ups and voluntary liquidations. A new legal entity generally is created with each restructuring strategy, except for voluntary liquidations. 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 15.4. Key Characteristics of Alternative Exit/Restructuring Strategies
a Applies to subsidiary carve-outs only.
b The proceeds are taxable if returned to shareholders as a dividend or tax deferred if used to repurchase the parent's stock.
c The transaction is generally not taxable if properly structured.
d Only dividend payments and shareholder gains on the sale of stock are taxable.
Choosing among Divestiture, Carve-Out, and Spin-Off Restructuring Strategies
Parent firms that engage in divestitures often are highly diversified in largely unrelated businesses and have a desire to achieve greater focus or raise cash.17 Parent firms that use carve-out strategies usually operate businesses in somewhat related industries exhibiting some degree of synergy and a desire to raise cash. Consequently, the parent firm may pursue a carve-out rather than a divestiture or spin-off strategy to retain perceived synergy.18 Evidence shows that the timing of the carve-out is influenced by when management sees its subsidiary's assets as overvalued.19 Firms engaging in spin-offs often are highly diversified but less so than those that are prone to pursue divestiture strategies and have little need to raise cash.20 Table 15.5 identifies characteristics of parent firm operating units that are subject to certain types of restructuring activities.
Table 15.5. Characteristics of Parent Company Operating Units That Undergo Divestiture, Carve-Out, or Spin-Off
Sources: Ravenscroft and Scherer (1991), Cho and Cohen (1997), Hand and Skantz (1997), Kang and Shivdasani (1997), Powers (2001, 2003), Chen and Guo (2005), and Bergh (2007).
The decision to exit a business is essentially a two-stage process. The first stage involves the firm deciding to exit a line of business or product line for one or more of the reasons described earlier in this chapter. The second stage entails selecting the appropriate exit strategy. Divestitures, carve-outs, and spin-offs are the most commonly used restructuring strategy when a parent corporation is considering partially or entirely exiting a business. The decision as to which of these three strategies to use is often heavily 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.21 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. Table 15.6 illustrates this two-stage procedure.
Table 15.6. Divestitures, Carve-Outs, and Spin-Offs: Selecting the Appropriate Restructuring Strategy
 |
It may seem that a divestiture or carve-out generally would be preferable to a spin-off if the after-tax proceeds from the sale of all or a portion of the operating unit exceed its after-tax equity value to the firm. 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. In contrast, the cash proceeds from an outright sale may be taxable to the parent to the extent a gain is realized.
Moreover, management must be able to reinvest the after-tax proceeds in a project that has a reasonable likelihood of returning the firm's cost of capital. If management chooses to return the cash proceeds to shareholders as a dividend or through a stock repurchase, the shareholders also must pay taxes on the dividend at their ordinary tax rate or on any gain realized through the share repurchase at the generally lower capital gains tax rate. 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 generally suffers, and customers may not renew contracts until the new owner is known.
Determinants of Returns to Shareholders Resulting from Restructuring Strategies
In general, restructuring strategies create shareholder value by increasing parent firm focus and by transferring businesses to those who can operate them more efficiently. These factors are reflected in the abnormal financial returns frequently associated with the announcement of corporate restructurings.
Preannouncement Abnormal Returns
Empirical studies indicate that the alternative restructuring and exit strategies discussed in this chapter generally provide positive abnormal returns to the shareholders of the company implementing the strategy. This should not be surprising, since such actions often 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. Alternatively, restructuring strategies involving a divisional or asset sale may create value simply because the asset is worth more to another investor. Table 15.7 provides a summary of the results of selected empirical studies of restructuring activities.
Table 15.7. Returns to Shareholders of Firms Undertaking Restructuring Actions
| Restructuring Action | Average Preannouncement Abnormal Returns |
| Divestitures Spin-Offs Tracking Stocks Equity Carve-Outs Voluntary Liquidations (bust-ups) |
1.6% 3.7% 3.0% 4.5% 17.3% |
| Study | Preannouncement Abnormal Returns by Studya |
| Divestitures | |
| Alexander, Benson, and Kampmeyer (1984): 53, 1964–1973 Linn and Rozeff (1984): 77, 1977–1982 Jain (1985): 1,107, 1976–1978 Klein (1986): 202, 1970–1979 Lang, Poulsen, and Stulz (1995): 93, 1984–1989 Allen (2000): 48, 1982–1991 Mulherin and Boone (2000): 139, 1990–1998 Clubb and Stouraitis (2002): 187, 1984–1994 Dittmar and Shivdasani (2002): 188, 1983–1994 Bates (2005): 372, 1990–1998 Slovin, Sushka, and Polonchek (2005): 327, 1983–2000 |
0.17% 1.45% 0.70% 1.12% When percentage of equity sold <10%: none >10 and <50%: 2.53% >50%: 8.09% 2.0% for firms distributing proceeds to shareholders; (0.5)% for those reinvesting proceeds 0.8% 2.6% 1.1% 2.6% 1.2% for firms using proceeds to reduce debt; 0.7% for firms using proceeds to repurchase stock or pay dividends 1.9% for seller receiving cash 3.2% for seller receiving equity |
| Spin-Offs | |
| Hite and Owers (1983): 56, 1963–1979 Miles and Rosenfeld (1983): 62, 1963–1981 Michaely and Shaw (1995): 91, master limited partnerships 1981–1989 Loh, Bezjak, and Toms (1995): 59, 1982–1987 J.P. Morgan (1995): 77, since beginning of 1995 Vroom and van Frederikslust (1999): 210 worldwide spin-offs, 1990–1998 Mulherin and Boone (2000): 106, 1990–1998 Davis and Leblond (2002): 93, 1980–1999 Veld and Veld-Merkoulova (2004): 200, 1987–2000 Maxwell and Rao (2003): 80, 1976–1997 McNeil and Moore (2005): 153, 1980–1996 Harris and Glegg (2007): 58 cross-border spin-offs, 1990–2006 |
3.8% 2.33% 4.5% 1.5% 5% 6% if spin-off >10% of parent's equity 4% if spin-off <10% of parent's equity 2.6% 4.51% 2.92% 2.66% 3.60% 3.5% 2.23% |
| Tracking Stocks | |
| Logue, Seward, and Walsh (1996): 9, 1991–1995 D'Souza and Jacob (2000): 19, 1984-1998 Elder and Westra (2000): 35, 1984–1999 Haushalter and Mikkelson (2001): 31, 1994–1996 Chemmanur and Paeglis (2000): 19, 1984–1998 Billet and Vijh (2004): 29, 1984–1999 |
2.9% 3.6% 3.1% 3.0% 3.1% 2.2% |
| Equity Carve-Outs/IPOs | |
| Schipper and Smith (1986): 81, 1965–1983 Michaely and Shaw (1995): 91 limited partnerships, 1981–1989 Allen and McConnell (1998): 188, 1978–1993 Vijh (1999): 628, 1981–1995 Mulherin and Boone (2000): 125, 1990–1998 Prezas, Tarimcilar, and Vasudevan (2000): 237, 1985–1996 Hulburt, Miles, and Wollridge (2002): 245, 1981–1994 Hogan and Olson (2004): 458, 1990–1998 Wagner (2004): 71, 1984–2002 |
1.7% 4% 6.63% when proceeds used to pay off debt; zero otherwise 6.2% 2.3% 5.8% 2.1% 8.8% 1.7% |
| Voluntary Liquidations | |
| Skantz and Marchesini (1987): 37, 1970–1978 Hite, Owers, and Rogers (1987): 49, 1966–1975 Kim and Schatzberg (1987): 73, 1963–1981 Erwin and McConnell (1997): 61, 1970–1991 |
21.4%b
13.6%b 14% 20% |
a Abnormal mean returns measured from one to three before and including announcement date of restructuring action.
b Abnormal mean returns measured during the month of the announced restructuring action.
Divestitures
The empirical evidence suggests that divestitures generally create value by increasing the diversified firm's focus and reducing the conglomerate discount (see Chapter 1), transferring assets to those that can use them more effectively, resolving agency conflicts, and mitigating financial distress. Abnormal returns around the announcement date of the restructuring strategy average 1.6% for sellers. Buyers average abnormal returns of about 0.5%.22 While both sellers and buyers gain from a divestiture, most of the gain appears to accrue on average to the seller. However, how the total gain is divided ultimately depends on the relative bargaining strength of the seller and the buyer.
Increasing Focus
A substantial body of evidence indicates that reducing a firm's complexity can improve financial returns to shareholders. The difficulty in managing diverse portfolios of businesses in many industries and the difficulty in accurately valuing 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 earned by the shareholders of a firm divesting a business result largely from improved management of the assets that remain after the divestiture is completed. With 75% of the divested units unrelated to the selling firm, these returns may be attributed to increased focus and the ability of management to understand fewer lines of business.23 Divesting firms tend also to improve their investment decisions in their remaining businesses following divestitures by achieving levels of investment in core businesses comparable to their more focused peers.24
Firms tend to sell operations representing a relatively small portion of the parent's total operations. Such sales often are of previously acquired units with a profitability that has improved or represent businesses no longer considered critical to the parent's business strategies.25
Restructuring decisions, such as divestitures, and investment decisions are interdependent. A parent may divest a unit to raise cash to finance what ultimately turns out to be a successful investment decision. While the divestiture was related to the successful investment, it does not follow that the decision to divest resulted in better investment decision making. Therefore, other factors unrelated to the divestiture decision, such as the firm's competitive position in high-growth markets, often explain the success of the firm's investment decisions.26
Transferring Assets to Those Who Can Use Them More Efficiently
Divestitures result in productivity gains by redeploying assets from less productive sellers to more productive buyers, who believe they can generate a higher financial return than the seller.27
Resolving Differences between Management and Shareholders (Agency Conflicts)
A firm's senior managers serve as agents of the shareholders in conducting the firm's operations. 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, paid 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 debt28 or distributed to the shareholders.29 Such results are consistent with a lack of shareholder confidence in management's ability to invest funds intelligently.
The form of payment appears to affect excess returns. Abnormal returns to sellers are much smaller when the seller receives cash rather than buyer equity. Asset sales paid for with buyer shares generate abnormal or excess returns of about 10% for buyers and 3% for sellers on or about the announcement date of the divestiture. The higher returns for buyers may reflect information communicated to the seller not generally known by the investing public about the synergy between the divested asset and the buyer's operations and the overall future earnings potential of the buyer's business. In contrast, excess returns to sellers receiving cash average about 3% for sellers and about zero for buyers.30
Mitigating Financial Distress
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.31 Firms that divest assets often have lower cash balances, cash flow, and bond credit ratings than firms exhibiting similar growth, risk, and profitability characteristics.32 Firms experiencing financial distress are more likely to utilize divestitures as part of their restructuring programs than other options because they generate cash.33
Spin-Offs
At 3.7%, the average abnormal return to parent firm shareholders associated with spin-off announcements is more than twice the 1.6% average return on divestitures. However, the differences in announcement date returns between spin-offs and divestitures is smaller than it appears if we note that some portion of the total gain in wealth created by divestitures is shared with the buying firm's shareholders. In contrast, the jump in the parent firm's share price following the announcement of a spin-off reflects the total gain due to the spin-off. Including the abnormal return to the buyer's shareholders of 0.5%, the total gain from a divestiture is 2.1%. Much of the remaining 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 realized 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.
Increasing Focus
Spin-offs increasing the parent's focus show significant positive announcement date returns. However, 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.34 Spin-offs that increase parent focus also improve operating performance more than spin-offs that do not increase focus.35 There is also a reduction in the diversification discount when a spin-off increases corporate focus but not for those that do not.36
Like divestitures, spin-offs eliminate the tendency to use the cash flows of efficient businesses to finance investment in less efficient business units; firms are more likely to invest in their attractive businesses after the spin-off.37
Achieving Greater Transparency (Eliminating Information Asymmetries)
Divestitures and spin-offs that tend to reduce a firm's complexity help to improve investors' ability to evaluate the firm's operating performance. The coverage of publicly traded firms by financial analysts provides an important source of information for investors. By reducing complexity, financial analysts are better able to forecast earnings accurately.43 Analysts tend to revise upward their earnings forecasts of the parent in response to a spin-off.39 These findings are consistent with the observation that reduced information asymmetries tend to increase shareholder value.
Wealth Transfers
Evidence shows that spin-offs transfer wealth from bondholders to stockholders for several reasons.40 First, spin-offs reduce the assets available for liquidation in the event of business failure. Therefore, investors may view the firm's existing debt as more risky.41 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.
Equity Carve-Outs
Investors view the announcement of a carve-out as the beginning of a series of restructuring activities, such as a reacquisition of the unit by the parent, a spin-off, a secondary offering, or an M&A. The sizeable announcement date abnormal returns to parent firm shareholders averaging 4.5% reflect investor-anticipated profit from these secondary events. These abnormal positive returns are realized only when the parent firm retains a controlling interest after a carve-out announcement allowing the parent to initiate these secondary actions.42 Furthermore, these returns tend to increase with the size of the carve-out.43 Announcement date returns are significant for both parent firm stock and bond investors when the parent of the carve-out unit indicates that the majority of the proceeds resulting from the carve-out will be used to redeem debt.44
Managers use their inside information about the subsidiary's growth prospects to decide how much of the subsidiary to issue to the public. They are more inclined to retain a larger percentage of the business if they feel the unit's growth prospects are favorable.45 Carve-outs may show poorer operating performance than their peers when their parents keep less than 50% of the subsidiary's equity. Either the parent chooses not to consolidate the carved-out unit due to its expected poor performance or it intends to transfer cash from minority-owned businesses through intercompany loans or dividends.46 Value is created by increased parent focus, providing a source of financing, and resolving differences between the parent firm's management and shareholders (i.e., agency issues).
Increasing Focus
Parents and subsidiaries involved in carve-outs are frequently in different industries. Positive announcement date returns often are 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. It is unclear if operating performance improves following equity carve-outs.47 Evidence has shown 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.48 However, other studies have shown that operating performance declines following a carve-out.49
Providing a Source of Financing
Equity carve-outs can help to finance the needs of the parent or the subsidiary involved in the carve-out. Firms may use carve-outs to finance their high-growth subsidiaries.50 Corporations tend to choose equity carve-outs and divestitures over spin-offs when market to book value and revenue growth of the carved-out unit are high to maximize the cash proceeds of the sale of equity or asset sales.51
Resolving Agency Issues
There is evidence that investor reaction to the announcement of a carve-out 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.52
Tracking Stocks
Reflecting initial investor enthusiasm, a number of studies show that tracking stocks experience significant positive abnormal returns around their announcement date. Studies addressing the issue of whether the existence of publicly listed tracking shares increases the demand for other stock issued by the parent give mixed results.53 However, there is some evidence that investors become disenchanted with tracking stocks over time. In 11 instances between 1984 and 1999, excess returns to shareholders averaged 13.9% around the date of the announcement that target stock structures would be removed.54
Voluntary Liquidations (Bust-Ups)
The exceptional average 17.3% abnormal returns for voluntary liquidations or bust-ups may reflect investors' concurrence with management that continued operation of the firm is likely to erode shareholder value. Busting up the firm enables shareholders to redeploy the proceeds of the liquidation to potentially more attractive alternative investments. Consistent with a perceived lack of investment options, empirical research indicates that firms that voluntarily liquidate have low market-to-book ratios, cash balances well in excess of their operating needs, and low debt-to-equity levels. Such firms also tend to have high equity ownership by senior managers who tend to gain significantly by liquidating the firm.55 The high abnormal returns also may reflect the potential for firms announcing their intention to voluntarily liquidate to receive acquisition bids.56
Post-Carve-Out and Post-Spin-Off Returns to Shareholders
Carve-outs and spin-offs are more likely to outperform the broader stock market indices because their share prices reflect speculation that they will be acquired rather than any improvement in the operating performance of the units once they have been spun off from the parent. One-third of spin-offs are acquired within three 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 perform no better than their peers.57
Many historical studies that show superior post-spin-off returns are indeed heavily biased by the inclusion of one or two firms in the sample with excess returns that are the result of having been acquired. Spin-offs simply may create value by providing an efficient method of transferring corporate assets to the acquiring companies.58 The probability of acquisition is higher for units that are subject to a carve-out than it is for similar firms that are in the same industry.59
Spin-offs involving parents and subsidiaries that are in different countries often show significant positive abnormal returns. The magnitude of the wealth gain accruing to holders of stock in the unit spun off by the parent is higher in countries where takeover activity is also high. This reflects the increased likelihood that the spun-off units will become takeover targets.60
In a study of 232 spin-offs and equity carve-outs during the 1990s, Booz-Allen Hamilton found that only 26% of the units outperformed the broader stock market indices during the two years following their separation from the parent.61 Smaller spin-offs (i.e., those with a market cap of less than $200 million) tend to outperform larger ones (i.e., those with a market cap greater than $200 million).62 This may be a result of a tendency of investors who are relatively unfamiliar with the business that is spun off by the parent to undervalue the spin-off. Carve-outs that are largely independent of the parent (i.e., in which the parent generally owned less than 50% of the spin-off's equity) tended to significantly outperform the S&P 500.63 The evidence for the long-term performance of tracking stocks is mixed.64
Some Things to Remember
Divestitures, spin-offs, equity carve-outs, split-ups, split-offs, and voluntary bust-ups are commonly used restructuring and exit 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 because they tend to correct problems facing the parent. However, the longer-term performance of spin-offs, carve-outs, and tracking stocks is problematic. The extent to which such stocks outperform their industry stock indices reflects more the likelihood that they will be acquired than improved operating performance.
Discussion Questions
15.1 How do tax and regulatory considerations influence the decision to exit a business?
15.2 How would you decide when to sell a business?
15.3 What are the major differences between a spin-off and an equity carve-out?
15.4 Under what conditions is a spin-off tax free to shareholders?
15.5 Why would a firm decide to voluntarily split up?
15.6 What are the advantages and the disadvantages of tracking stocks to the investors and the firm?
15.7 What factors contribute to the high positive abnormal returns to shareholders before the announcement of a voluntary bust-up?
15.8 What factors influence a parent firm's decision to undertake a spin-off rather than a divestiture or equity carve-out?
15.9 How might the form of payment affect the abnormal return to sellers and buyers?
15.10 How might spin-offs result in a wealth transfer from bondholders to shareholders?
15.11 Explain how executing successfully a large-scale divestiture can be highly complex. This is especially true when the divested unit is integrated with the parent's functional departments and other units operated by the parent. Consider the challenges of timing, interdependencies, regulatory requirements, and customer and employee perceptions.
15.12 On April 25, 2001, in an effort to increase shareholder value, USX announced its intention to split U.S. Steel and Marathon Oil into two separately traded companies. The breakup gives holders of Marathon Oil stock an opportunity to participate in the ongoing consolidation within the global oil and gas industry. Holders of USX–U.S. Steel Group common stock (target stock) would become holders of newly formed Pittsburgh-based United States Steel Corporation. What other alternatives could USX have pursued to increase shareholder value? Why do you believe it pursued the breakup strategy rather than some of the alternatives?
15.13 Hewlett-Packard announced in early 1999 the spin-off of its Agilent Technologies unit to focus on its main business of computers and printers. HP retained a controlling interest until mid-2000, when it spun off the rest of its shares in Agilent to HP shareholders as a tax-free transaction. Discuss the reasons why HP may have chosen a staged transaction rather than an outright divestiture or spin-off of the business.
15.14 After months of trying to sell its 81% stake in Blockbuster Inc., Viacom undertook a spin-off in mid-2004. Why would Viacom choose to spin off rather than divest its Blockbuster unit? Explain your answer.
15.15 Since 2001, GE, the world's largest conglomerate, had been underperforming the S&P 500 stock index. In late 2008, the firm announced that it was considering spinning off its consumer and industrial unit. What do you believe are GE's motives for its proposed restructuring? Why do you believe it chose a spin-off rather than an alternative restructuring strategy?
Answers to these Chapter Discussion Questions can be found in the Online Instructor's Manual for instructors using this book.
Chapter Business Cases
Case Study 15.5
Kraft Foods Undertakes Split-Off of Post Cereals in Merger-Related Transaction
In August 2008, Kraft Foods announced an exchange offer related to the split-off of its Post Cereals unit and the closing of the merger of its Post Cereals business into a wholly-owned subsidiary of Ralcorp Holdings. Kraft is a major manufacturer and distributor of foods and beverages; Post is a leading manufacturer of breakfast cereals; and Ralcorp manufactures and distributes brand-name products in grocery and mass merchandise food outlets. The objective of the transaction was to allow Kraft shareholders participating in the exchange offer for Kraft Sub stock to become shareholders in Ralcorp and Kraft to receive almost $1 billion in cash or cash equivalents on a tax-free basis.
Prior to the transaction, Kraft borrowed $300 million from outside lenders and established Kraft Sub, a shell corporation wholly owned by Kraft. Kraft subsequently transferred the Post assets and associated liabilities, along with the liability Kraft incurred in raising $300 million, to Kraft Sub in exchange for all of Kraft Sub's stock and $660 million in debt securities issued by Kraft Sub to be paid to Kraft at the end of ten years. In effect, Post was conveyed to Kraft Sub in exchange for assuming Kraft's $300 million liability, 100% of Kraft Sub's stock, and Kraft Sub debt securities with a principal amount of $660 million. The consideration that Kraft received, consisting of the debt assumption by Kraft Sub, the debt securities from Kraft Sub, and the Kraft Sub stock, is considered tax free to Kraft, since it is viewed simply as an internal reorganization rather than a sale.* Kraft later converted to cash the securities received from Kraft Sub by selling them to a consortium of banks.
In the related split-off transaction, Kraft shareholders had the option to exchange their shares of Kraft common stock for shares of Kraft Sub, which owned the assets and liabilities of Post. If Kraft was unable to exchange all of the Kraft Sub common shares, it would distribute the remaining shares as a dividend (i.e., spin-off) on a pro rata basis to Kraft shareholders.
With the completion of the merger of Kraft Sub with Ralcorp Sub, which was a Ralcorp wholly-owned subsidiary, the common shares of Kraft Sub were exchanged for shares of Ralcorp stock on a one-for-one basis. Consequently, Kraft shareholders tendering their Kraft shares in the exchange offer owned 0.6606 of a share of Ralcorp stock for each Kraft share exchanged as part of the split-off.
Concurrent with the exchange offer, Kraft closed the merger of Post with Ralcorp. Kraft shareholders received Ralcorp stock valued at $1.6 billion, resulting in their owning 54% of the merged firm. By satisfying the Morris Trust tax code regulations,** the transaction was tax free to Kraft shareholders. Ralcorp Sub was later merged into Ralcorp. As such, Ralcorp assumed the liabilities of Ralcorp Sub, including the $660 million owed to Kraft.
The purchase price for the Post Cereals business equaled $2.56 billion. This price consisted of $1.6 billion in Ralcorp stock received by Kraft shareholders and $960 million in cash equivalents received by Kraft. The $960 million included the assumption of the $300 million liability by Kraft Sub and the $660 million in debt securities received from Kraft Sub.† The steps that were involved in the transaction are described in Exhibit 15.1.
Discussion Questions
1. The merger of Post with Ralcorp could have been achieved through a spin-off. Explain the details of how this might have happened.
2. Speculate as to why Kraft chose to split off rather than spin off Post as part its plan to merge Post with Ralcorp. Be specific.
3. Why was this transaction subject to the Morris Trust tax regulations (see Chapter 12)?
4. How is value created for the Kraft and Ralcorp shareholders in this type of transaction?
Answers to this case study are found in the Online Instructors Manual for instructors using this book.
Exhibit 15.1 Structuring the Transaction
Step 1: Kraft creates a shell subsidiary (Kraft Sub) and transfers Post assets and liabilities and $300 million in Kraft debt into the shell in exchange for Kraft Sub stock plus $660 million in Kraft Sub debt securities. Kraft also implements an exchange offer of Kraft Sub for Kraft common stock.
Step 2: Kraft Sub, as an independent company, is merged in a forward triangular tax-free merger with a Sub of Ralcorp (Ralcorp Sub) in which Kraft Sub shares are exchanged for Ralcorp shares, with Ralcorp Sub surviving.*
Case Study 15.6
Sara Lee Attempts to Create Value through Restructuring
After spurning a series of takeover offers, Sara Lee, a global consumer goods company, announced in early 2011 its intention to split the firm into two separate publicly traded companies. The two companies would consist of the firm's North American retail and food service division and its international beverage business. The announcement comes after a long string of restructuring efforts designed to increase shareholder value. It remains to be seen if the latest effort will be any more successful than earlier efforts.
Reflecting a flawed business strategy, Sara Lee had struggled for more than a decade to create value for its shareholders by radically restructuring its portfolio of businesses. The firm's business strategy had evolved from one designed in the mid-1980s to market a broad array of consumer products, from baked goods to coffee to underwear under the highly recognizable brand name of Sara Lee, into one that was designed to refocus the firm on the faster-growing food and beverage and apparel businesses. Despite acquiring several European manufacturers of processed meats in the early 1990s, the company's profits and share price continued to founder.
In September 1997, Sara Lee embarked on a major restructuring effort designed to boost both profits, which had been growing by about 6% during the previous five years, and the company's lagging share price. The restructuring program was intended to reduce the firm's degree of vertical integration, shifting it from a manufacturing and sales orientation to one focused on marketing the top brands of the firm. Increasingly it viewed itself as more of a marketing than a manufacturing enterprise.
Sara Lee outsourced and/or sold 110 of its manufacturing and distribution facilities over the next two years. Nearly 10,000 employees, representing 7% of the workforce, were laid off. The proceeds from the sale of facilities and the cost savings from outsourcing were either reinvested in the firm's core food businesses or used to repurchase $3 billion in company stock. In 1999 and 2000, the firm acquired several brands in an effort to bolster its core coffee operations, including names such as Chock full o'Nuts, Hills Bros, and Chase & Sanborn.
Despite these restructuring efforts, the firm's stock price continued to drift lower. In an attempt to reverse its misfortunes, the firm announced an even more ambitious restructuring plan in 2000. Sara Lee would focus on three main areas: food and beverages, underwear, and household products. The restructuring efforts resulted in the shutdown of a number of meat packing plants and a number of small divestitures, resulting in a 10% reduction (about 13,000 people) in the firm's workforce.
Sara Lee also completed the largest acquisition in its history, purchasing The Earthgrains Company for $1.9 billion plus the assumption of $0.9 billion in debt. With annual revenue of $2.6 billion, Earthgrains specialized in fresh packaged bread and refrigerated dough. However, despite ongoing restructuring activities, Sara Lee continued to underperform the broader stock market indices.
In February 2005, Sara Lee executed its most ambitious plan to transform the firm into a company focused on the global food, beverage, and household and body care businesses. To this end, the firm announced plans to dispose of 40% of its revenues, totaling more than $8 billion, including its apparel, European packaged meats, U.S. retail coffee, and direct sales businesses.
In 2006, the firm announced that it had completed the sale of its branded apparel business in Europe, its Global Body Care and European Detergents units, and its European meat processing operations. Furthermore, the firm spun off its U.S. Branded Apparel unit into a separate publicly traded firm called HanesBrands Inc. The firm raised more than $3.7 billion in cash from the divestitures. The firm was now focused on its core businesses: food, beverages, and household and body care.
In late 2008, Sara Lee announced that it would close its kosher meat processing business and sold its retail coffee business. In 2009, the firm sold its Household and Body Care business to Unilever for $1.6 billion and its hair care business to Procter & Gamble for $0.4 billion.
In 2010, the proceeds of the divestitures carried out the prior year were used to repurchase $1.3 billion of Sara Lee's outstanding shares. The firm also announced its intention to repurchase another $3 billion of its shares during the next three years. If completed, this would amount to about one-third of its approximate $10 billion market capitalization at the end of 2010.
What remains of the firm are food brands in North America, including Hillshire Farm, Ball Park, and Jimmy Dean processed meats, and Sara Lee baked goods and Earthgrains. A food distribution unit will also remain in North America, as will its beverage and bakery operations. Sara Lee is rapidly moving to become a food, beverage, and bakery firm. As it becomes more focused, it could become a takeover target.
Has the restructuring program started in 2005 worked? To answer this question, it is necessary to determine the percentage change in Sara Lee's share price from the announcement date of the restructuring program to the end of 2010, as well as the percentage change in the share price of HanesBrands Inc., which was spun off on August 18, 2006. The Sara Lee shareholders of record received one share of HanesBrands Inc. for every eight Sara Lee shares they held.
Sara Lee's share price jumped by 6%, closing at $19.56 when the restructuring was announced on February 21, 2005. Six years later, the stock price ended 2010 at $14.90, an approximate 24% decline since the announcement of the restructuring program in early 2005. Immediately following the spinoff, HanesBrands' stock traded at $22.06 per share; at the end of 2010, the stock traded at $25.99, a 17.8% increase.
A shareholder owning 100 shares of Sara Lee when the spin-off was announced would have been entitled to 12.5 shares of HanesBrands. However, they would have actually received 12 shares plus $11.03 for fractional shares (i.e., 0.5 × $22.06).
Individual shareholders of record who had 100 Sara Lee shares on the date of the announcement of the restructuring program and held their shares until the end of 2010 would have seen their investment decline 24% from $1,956 (100 shares × $19.56 per share) to $1,486.56 by the end of 2010. However, this would have been partially offset by the appreciation of the HanesBrands shares between 2006 and 2010. Therefore, the total value of the hypothetical shareholders' investment would have decreased by 7.5% from $1,956 to $1,809.47 (i.e., $1,486.56 + 12 HanesBrands shares × $25.99 + $11.03). This compares to a more modest 5% loss for investors who put the same $1,956 into a Standard & Poor's 500 stock index fund during the same period.
Why did Sara Lee underperform the broader stock market indices during this period? Despite the cumulative buyback of more than $4 billion of its outstanding stock, Sara Lee's fully diluted earnings per share dropped from $0.90 per share in 2005 to $0.52 per share in 2009. Furthermore, the book value per share, a proxy for the breakup or liquidation value of the firm, dropped from $3.28 in 2005 to $2.93 in 2009, reflecting the ongoing divestiture program. While the HanesBrands spin-off did create value for the shareholder, the amount was far too modest to offset the decline in Sara Lee's market value. During the same period, total revenue grew at a tepid average annual rate of about 3% to about $13 billion in 2009.
Discussion Questions
1. In what sense is the Sara Lee business strategy in effect a breakup strategy? Be specific.
2. Would you expect investors to be better off buying Sara Lee stock or investing in a similar set of consumer product businesses in their own personal investment portfolios? Explain your answer.
3. Why did the 2005 restructuring program appear to have been unsuccessful in achieving a sustained increase in Sara Lee's earnings per share and in creating value for the Sara Lee shareholders?
4. Why is a breakup strategy conceptually simple to explain but often difficult to implement? Be specific.
5. Explain why Sara Lee may have chosen to spin off rather than to divest HanesBrands Inc. Be specific.
Answers to these questions are found in the Online Instructor's Manual available for instructors using this book.
1 In some accounting texts, divestitures (referred to as sell-offs), spin-offs, and split-offs are all viewed as different forms of equity carve-outs and discussed in terms of how they affect the parent firm's shareholders' equity for financial reporting purposes.
2 FactSet Mergerstat Review
3 A liquidating dividend is a payment made to shareholders exceeding the firm's net income. It is a “liquidating” dividend because the firm must sell assets to make the payment.
4 For example, in a vertically integrated business, such as a steel manufacturer that obtains both iron ore and coal from its operating subsidiaries, the majority of the revenue generated by the iron ore and coal operations often comes from sales to the parent company's steelmaking operations. The parent may value this revenue for financial reporting purposes using product transfer prices, which may reflect current market prices or some formula, such as a predetermined markup over the cost of production. If the transfer prices do not reflect actual market prices, intercompany revenue may be artificially high or low, depending on whether the transfer prices are higher or lower than actual market prices. Intercompany revenues associated with the operating unit should be restated to reflect actual market prices.
5 In 1980, the oil exploration business was booming; by 1983, it was in the doldrums. It recovered by the mid-1990s. What's hot today can fizzle tomorrow. A similar story could be told about many of the high-flying Internet-related companies of the late 1990s.
6 See the discussion of the screening and contacting process in Chapter 5 for more details.
7 The VDR is intended to replace the traditional paper-based data room and the challenges of keeping such information current and secure. Because the VDR is searchable electronically, potential bidders have easier and more rapid access to the specific information they are seeking. Since multiple parties can access the information simultaneously from anywhere in the world unaware of the presence of others, the VDR provides for more efficient and thorough due diligence. VDRs also allow for online questions and answers. The major limitations of the VDR are the expense and technical expertise required and the inability to meet the management of the unit to be sold in person.
10 If the divested division or subsidiary is a discontinued segment, the parent firm must estimate the gain or loss from the divestiture on the date that management approves a formal plan to dispose of the division or subsidiary.
11 A spin-off cannot be used to avoid the payment of taxes on capital gains that might have been incurred if the parent had chosen to sell a subsidiary in which it had a low tax basis.
12 Allen and McConnell (1998) found a median retention of subsidiary shares of 69 percent, while Vijh (2002) found a median ownership stake of 72 percent.
13 Annema, Fallon, and Goedhart, 2002
15 When GM sold part of its Hughes unit and all of EDS, holders of H shares sued the GM board of directors, complaining that they were underpaid.
17 Bergh, Johnson, and Dewitt, 2007
19 Powers, 2003; Chen and Guo, 2005
20 John and Ofek, 1995; Kaplan and Weisbach, 1992
22 Hanson and Song, 2000; John and Ofek, 1995; Sicherman and Pettway, 1992
23 Petty, Keown, Scott, and Martin, 1993; John and Ofek, 1995
24 Dittmar and Shivdasani, 2003
25 Maksimovic and Phillips (2001) and Kaplan and Weisback (1992) found that firms tend to sell noncore operations, while Moeller, Schlingemann, and Stulz (2004) demonstrated that divested units tend to represent a relatively small portion of the parent's operations. Kaplan and Weisback argue that firms tend to sell previously acquired units more because of the improvement in their profitability or because they no longer support the parent's strategy than because they have failed to achieve expectations.
27 Using Tobin q-ratios (i.e., the ratio of the market value of a firm to the cost of replacing the firm's assets) as a proxy for better-managed firms, Datta, Iskandar-Datta, and Raman (2003) found that announcement period returns are highest for transactions in which the buyer's q-ratio is higher than the seller's. This implies that the assets are being transferred to a better-managed firm. Maksimovic and Phillips's (2001) findings also support this conclusion.
28 Lang et al., 1995; Kaiser and Stouraitis, 2001
31 Lang et al., 1995; Schlingemann et al., 2003
33 Nixon, Roenfeldt, and Sicherman, 2000; Ofek, 1993
34 Daley, Mehrotra, and Sivakumar, 1997
36 Burch and Nanda (2001) and Seoungpil and Denis (2004) demonstrate that spin-offs reduce the magnitude of the discount for firms trading at a conglomerate discount prior to the spin-off. Such firms are also more inclined to invest in their remaining high-growth segments.
37 Gertner, Powers, and Scharfstein, 2002
38 Gilson et al. (2001) note a substantial increase in analyst coverage and earnings forecast accuracy in the three years following a spin-off or equity carve-out.
40 Maxwell and Rao (2003), in a sample of 80 spin-offs between 1976 and 1997, note that bondholders on average suffer a negative abnormal return of 0.8 % in the month of the spin-off announcement. Stockholders experience an increase of about 3.6 % during the same period.
41 Note that assets actually pledged as collateral to current debt may not be spun off without violating loan covenants.
43 Allen and McConnell, 1998; Vijh, 2002
44 The carve-out proceeds boost bondholder returns as current debt is repurchased. The reduction in outstanding debt means less interest expense is incurred and more cash is available for dividend payments and share repurchases of stock held by current shareholders. See Thompson and Apilado (2009).
46 Atanasov, Boone, and Haushalter, 2005
49 Powers et al., 2003; Boone, Haushalter, and Mikkelson, 2003
53 Clayton and Qian (2004) found evidence that parent shares rise following the issuance of publicly listed tracking stocks. However, Elder et al. (2000) found no evidence that tracking shares lead to greater interest in the parent's and other subsidiary shares.
55 Fleming and Moon, 1995
56 Hite, Owers, and Rogers, 1987
57 Cusatis, Miles, and Woolridge, 1993
58 McConnell, Ozbilgin, and Wahal, 2001
64 Chemmanur and Paeglis (2000) found that the stock of parent firms tends to underperform the major stock indices, while the average tracking stock outperforms its industry stock index. However, Billett and Vijh (2004) found negative financial returns following the issue date for tracking stocks and positive, but statistically insignificant, returns for parents.
* The intracompany transfer of certain assets and associated liabilities is considered a tax-free event if it complies with the requirements of a D reorganization under Section 355 of the U.S. Internal Revenue Code.
** Split-offs and spin-offs undertaken as part of a merger must be structured to satisfy Morris Trust tax code rules if they are to be tax-free. Such rules require that the shareholders of the parent undertaking the split-off or spin-off end up as majority shareholders in the merged firm.
† The $660 million represents the book value of the debt on the merger closing date. The more correct representation in calculating the purchase price would be to estimate its market value.
* The merger is tax free to Kraft Sub shareholders in that it results in Kraft Sub shareholders owning a significant ongoing interest in Ralcorp and Ralcorp owning the Kraft Sub assets. Consequently, both the continuity of interests and continuity of business enterprise principles are satisfied. See Chapter 12 for a more detailed discussion of these issues.