EXECUTIVE INSIGHTS
VOLUME III, ISSUE 1
The Risks and Rewards of Spin-Offs, Equity Carve-Outs and Tracking Stocks In the drive to maximize shareholder value, corporate managers must
• Profile the recent explosion of spin-offs, equity carve-outs and tracking stocks
most challenging times to address this question occurs when one part of the company has significantly higher growth opportunities than the rest of the company. At this point, management should consider whether to change the ownership structure of the higher-potential
• Outline the key areas of costs and benefits when evaluating a separation • Review traditional methods of separation as well as some innovative variations • Provide guidelines for selecting the best vehicle
entity to unlock its full value. As valuations of new economy companies skyrocket and the numbers of in-house Internet
The Separation Explosion
and technology divisions increase, this
The recent explosion of equity separation
issue has become a consideration for
is focused in large part on the high-
more companies than ever before.
technology sector, especially units related
With the recent increase of spin-offs, equity carve-outs and tracking stock issues (collectively termed “equity separations”) and the market and media attention these strategies receive, boards are requiring management to
value for the shareholders of the new entity as well as the parent company.
constantly ask: “Are my assets optimally configured to create value?” One of the
Equity separation can create substantial
to the Internet. In 1999 alone, the U.S. technology sector completed 20 equity carve-outs and 12 tracking stock issuances. This activity equals the number of equity carve-outs completed in the previous five years combined.
Analysis by J.P. Morgan shows that the average spin-off and equity carve-out increased the parent’s shareholder value by 6% and 2.5%, respectively, the day after the transaction and outperformed the market by 20% and 10%, respectively, 18 months after the transaction. A classic example of equity separation is the equity carve-out of Infinity Broadcasting (INF) from CBS. CBS sold 17% of Infinity, a network of 160 radio stations in an initial public offering in December 1998. As the figures below show, CBS market capitalization went from $20.9 billion to $28.9 billion in just a few months. Additionally, the Infinity shares offered to the public were worth an additional $3.6 billion for a total value of $32.5 billion, a 56% increase. Over the same period, a group of CBS’ peers was up
carefully evaluate these opportunities.
18.5%, the NASDAQ was up 15.4%
As such,we felt it timely to consider
and the S&P 500 was up 7.2%.
if, when, and how to implement a separation. This newsletter will:
L.E.K. Consulting Executive Insights
The Risks and Rewards of Spin-Offs, Equity Carve-Outs and Tracking Stocks was written by Bill Frack and Dan Schechter, Vice Presidents in L.E.K.’s Los Angeles office. Please contact L.E.K. at
[email protected] for additional information.
LEK.COM
EXECUTIVE INSIGHTS
What created these superior shareholder
Technology Equity Carve-Outs
returns? Before the equity carve-out, the market focused on the then-troubled television network, ignoring CBS’ valuable radio assets. The separation turned attention
Technology Equity Carve-Outs
to the high-profit radio holdings, created
management incentives for the new entity, reduced the inefficient cross-subsidies that drained value from radio to television, and created a new high-value stock for use as acquisition currency in the consolidating radio industry.
Analyzing the Benefits Traditionally, many of the benefits derived from separating a business unit from its parent have been achieved through management action rather than asset
1. Improved Access to Equity Markets:
enable management to access the vast
restructuring. If a division required a
Businesses often require significant
capital market necessary to compete in
different management culture than the
equity capital to fund early stages of
the new business sectors. This trend is
parent to succeed, it could be physically
development. Historically, these invest-
pronounced in the areas of technology
relocated and communication minimized
ments came from the corporate treasury,
where a disproportionate amount of
with the parent. Witness the number
where young projects competed for
analyst and investor attention is focused.
of automobile design studios located
special funding. Equity separations
in California, away from corporate headquarters. If there was a desire to tie compensation more closely to the performance of a high-growth division rather than the parent, phantom stock or a long-term valuation-based incentive system would be created. So why are shareholders now apparently better served by separate equity structures? In short, new economic developments have created more tangible, substantial benefits to separation than in the past. L.E.K. has identified six primary sources of value creation:
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EXECUTIVE INSIGHTS
2. Creation of a Currency for
for a new entity enables the creation
4. Reduced Costs from Incompatible
Acquisitions: Since acquisitions can
of stock option programs that can be
Management Cultures: High-growth,
be a critical component of a high-tech-
critical to motivating and retaining
embryonic divisions often have more
nology unit’s capability development,
management talent. While option-like
than a little problem blending into more
a separate equity structure can provide
incentives can be replicated with
traditional corporate cultures. Frequently,
stock whose high value makes it attractive
phantom stock and other mechanisms,
extraordinary amounts of management
to use as acquisition currency. Current
they do not provide the tangibility or
time and resources are spent reconciling
valuation levels of technology companies
liquidity of a market–based measure
differences and providing both cultures
of value compared to traded stock.
with appropriate support. Separation can
require serious acquisition players in these sectors to possess currency to make stock transactions. The media industry example below demonstrates how new online firms are valued relative to established companies on a total market capitalizationto-sales basis. By creating and owning a currency that trades on the same dynamics as the target stocks, companies can reduce the risk of heavily diluting existing shares of the parent company.
help companies circumvent potential conIn addition, the benefits of options are
flicts and deploy management resources difficult to replicate in phantom stock plans more effectively. The dress, work style, because of embedded reward ceilings. 24/7 hours, and rapid decision making This ceiling issue could be addressed by
found in many new businesses are often
using comparable e-business multiples
best separated structurally to encourage
to establish the phantom stock value.
the unique entrepreneurial spirit that
However, companies have been reluctant
drives success.
to do so, in large part because of the difficulty of analytically supporting current e-valuations. Finally, phantom plans are not as easily understood and their
3. Stock Option Incentive Plans
link between pay and performance
for Management Motivation and
is perceived to be less reliable.1
1. See Alfred Rappaport’s Harvard Business Review article,“New Thinking on How to Link Executive Pay with Performance”
Retention: Creating a separate equity
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EXECUTIVE INSIGHTS
Many people believe that toysrus.com is
courage increased investment in the par-
Not all equity separations create share-
a business unit example that has failed
ent company, as recent valuations have
holder value. Less publicized failures
to maximize its potential by remaining
shown that shareholder value rises when
include TCI Satellite Entertainment from
part of the corporate organization too
a sound and well-executed equity separa-
TCI, Aztec Technology Partners from U.S.
long. While Toys “R” Us has been selling
tion strategy is completed. Of course,
Office Products, Midway Games from
online since 1998, its web initiative has
increased visibility can be a double-edged
WMS Industries, and Imation from 3M.
been fraught with problems: frequent
sword. While it reveals the strength of
In many cases, unsuccessful separations
outages, poor selection, minimal market-
a new business, it can simultaneously
are the result of management focusing
ing, and an inadequate order-fulfillment
expose a weakness in the core business.
on short-term financial engineering goals
system that caused it to remain a weak
If enhanced visibility is the primary reason
rather than long-term value creation.
competitor to eToys and Brainplay during
management is considering an equity
Leveraging the proceeds from an
the 1999 holiday season. Insiders have
separation, a targeted investor commu-
equity separation to pay down a parent
indicated that one of the primary factors
nication program should be considered
company’s debt is consistently viewed
that contributed to these problems was
before implementing more drastic equity
unfavorably by the market. Separating
the online group’s structure as an operat-
separation options.2
a business unit that lacks a strong
ing division of the parent versus as a
competitive advantage or strategy is
stand-alone entity.
Costs of Separation
5. Accelerated Time to Market: New
While there are many potential benefits
companies operating outside the parent
to equity separation, there are significant
company’s structure may be able to ac-
costs that must be carefully assessed. Eq-
celerate the time needed for innovation
uity separations create new administrative
cycles. This ability is critical in the fast-
burdens such as financial reporting,
moving e-business environment. In some
Once management has determined that
market communication, and corporate
market segments, first-mover advantage
the likely benefits of separation sub-
governance, which are required by every
and/or being one of the lead players is
stantially outweigh the costs, the most
new company. Costs are also increased
extremely important as companies com-
appropriate separation vehicle must be
by the separation of shared departments
pete to make their platform the standard.
selected. There are three primary ways
such as human resources, information
Before barnesandnoble.com separated
to separate the value of a business unit
systems, and accounting. Separations
from Barnes & Noble, studies indicated
from its parent: spin-off, equity carve-out
can also divert management’s focus away
that Amazon.com released three times
and tracking stock. These vehicles vary on
from strategic and operational issues
the number of business process improve-
many dimensions, including the degree
at a key juncture in a company’s develop-
ments compared to Barnes & Noble over
of separation, transfer of assets, capital
ment. In some situations, equity separa-
that same period.
structure, taxability of the transaction,
tions are executed at a discount to fair
and resulting control of the entity. Each
market value, effectively increasing the
approach has unique benefits, drawbacks,
cost of financing. In addition, the shares
and value creation potential depending
of the parent company may fall when
on the specific situation.
6. Enhanced Market Coverage and Market Value Recognition: If a company’s business unit is not being appropriately valued due to a lack of market scrutiny or understanding, equity separation forces current analysts to assess its value and may attract new ones. Equity restructuring can also en-
another source of concern to market makers and other lead-steer investors.
Comparing Separation Methods
the fast-growing assets are removed from the corporate balance sheet. Other
In a spin-off, the parent distributes all
significant expenses include the legal,
shares of a wholly owned subsidiary to its
consulting, and investment banking fees
existing shareholders and a new entity is
related to implementing the separation.
created with a separate governing board. 2. See Volume II, Issue 1, Market Signals Analysis.
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EXECUTIVE INSIGHTS Equity Separation Comparisons Assets are transferred to a new balance Spin-Off
Equity Comparisons TrackingSeparation Stock
Equity Carve-Out
sheet, and the separation from the parent
with no gain or loss realized by the parent
Generally partial
Parent issues shares Spin-Off Equity Carve-Out representing ownership Parents IPO of subsidiary of thedistributes earnings of shares of subsidiary to existing shareholders Notional
No purest form Reversible or its shareholders. This is the
Degree of Separation Dependent
Complete Yes
Generally partial
(upstream dividend) Cash Proceeds of separation and frees theYes operation to
Yes Reversible
NoYes (with offering)
Dependent
tax-free competeTaxability as an independentGenerally company.
(upstream dividend) Cash Proceeds Potential capital gains YesTax free tax but avoidable Generally tax-free Taxability on depending percentage carved out, tax basis and business
Parents distributes of subsidiary to irreversible.shares Generally, existing shareholders
IPO of subsidiary
Description
is complete and
Description
spin-offs are structured to be tax free, Degree of Separation
Complete
The equity carve-out is a subsidiary initial public offering and can be structured as either a primary or secondary offering
Pro rata distribution
Mechanics of
Parent issuesOptions shares Partnership representing ownership of the earnings of
and Joint Venture
borrowing costs of
separate balance sheet, a separate board No Consolidation
is established, and the parent company
relinquishes of the subsidiary to Assetcontrol Transfer to Yes New Company
the extent that stock is offered. Typically, Parent Control Newthan No 20% of the companies carve outofless Company Cash Flows
subsidiary in order to retain control, to Separate
preserve tax and accounting consolidation,
CBS–MarketWatch
Notional Yes
W N Capital
J Yes (with offering) a VC Fund
Yes
Potential capital gains Tax free tax but avoidable depending on percentage carved out, Partner tax basis and business
Asset Transfer to New Company No (generally)
Yes
Parent Control of New Company Cash Flows Separate
No Status Quo
No (generally)
Separate
Separate
Board of Directors
and to enable a tax-free spin-off at a later date.
Yes
No
Established Corporation
Some
• • Some • • • Status Quo • Market credibility
E
• • • • • •
Establishing a tracking stock involves
the form of an IPO. Unlike spin-offs and
currency Onlinethe Company to participate or Private “track” performance,
issuing a second class of common stock
equity carve-outs, the separation is only
• the limitations around further restructur•
whose value reflects the earnings of a
Leading Exam
Pro rata stock dividend establishes a visible valuation (investment by Bert No impact on total Proborrowing rata distribution Pro rata stock dividend capacity and IPO Could increase Could increase borrowing costs of No impact on total borrowing costs of carve-out (depends on borrowing capacity and capital structure) spin-off (depends on Full tax consolidation if Tax consolidation sell less than 20% C Combined-Asset Spin-Off an Consolidation No Consolidation Full tax consolidation if Tax consolidation sell less than 20% Yes No
to a spin-off, assets are transferred to a on spin-off (depends
Board of Directors
C
followed by an IPO
IPO Could increase borrowing costs of Mechanics of carve-out (depends on Borrowing Costs capital structure)
Could increase Borrowingcommon Costs of a subsidiary’s stock. Similar
Consolidation
Creative Separation and Tracking Stock
notional; the parent company’s board
Busine
P
•
• • •
ing are considerable and the inherent •
particular division. These shares can be
retains control over the division’s cash
conflict of interestmarketing for the board has expertise
distributed as a dividend to shareholders
flows and assets are not transferred.
often resulted in litigation.
in the parent company, or they can take
While this structure allows an investor
•
Benefits and Drawbacks of Equity Separation Methods Spin-Off Description
Benefits and DrawbacksTracking of Equity Separation Methods Stock
Equity Carve-Out
· Greater flexibility Spin-Off · Culture changes more likely · Flexibility Description · Stock useful for incentive/ some · Stock useful for incentives/acquisitions · Facilities culture change acquisitions · Volatile earnings stream separated out · Stock useful for incentives/acquisitions · Volatile earnings stream separated out · Complete freedom · Volatile earnings stream separated out · Consolidation if