Alternative Restructuring Strategies

Experience is the name everyone gives to their mistakes. Oscar Wilde

Cross-BorderTransactions

Learning ObjectivesPrimary Learning Objective: To provide students with an understanding of alternative exit and restructuring strategies.Secondary Learning Objectives: To provide students with an understanding ofDivestiture, spin-off, split-up, equity carve-out, split-off, and tracking stock strategiesCriteria for choosing strategy for viable firmsOptions for failing firms

DivestituresSale of a portion of the firm to an outside party generally resulting in a cash infusion to the parent. Most common restructuring strategy.Motives:De-conglomeration / Increasing Corporate FocusMoving away from the core businessAssets are worth more to the buyer than to the sellerSatisfying government requirementsCorrecting past mistakesAssets have been interfering with profitable operation of other businesses

Deciding When to Sell: Financial Evaluation of DivestituresEstimate units after-tax cash flows viewed on a standalone basis, carefully considering dependencies with other operating divisionsDetermine appropriate discount rateCalculate the units PV to estimate enterprise valueCalculate the equity value of the unit as part of the parent by deducting the market value of liabilitiesDecide to sell or retain the division by comparing the market value of the division (step 3) minus its operating liabilities (step 4) with the after-tax proceeds from the sale of the division.

Divestiture Selling Process

Potential Seller

Reactive SaleProceed to Negotiated SettlementPursue Alternative Bidders

Public Sale or AuctionPrivate One on One or Controlled Sale

Proactive Sale

Public Sale or AuctionPrivate One on One or Controlled SaleSequence of events:1. Qualified bidders sign nondisclosure / receive prospectus2. Submission of non-binding bids expressed as range3. Bids ranked by price, financing ability, form of payment, form of acquisition; and ease of deal4. Best and final offers

Choosing the Right Selling ProcessSelling ProcessOne on One Negotiation (single bidder)

Public Auction (no limit on number of bidders)

Controlled Auction (limited number of carefully selected bidders)Advantages/DisadvantagesEnables seller to select buyer with greatest synergyMinimizes disruptive due diligenceLimits potential for loss of proprietary information to competitorsMost appropriate for small, private, or hard to value firmsMay discourage some bidders concerned about excessive bidding by uninformed biddersPotentially disruptive due to multiple due diligencesSparks competition without disruptive effects of public auctionsMay exclude potentially attractive bidders

Spin-Offs Spin-Offs: New legal subsidiary created by parent with new subsidiary shares distributed to parent shareholders on pro-rata basis (e.g., Medco by Merck in 2004)Shareholder base in new company is same as parentSubsidiary becomes a publicly traded companyNo cash infusion to parentTax-free to shareholders if properly structured

Spin-OffsStage 1Stage 2Parent FirmParent Firm ShareholdersSubsidiaryParent FirmParent FirmShareholdersSubsidiaryIndependent of FormerParentSubsidiary StockPaid to ShareholdersAs DividendParent Shareholders Own Both Parent & Subsidiary StockHow might a spin-off create value for parent company shareholders?

Equity Carve-outsTwo forms: Initial public offering (IPO) and subsidiary equity carve-outIPOs represent the first offering of stock to the public of all or a portion of the equity of a formerly privately held firm (e.g., UPS sells 9% of its shares in 1999) or a firm emerging from bankruptcy (e.g., GM in 2010)The cash may be retained by the parent or returned to shareholdersSubsidiary equity carve-out is a transaction in which the parent sells a portion of the stock of a wholly-owned subsidiary to the public. (e.g., Phillip Morris 2001 sale of 15% of its Kraft subsidiary)The cash may be invested in the subsidiary, retained by the parent, or returned to the parents shareholdersAlthough the parent generally sells less than 20% of the subs equity, the subs shareholder base may be different than that of the parent

How might an equity carveout create value for parent firm shareholders?

Equity Carve-OutsPrivate Firm Sells A Portion of Its Equityto the PublicPublic/Private Equity Markets

Parent Firm SellsA Portion of Its Subsidiary Stockto the PublicPublic/PrivateEquity Markets

Subsidiary of Parent FirmInitial Public OfferingSubsidiary Equity Carve-OutCashStockSubsidiary StockCash

Tracking StocksSeparate classes of common stock created by the parent for one or more of its operating units (e.g., USX creates Marathon Oil stock in 1991)Each class of stock links the shareholders return to the performance of the individual operating unitFor the investor, such shares enable investment in a single operating unit (i.e., a pure play) rather than in the parentFor the parent and the operating unit, such shares Give the parent another means of raising capital, Enable parent to retain controlRepresent an acquisition currency for the unit, and Provide an equity-based incentive plan to attract and maintain key managersMay create conflict of interest

Tracking StocksTracking StocksIssued by the Parent FirmValue of the Tracking StockDepends on thePerformance of Subsidiary

Split-OffsA variation of a spin-off in which some parent company shareholders receive shares in a subsidiary in return for their parent shares. (e.g., AT&T spun-off its wireless operations in 2001 to its shareholders for their AT&T shares)Frequently used when a parent owns a less than 100% investment stake1 in a subsidiary in order to:Reduce pressure on the spun-off firms share price, because shareholders who exchange their stock are less likely to sell the new stock andIncrease the parents EPS by reducing the number of its shares outstandingEliminate minority shareholders in a subsidiary

1Minority shareholders add to financial reporting costs and can become contentious if they disagree with parent company policies. Parent firm efforts to sell its ownership stake may be difficult since potential buyers generally prefer to acquire 100% ownership of a business to avoid minority shareholders. Therefore, the parent firm may exit its ownership interest by transferring its stake to the parent firms shareholders through a split-off.

Split-Off IllustrationStage 1Stage 2Parent FirmParent FirmShareholdersSubsidiaryParent FirmFormerParent FirmShareholdersSubsidiary Independentof Former ParentSubsidiary Stock Subsidiary stocknow held by formerparent shareholders. Parent has no relationship with former subsidiary

ParentStockNote: If the parent cannot exchange all of its subsidiary shares, it will spin off any remaining shares to current shareholders on a pro rata basis.

Kraft Foods Splits-Off Post Cereals in Merger-Related Transaction Step 1: Kraft Implements Tax-Free Exchange Offer (a split-off)Step 2: Kraft Sub Merged with Ralcorp Sub in a Tax-Free Forward Triangular MergerKraft FoodsKraft ShareholdersKraft Sub (Post)Post Assets& Liabilities Incl. $300 in Kraft Debt1 Kraft Sub Shares + $660 Million Note Payable to Kraft over 10 Years2 Kraft SharesKraft Sub SharesRalcorpKraft Sub (Post)Ralcorp SubKraft SubShareholdersRalcorp StockRalcorpSub StockRalcorp Stock3,4Kraft Sub Assets & LiabilitiesKraft Sub Shares1Kraft Foods retained the cash and Kraft Sub paid off the liability.2Kraft Food receives 100% of the Post shares plus the present value of the ten-year note, which it converted to cash by selling it to a banking consortium.3Ralcorp stock received by Kraft shareholders was valued at $1.6 billion at that time. Total purchase price for Post equaled $2.56 billion consisting of $1.6 billion in Ralcorp stock, $300 million in Kraft debt and a $660 million note payable to Kraft. The transaction had to satisfy Morris Trust regulations requiring the selling firms shareholders to become the majority shareholder in the merged firms. This normally requires the selling firm to have a larger market value than the buyer.4Cash received by Kraft was tax free (since it is viewed as an internal reorganization) as were the share exchange of Kraft Sub shares with Kraft shareholders and the subsequent exchange for Ralcorp stock.

Voluntary Liquidations or Bust-UpsInvolves the sale of all of a firms individual operating unitsAfter paying off any remaining outstanding liabilities, after-tax proceeds are returned to the parents shareholders and the corporate shell is dissolvedThis option may be pursued if management views the growth prospects of the consolidated firm as limited

Choosing Appropriate Restructuring Strategy: Viable FirmsChoice heavily influenced by the following:Parents need for cashDegree of operating units synergy with parentPotential selling price of operating entityImplications:Parent firms needing cash more likely to divest or engage in equity carve-out for operations exhibiting high selling prices relative to their synergy valueParent firms not needing cash more likely to spin-off units exhibiting low selling prices and synergy with parentParent firms with moderate cash needs likely to engage in equity carve-out when units selling price is low relative to synergy

Choosing Appropriate Restructuring Strategy: Failing FirmsChoice heavily influenced by the following:Going concern value of debtor firmSale value of debtor firmLiquidation value of debtor firmImplications:If sale value > going concern or liquidation value, sell firmIf going concern value > sale or liquidation value, reach out of court settlement with creditors or seek bankruptcy protection under Chapter 11If liquidation value > sale or going concern value, reach out of court settlement with creditors and liquidate or liquidate under Chapter 7

Discussion QuestionsDivestitures, equity carve-outs, and spin-offs represent alternative restructuring strategies? Explain the primary advantages and disadvantages of each.Under what circumstances might senior management prefer to divest a business unit rather than to spin-off the business?Under what circumstances might senior management prefer an equity carve-out to a spin-off?

Things to RememberDivestitures, spin-offs, equity carve-outs, split-ups, split-offs, and tracking stock are common restructuring strategies to enhance shareholder valueDivestitures and equity carve-outs are more likely for operating units whose selling price is much higher than its perceived synergy with parent and whose parents need cashSpin-offs are more likely for operating units whose selling price and synergy are low and whose parent firm does not need cash