1 Leveraged Recapitalizations & Asset Restructuring Chapter 13 Part 3

Leveraged recapitalizations Same finance-driven reasons as financial acquisitions Deals produce leverage but co doesn’t go private – See Interco in ch. 7, e.g. & Blasius deal in ch. 8 Not always a good deal for s/h Increases risk of bankruptcy Even “scorched earth defense” can be well within BJR; doesn’t necessarily even trigger Unocal review – See Interco Simple deals – borrow money, pay dividend or buyback stock 2

Asset Restructuring M&A -like transactions that don’t fit definition of merger or other fundamental corp change Legal: who decides? Financial: how is value created? 3

Asset Restructuring Methods Divestitures/Asset Sales – Sale of subsidiary, division or assets to third party usually for cash – Often sale of unrelated or geographically separate – Divesting firms often have high leverage and/or are experiencing losses Carve-outs – Public offering of minority equity interest (e.g. 20%) in subsidiary (IPO) Spin-offs – Distribution of parent stockholdings in a subsidiary to parent shareholders via dividend 4

How Restructuring Creates Value: Seller A liquidity event (often, but not always) – Taxes (tends to follow liquidity events; often, but not always) Reducing costs via more precise management focus – Harder to hide poor parent performance without unrelated subsidiary – Elimination of negative synergies e.g. lost sales because competitors who won’t be subsidiary or parent customers – Improved market-based capital allocation e.g. reduces subsidies to weaker company 5

How Restructuring Creates Value: Seller Better monitoring by board/shareholders/market (i.e. Improves firm transparency) – Increases analysts coverage of “pure plays” – Overcomes difficulty in valuing diversified firms – Offers investors “pure plays” in parent & subsidiary stock 6

How Restructuring Creates Value: Buyer Transfers assets to owners with higher valuation (e.g. divestiture) – Assets generally have synergies when combined with buyer Improves subsidiary manager incentives (except divestitures) – Stock-based compensation for subsidiary managers more closely tied to specific operations – More decentralized decision-making Improves board monitoring—a new board or more independent subsidiary board of directors established 7

How Restructuring Creates Value: Buyer Improves market monitoring--Transparency – Public disclosure of operations & financials reduces information asymmetries - more accurate market valuation of subsidiary Creates a market price for subsidiary equity increasing its liquidity – Makes it easier to sell remaining subsidiary stock (carve- out) – Improves subsidiary’s capital market access – Managers able to sell stock in public market – Subsidiary can use its stock as acquisition currency 8

9 The Legal Dimension Who gets to decide? – Divestiture – Carve-out – Spin-off So what legal review? Who is pushing restructuring?

Empirical Evidence on divestiture Seller’s operations become more focused: – Decrease in number of reported lines of business – Divested assets are unrelated to seller’s main operations in 75% of cases – Seller’s remaining assets become more profitable negative synergies from divested assets eliminated Performance gains related to improved focus 10

Empirical Evidence on divestiture Announcement returns to seller are positive (2%) overall and more specifically reflect use of proceeds – Positive for firms paying down debt (4.5%) – Positive for firms expected to pay out proceeds – Insignificant for firms expected to retain proceeds – Stock price reactions are larger for firms in financial distress (reduction of expected bankruptcy costs?) – Stock price reactions increase as a fraction of assets sold relative to a divesting firm’s total assets – Announcement return higher if buyer has comparative advantage in managing divested assets. 11

Buyer motives 1. Assets with synergies when combined with a buyer operations—needs transfer of control to realize gain 2. Assets are undervalued because managers or Target’s parent are not efficiently using them 3. Target parent underestimates the expected future CFs 4. Buyer has large free cash flows and managers value growth above stock value First 3 hypotheses predict gains to buyers and fourth predicts a loss 12

Buyer motives – evidence Empirical Evidence: – Acquisitions of subsidiaries are much more profitable than acquisitions of public companies - larger buyer announcement effect – Buyer stock prices fall back to pre-acquisition announcement levels when proposed sales are cancelled – Firms with weak corporate governance generally make less profitable acquisitions and more often realize losses 13

Divestitures follow M&A deals Strong correlation between merger & divestiture activity – Number of divestitures averages 40% of number of M&A deals over – Lower divestiture activity in years when stock market falls and higher activity when stocks perform well – LBOs lead to many divestitures – Financial distress can trigger significant divestitures – Antitrust or other regulatory authorities often force divestitures (e.g. Exxon-Mobil $4 billion divested to get antitrust approval) 14

Divestitures follow M&A deals What does close empirical relationship between M&A deals and divestitures tell us? –Buyer only wants part of Target and divests remainder –Divestitures help pay for acquisitions – Bust-up Takeover 15

Equity Carve-Outs Initial public offering of stock in a wholly owned subsidiary Parent firm typically retains a controlling interest in the carved-out subsidiary (median 80%); Assets of carved out subsidiary on average represents 20% of pre-carve-out firm Means of raising funds (cash) in the capital market Reduces parent managers’ control over subsidiary; former subsidiary managers have greater control, often more high-powered incentives and report to their own board After the carve-out, the subsidiary subject to SEC disclosure requirements and its board of directors subject to state law fiduciary duties 16

Carve-Out tax treatment Parent recognizes capital gains or loss recognition on the cash raised in carve-out Sub can borrow cash and pay it to parent as a dividend, before a spin-off of remaining 80% of stock without changing tax treatment of the transaction If carve-out leaves behind 80% or more, then parent can continue to benefit from tax consolidation of sub No tax consequence if sub keeps cash raised in sale of stock – later sub could pay cash to parent – but to avoid an IRS challenge to tax-free treatment of prior sale of stock, it must be “old and cold” 17

Evidence on carve-outs Positive announcement stock return (2-3%) –Positive returns when proceeds are paid out to creditors or shareholders (7%) –Insignificant returns when proceeds are retained for investment purposes Stock announcement return increases in its relative size Prior to initiating a carve-out, parent firms have –Higher leverage than industry norm –Lower interest coverage ratios –Poor operating performance compared to industry  Consistent with managerial discretion hypothesis 18

Carve-outs: What happens next? Most carve-outs are followed by a second ‘event’: –Shares initially retained by parent are sold to another firm or its management, or spun off (within 1-3 years) –Subsequent tax-free spin-off of 80% ownership –Subsequent public offering of parent’s remaining stock –Parent reacquires subsidiary shares (within 4-5 years) –Positive stock returns for parents and subsidiary on announcement of second event 19

Corporate spin-offs A distribution of shares in a subsidiary to shareholders of the parent company as a dividend Distribution is usually pro-rata and does not change the proportional ownership of parent and subsidiary No inflow of capital The spinoff separates the common stock of the parent and subsidiary companies for subsequent trading Grants complete operational decision-making authority to the subsidiary’s management team One way to divest assets on a tax-free basis 20

Tax-free spin-offs For a spinoff to be tax free (i.e., tax is deferred for shareholder until sale of the subsidiary stock) Section 355 of Internal Revenue Code requires that: Spinoff is motivated by a valid “business purpose” (not a tax free distribution of earnings) Both subsidiary and parent actively conducts some business for at least 5 years prior to the spinoff Parent owns at least 80 percent of subsidiary Parent distributes all its securities in the subsidiary and retains no ‘practical control’ Beware of anti-Morris Trust provision of sec 355(e) IRC - makes spin- offs by Target within 2 years of a merger taxable to Target firm, even retroactively If taxable, shareholders are treated as receiving a dividend 21

Why do spin-offs create value? Added tax advantages – spin-off need not be a corporation –REITS and some royalty trusts pay no taxes Regulatory advantages –Frees parent from regulations on a sub, such as a utility or bank –Circumvents US restrictions on foreign subsidiaries Wealth transfer from creditors to stockholders –Due to transfer of too much or too little debt to the subsidiary being spun-off But ….. –Legal separation of entities is needed prior to spinoff –Debt can be protected by change of control provision –Tempered by threat of bondholder class action suits 22

Empirical evidence on spin-offs Positive stock price announcement reaction (3% return) Announcement returns increases with relative size of spun-off subsidiary as a percent of parent assets Insignificant returns to bondholders at spin-off announcement Significant improvements in performance & growth (in sales, earnings and assets) for both parent and subsidiary, when both are in different industries Increased probability of becoming a takeover target 23

Asset restructuring variations Spin-outs: Partial spin-off where parent retains some subsidiary shares Split-offs: Exchange of subsidiary stock for some parent stock. Can be tax-free & is used to breakup family-owned business facing divisiveness Split-ups: Incorporate two new corporations from company assets. Exchange stock in two new companies for all the outstanding old stock of parent – reverse consolidation Joint Venture: When one or both parents contribute a subsidiary to establish JV Eliminate Minority Interest: Dispose of parent’ non-controlling shareholdings in another corporation Asset Swap: Two companies exchange divisions or subsidiaries Piecemeal Liquidation: Subsidiaries and divisions can be separately sold off and proceeds distributed to shareholders 24