©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston Chapter Restructuring Organization and Ownership Relationships

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2 Spin-Offs Company owns or creates a subsidiary whose shares are distributed on a pro rata basis to shareholders of parent company Subsidiary becomes publicly owned corporation

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3 Parent company often will retain from 10% to under 20% of shares of the new subsidiary Spin-off often follows the initial sale of up to 20% of the shares in an initial public offering (IPO) — transaction known as an equity carve-out

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4 Event return studies of spin-offs –Significant positive 3-5% abnormal return to parent shareholders –Size of announcement effect positively related to size of spin-off –Spin-offs to avoid regulation experienced abnormal returns of 5-6% as compared to 2-3% for the remainder of the sample –No adverse effect on bondholders

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5 –Tax effects No positive abnormal returns for taxable spin-offs Positive abnormal returns for nontaxable Controlling for size, tax effects disappear –Both spin-offs and their parents are more frequently involved in subsequent takeovers Firms which engage in no further restructuring activity earn only normal returns Firms which engage in subsequent takeovers account for positive abnormal returns

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6 Performance studies of spin-offs –Bregman Annualized returns were 31.8%, 18 points better than S&P 500 –Karen and Eric Wruck Spin-offs outperformed overall stock market Few spectacular performances dominated results –Forbes study Combined stock performance of parent and spin- off –40% did better than S&P 500 –60% underperformed

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7 –Anslinger, Klepper, and Subramaniam (1999) Sample of 12 spin-offs achieved returns over a two-year period of 26.9% compared to 17.2% for the S&P spin-offs underpeformed index –Mixed results may reflect characteristics of industries –Firms in industries with excess capacity or low sales growth underperform broader indexes –Results should be related to industry peers

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8 Tax aspects of spin-offs –Spin-off qualify for tax-exempt status if parent company own 80% of voting subsidiary stock –Spin-off transactions Companies spin off with two classes of stock –Parent sells nonvoting class of stock in public offering and then spins off voting stock tax free –Parent can do an equity carve-out of 20% of the voting stock, spin off remainder and entire spin-off transaction is tax free

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9 Companies create new subsidiary –Parent company creates subsidiary –Subsidiary has two classes of shares: Class A non- voting, Class B voting –Parent company owns all B shares –Parent company distribute A shares to its shareholders –Parent company may have option to buy back proportion of subsidiary's stock it does not now own –Parent company is not required to buy back shares or to put more money into subsidiary –Creation of subsidiary allows parent to separate risk of subsidiary business from its core operations — shareholders decide whether to increase or decrease their own risk

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10 Equity Carve-Outs Equity carve-out is an IPO of some portion of the common stock of a wholly owned subsidiary Also referred as "split-off IPOs" Resembles seasoned equity offering of the parent in that cash is received from a public sale of equity

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11 Other changes when subsidiary equity is "carved out" –IPO of common stock of subsidiary initiates public trading in a new and distinct set of equity claims on assets of subsidiary –Management system for operating the assets is likely to be restructured –Public market value for operations of subsidiary becomes established –Financial reports are issued on the subsidiary operations

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12 Equity carve-outs can be used by a firm to raise equity funds directly related to the operation of a particular segment or industry Equity carve-outs also used as first step in spin-off and split-ups

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13 Comparison to spin-off –Similar to voluntary spin-off in that it results in subsidiary's equity claims traded separately from the equity claims on the parent entity –Differences In spin-off a distribution is made pro rata to shareholders of parent firm as dividend; in equity- carve-out, stock of subsidiary is sold in public markets for cash which is received by parent In spin-off, parent firm no longer has control over subsidiary assets; in carve-out, parent generally sells only minority interest in subsidiary and maintains control over subsidiary assets and operations

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14 Comparison to divestitures –Similar in that cash is received –Differences Divestiture is usually to another company Control over assets sold is relinquished by parent-seller and trading of subsidiary is not initiated

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15 Transaction examples –GM-Delphi In August 1998, the GM board of directors voted to separate Delphi from GM In February 1999, Delphi completed its IPO of 100,000,000 shares of common (17.7% equity carve-out) while GM held remaining 465,000,000 (82.3%) of Delphi's outstanding stock In April 1999, board of directors approved spin-off of 452,565,000 of GM's Delphi shares through a dividend of 0.7 shares of Delphi for one share of GM common stock Remaining 12,435,000 of GM's shares were contributed to the General Motors Welfare Benefit Trust Delphi became a fully independent, publicly traded company (split-up) after the spin-off

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16 –DuPont-Conoco DuPont bought Conoco in 1981 On May 12, 1998, DuPont announced it would divest itself of 20% of its Conoco oil subsidiary and subsequently spin-off remainder In initial IPO, DuPont sold 150 million A shares which carried one vote Spin-off of remainder of Conoco was accomplished by a share exchange in which for each share of DuPont stock, holder could receive 2.95 shares of class B stock of Conoco Class B stock was identical to class A stock except that each share carried 5 votes GM paid Delphi's shares as a dividend; to obtain Conoco shares, DuPont shareholders had to exchange their DuPont shares Share exchange method allowed DuPont's shareholders to choose whether they wanted to invest in the chemical industry versus petroleum industry

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17 Carve-out event returns –Market reaction not easily predictable since equity carve-outs have characteristics in common with spin-offs, divestitures, and seasoned equity issues Spin-offs — abnormal returns to parent firm of 2- 3% on average Divestitures — gains to selling firm of 1-2% on average Seasoned equity issues — negative residuals of 2-3% on announcement –Event returns %

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18 Performance studies of carve-outs –Vijh (1999) Compared performance of carve-outs to several benchmarks — carve-outs did not underperform benchmarks Carve-outs earned an annual raw return of 14.3% during first three years — contrast to poor performance of IPOs which have annual return of 3.4% Average initial listing-day returns for carve-outs of 6.2%, with median of 2.5% — much smaller than 15.4% for IPOs

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19 Possible performance explanations –Parent firms tend to be relatively unfocused — carve- outs are an opportunity to improve focus –Subsidiaries gain partial freedom to pursue own activities –Allen (1998) Examined performance of equity carve-outs at Thermo Electron Thermo Electron has performed well since program implementation –$100 invested in firm in 1983 would have appreciated to $1,667 by end of 1995 –Contrast to industry index which grew to $524, and S&P 500 which grew to $381

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20 Tracking Stock Tracking stocks are separate classes of common stock of parent corporation First issued in 1984 by GM in connection with its acquisition of EDS Also known as letter stock, targeted stock, and designer stocks

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21 Company's business operations are split into two or more common equity claims, but businesses remain as wholly owned segments of single parent Each tracking stock is regarded as common stock of consolidated company and not of subsidiary Tracking stock company is usually assigned its own distinctive name

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22 Tracking stock trades separately from parent company so that dividends paid to shareholders can be based on cash flows of tracking company alone Compensation of tracking company's managers can be based on financial results and stock price of tracking stock 80% of firms issuing tracking stocks use a dividend process but some firms use the issuance of tracking stock as a source of cash

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23 Comparison to dual-class stock and spin- offs –Dual-class stocks In dual-class stocks, class A generally has one vote per share versus five or more per share for class B, but class A has higher allocations of dividends Tracking stock has same voting rights as shareholders who hold stock in parent

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24 –Spin-off Similar to spin-off in that financial results of parent and subsidiary are reported separately Different in that spin-off is a separate entity with its own board of directors and shareholders who can vote for board of their separate company but not for the parent In spin-off, initial assignment of assets and other relationships are defined, thereafter they are independent entities In tracking stock, board of parent continues to control activities of tracking segment

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25 Benefits and limitations –Benefits Tax-free issuance Financial markets can value different businesses based on their own performance Analysts' coverage likely to be improved Stock-based management incentive programs can be related to each tracking business unit Investors are provided with quasi-pure play opportunities Increase flexibility in raising equity capital Provides alternative types of acquisition currency

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26 –Limitations Tracking stock subsidiary is generally subject to will of parent Potential conflict of interest over cost allocations or other internal transfer transactions Tracking stock subsidiary may command less takeover interest because of blurred relationship with parent

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27 Price performance –Main determinant is economic characteristics of businesses in which tracking stock subsidiary have been established –Combined parent/tracking stock performance has been, with exceptions, superior to performance of their peer groups

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28 Split-Ups Companies split into two or more parts Accomplished usually by initial carve- outs, followed by spin-offs of individual parts

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29 Examples –Hewlett-Packard and Agilent Bring more focus Avoid overlap of capabilities –AT&T restructuring Avoid conflicts from AT&T’s role as supplier and competitor in long distance business Improve valuation multiples for core business –ITT Corp Attempt to improve share price Separate poor performers Resulted in takeover

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30 Rationale for Gains to Sell-Offs and Split-Ups Information –Subsidiary true value hidden –Preference for pure-play (single-industry) securities –Increased availability of information

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31 Managerial efficiency –Management's inability to manage complex organizations –Sell-offs sharpen focus, get rid of poor fit subsidiaries, eliminate negative synergy

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32 Management incentives –Bureaucracy and consolidation of financial statements stifle entrepreneurial spirit — hide good (bad) performance –Conflict of objectives between parent and subsidiary –Tie compensation directly to subsidiary performance

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33 Tax and/or regulatory factors –Subsample of spin-offs citing tax benefits have higher abnormal returns –Tax motives — subsidiaries can take forms that shelter income –Regulatory motives — spin-offs can free parent from regulatory scrutiny

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34 Bondholder expropriation –Spin-off reduces bondholder collateral –Unsupported by evidence Bondholders can anticipate spin-offs and write protective covenants Subsidiaries have their own debt or take on a pro rata share of parent debt Bondholders may benefit if junior debt of parent becomes senior debt of subsidiary No evidence of bond price or ratings decline at spin-off announcements

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35 Changing economic environment –Major shifts in economic environment alter parent and subsidiary opportunity sets such that separate operations become optimal Avoiding conflicts with customers –Spin-off can deal more effectively with customers –Spin-off can avoid conflict if customer is a competitor of parent firm

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36 Provide investors with pure winners –Separate segments that lower valuation multiple on overall company Option creation –Common stock is an option on underlying technology of firm –Spin-off creates two options on same assets, therefore more value

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37 Increase market spanning –Expanded opportunity sets to appeal to different investor clienteles –Improve completeness of markets — increased number of securities for given number of possible states of the world Enable more focused mergers –Facilitate more focused mergers where bidder is interested in only a subset of target assets

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38 The Choice of Restructuring Methods Spin-offs –Parent's potential position to create value through skills, systems, or synergies is weak –Parents and subsidiaries have conflicts of interest

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39 Equity carve-outs –Firms can easily separate subsidiaries –Bring added attention to subsidiaries with high margins and growth –Provide capital for acquisitions or other investments –Allow division managers to take primary responsibility for financing and investment decisions

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40 –Subsidiaries may have better access to capital Take advantage of parent's debt rating Seek funding from capital markets instead of overstating budgeting needs to parent –Fund projects that otherwise would depress parent's earnings

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41 Tracking stocks –Provide capital for acquisition or other investment programs –Bring attention to subsidiaries with high growth or margins –Subsidiaries can take advantage of capital structure of parent –Reduce taxes — net operating losses of parent or subsidiary can be used to reduce overall corporate taxes –Useful for firms with divisions that share significant synergies so full separation not desirable

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42 –Limitations Parent still controls Potential conflicts of interest with parent Value depends on its performance