Alternative Restructuring Strategies

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

Course Layout: M&A & Other Restructuring Activities Part IV: Deal Structuring & Financing Part II: M&A Process Part I: M&A Environment Payment & Legal Considerations Public Company Valuation Financial Modeling Techniques M&A Integration Business & Acquisition Plans Search through Closing Activities Part V: Alternative Strategies Accounting & Tax Considerations Business Alliances Divestitures, Spin-Offs & Carve-Outs Bankruptcy & Liquidation Regulatory Considerations Motivations for M&A Part III: M&A Valuation & Modeling Takeover Tactics and Defenses Financing Strategies Private Company Valuation Cross-Border Transactions

Learning Objectives Primary Learning Objective: To provide students with an understanding of alternative exit and restructuring strategies. Secondary Learning Objectives: To provide students with an understanding of –Divestiture, spin-off, split-up, equity carve-out, split-off, and tracking stock strategies –Criteria for choosing strategy for viable firms –Options for failing firms

Divestitures Sale 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 Focus –Moving away from the core business –Assets are worth more to the buyer than to the seller –Satisfying government requirements –Correcting past mistakes –Assets have been interfering with profitable operation of other businesses

Deciding When to Sell: Financial Evaluation of Divestitures 1.Estimate unit’s after-tax cash flows viewed on a standalone basis, carefully considering dependencies with other operating divisions 2.Determine appropriate discount rate 3.Calculate the unit’s PV to estimate enterprise value 4.Calculate the equity value of the unit as part of the parent by deducting the market value of liabilities 5.Decide 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.

Potential Seller Reactive Sale Proceed to Negotiated Settlement Pursue Alternative Bidders Public Sale or Auction Private “One on One” or Controlled Sale Proactive Sale Public Sale or Auction Private “One on One” or Controlled Sale Sequence of events: 1. Qualified bidders sign nondisclosure / receive prospectus 2. Submission of non-binding bids expressed as range 3. Bids ranked by price, financing ability, form of payment, form of acquisition; and ease of deal 4. Best and final offers Divestiture Selling Process

Choosing the Right Selling Process Selling Process One on One Negotiation (single bidder) Public Auction (no limit on number of bidders) Controlled Auction (limited number of carefully selected bidders) Advantages/Disadvantages Enables seller to select buyer with greatest synergy Minimizes disruptive due diligence Limits potential for loss of proprietary information to competitors Most appropriate for small, private, or hard to value firms May discourage some bidders concerned about excessive bidding by uninformed bidders Potentially disruptive due to multiple due diligences Sparks competition without disruptive effects of public auctions May 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 parent –Subsidiary becomes a publicly traded company –No cash infusion to parent –Tax-free to shareholders if properly structured

Spin-Offs Stage 1Stage 2 Parent Firm Parent Firm Shareholders Subsidiary Parent Firm Parent Firm Shareholders Subsidiary Independent of Former Parent Subsidiary Stock Paid to Shareholders As Dividend Parent Shareholders Own Both Parent & Subsidiary Stock How might a spin-off create value for parent company shareholders?

Equity Carve-outs Two forms: Initial public offering (IPO) and subsidiary equity carve- out IPOs 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 shareholders Subsidiary 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 parent’s shareholders –Although the parent generally sells less than 20% of the sub’s equity, the sub’s shareholder base may be different than that of the parent How might an equity carveout create value for parent firm shareholders?

Equity Carve-Outs Private Firm Sells A Portion of Its Equity to the Public Public/Private Equity Markets Parent Firm Sells A Portion of Its Subsidiary Stock to the Public Public/Private Equity Markets Subsidiary of Parent Firm Initial Public Offering Subsidiary Equity Carve-Out Cash Stock Subsidiary Stock Cash

Tracking Stocks Separate 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 shareholder’s return to the performance of the individual operating unit For the investor, such shares enable investment in a single operating unit (i.e., a pure play) rather than in the parent For the parent and the operating unit, such shares –Give the parent another means of raising capital, –Enable parent to retain control –Represent an “acquisition currency” for the unit, and –Provide an equity-based incentive plan to attract and maintain key managers May create conflict of interest

Tracking Stocks Parent Firm Parent Common Sub 1 Tracking Stock Sub 2 Tracking Stock Sub 3 Tracking Stock Subsidiary 1Subsidiary 2Subsidiary 3 Tracking Stocks Issued by the Parent Firm Value of the Tracking Stock Depends on the Performance of Subsidiary

Split-Offs A 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 stake 1 in a subsidiary in order to: –Reduce pressure on the spun-off firm’s share price, because shareholders who exchange their stock are less likely to sell the new stock and –Increase the parent’s EPS by reducing the number of its shares outstanding –Eliminate minority shareholders in a subsidiary 1 Minority 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 firm’s shareholders through a split-off.

Split-Off Illustration Stage 1 Stage 2 Parent Firm Parent Firm Shareholders Subsidiary Parent Firm Former Parent Firm Shareholders Subsidiary Independent of Former Parent Subsidiary Stock Subsidiary stock now held by former parent shareholders. Parent has no relationship with former subsidiary Parent Stock Note: 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 Merger Kraft Foods Kraft Shareholders Kraft Sub (Post) Post Assets & Liabilities Incl. $300 in Kraft Debt 1 Kraft Sub Shares + $660 Million Note Payable to Kraft over 10 Years 2 Kraft Shares Kraft Sub Shares RalcorpKraft Sub (Post) Ralcorp Sub Kraft Sub Shareholders Ralcorp Stock Ralcorp Sub Stock Ralcorp Stock 3,4 Kraft Sub Assets & Liabilities Kraft Sub Shares 1 Kraft Foods retained the cash and Kraft Sub paid off the liability. 2 Kraft 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. 3 Ralcorp 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 firm’s 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. 4 Cash 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-Ups Involves the sale of all of a firm’s individual operating units After paying off any remaining outstanding liabilities, after-tax proceeds are returned to the parent’s shareholders and the corporate shell is dissolved This option may be pursued if management views the growth prospects of the consolidated firm as limited

Choosing Appropriate Restructuring Strategy: Viable Firms Choice heavily influenced by the following: –Parent’s need for cash –Degree of operating unit’s synergy with parent –Potential selling price of operating entity Implications: –Parent firms needing cash more likely to divest or engage in equity carve-out for operations exhibiting high selling prices relative to their synergy value –Parent firms not needing cash more likely to spin-off units exhibiting low selling prices and synergy with parent –Parent firms with moderate cash needs likely to engage in equity carve-out when unit’s selling price is low relative to synergy

Choosing Appropriate Restructuring Strategy: Failing Firms Choice heavily influenced by the following: –Going concern value of debtor firm –Sale value of debtor firm –Liquidation value of debtor firm Implications: –If sale value > going concern or liquidation value, sell firm –If going concern value > sale or liquidation value, reach out of court settlement with creditors or seek bankruptcy protection under Chapter 11 –If liquidation value > sale or going concern value, reach out of court settlement with creditors and liquidate or liquidate under Chapter 7

Discussion Questions 1.Divestitures, equity carve-outs, and spin-offs represent alternative restructuring strategies? Explain the primary advantages and disadvantages of each. 2.Under what circumstances might senior management prefer to divest a business unit rather than to spin-off the business? 3.Under what circumstances might senior management prefer an equity carve-out to a spin-off?

Things to Remember… Divestitures, spin-offs, equity carve-outs, split- ups, split-offs, and tracking stock are common restructuring strategies to enhance shareholder value Divestitures 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 cash Spin-offs are more likely for operating units whose selling price and synergy are low and whose parent firm does not need cash