- March 5, 2020
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Spin-Offs in Corporate Restructuring
Spin-offs in corporate restructuring have become very relevant in today’s market. Corporate restructuring is an operation taken by a corporation to significantly transform the financial and operational perspectives of the organization, customarily when the business is encountering financial hardships. Restructuring entails considerably altering the debt, operations, or structure of a business as a method of checking financial impairment and developing the business. Let us discuss what spin-offs are and how it provides benefits to both the parent company and the spun business entity.
In a spin-off, the parent company (ParentCo) issues to its current shareholder’s new shares in a subsidiary, through forming a separate legal existence with its management team and board of directors. The assignment gets directed pro-rata, such that every current shareholder gets stock of the subsidiary in balance to the number of parent company stock already held. No cash exchanges hands, and the shareholders of the first parent company become the shareholders of the anew spun business (SpinCo).
Divesting a subsidiary can accomplish a mixture of strategic goals, such as:
- Unfastening latent value – Set a public market valuation for undervalued assets and build a pure-play entity that is clear and more straightforward to value
- Undiversification – Divest non-core businesses and intensify strategic focus when the immediate sale to a strategic or financial acquirer is both not compelling or not plausible
- Institutional support – Improve equity research coverage and ownership by refined institutional investors, each of which favors to endorse SpinCo as a standalone enterprise
- Public currency – Devise public capital for buyouts and stock-based compensation plans
- Driving management – Increase performance by better aligning management considerations with SpinCo’s performance (using SpinCo, rather than ParentCo, stock-based grants), producing immediate accountability to public stockholders, and enhancing clarity into management performance
- Omitting dis-synergies – Lessen bureaucracy and provide SpinCo management total autonomy
- Anti-trust – Break up a company in reply to anti-trust solicitudes
- Corporate defense – Divest “crown jewel” assets to execute an unfriendly takeover of ParentCo less attractive
In general, there are four steps to implement spin-offs in corporate restructuring:
- Regular spin-off – Closed all at once in a 100% placement to stockholders
- Majority spin-off – Parent maintains a minority stake (< 20%) in SpinCo and allocates the majority of the SpinCo stock to stockholders
- Equity carve-out (IPO) /spin-off – Performed as a second move following an earlier equity carve-out of less than 20% of the voting control of the subsidiary
ParentCo’s subsisting credit arrangements may inflict restraints on divestitures that are material in nature. It is necessary to decide if any credit terms will get infringed if ParentCo spins off a subsidiary that tangibly contributes to its business.
A spin-off usually is tax-free under the Internal Revenue Code (IRC) Section 355, signifying that no taxable earnings get recognized by both the parent entity or the parent’s subsisting shareholders. The spin-off must satisfy the resulting conditions to qualify for beneficial tax treatment.
- The parent and subsidiary must both have been involved in an “ongoing business” the whole five years heading to the spin-off, and neither entity may get acquired during that time in a taxable transaction.
- ParentCo and SpinCo must remain in an ongoing business following separation.
- ParentCo must have a tax check before the spin-off, described as possession of at least 80% of the vote and value of all classes of subsidiary stock.
- ParentCo must abandon tax control as a consequence of the spin-off (< 80% vote and value).
- The spin-off must have a legitimate business purpose and cannot get utilized as a “tool” to distribute earnings (dividends).
Accounting for Spin-Offs
From the declaration of the spin-off till the date it is closed, the parent accounts for the placement of its subsidiary in a separate line item on its balance sheet termed Net Assets of Discontinued Operations. The parent also separates the net income attributable to the subsidiary on its income statement in an account called Income from Discontinued Operations.
Capital Markets Implications of Spin-Offs
The separate business entities formed in a spin-off occasionally diverge in various ways from the consolidated business, and may no longer be proper investments for some original shareholders. Spun-off companies are usually much smaller than their parent company and get commonly distinguished by immense growth. Institutional investors assigned to particular investment techniques (e.g., value, growth, large-cap) or subjected to some fiduciary limitations may want to realign their holdings with their investment goals following a spin-off by one of their portfolio businesses.
As institutional investors trade, their parent and new subsidiary stock, the stocks may suffer short-term downward pricing stress persisting weeks or even months till the shareholder bases enter new steadiness. Stockholder churn and the similar potential for low pricing pressure can influence the timing of a spin-off when CEOs are susceptible to stock price play.
Spin-offs usually get effected in acknowledgment of shareholder demand to divest a subsidiary, possibly because the postulated sum-of-the-parts valuation surpasses the current value of the consolidated company. In these situations, the parent and new subsidiary stock may undergo upward pricing pressure following a spin-off that alleviates downward pressure due to stockholder rotation.
Additionally, when spin-off gets extremely levered as a consequence of debt pushdown or loans contracted before the spin-off, shareholder returns experience a boost when SpinCo produces profits over its cost of capital. The effect is similar to how the use of leverage in LBO transactions amplifies earnings to financial buyers.
Sponsored Spin-Offs in Corporate Restructuring
In a sponsored spin-off, a financial sponsor (e.g., a private equity firm) usually offers a pre-arranged “protection” investment in an anew spun company (SpinCo). Support by a mature investor is seen positively by the market because it endorses SpinCo as a standalone business and serves as approval of SpinCo’s management unit.
In general, if the sponsor’s assistance gets arranged before or within six months after the spin-off, the sponsor can acquire no larger than a minority interest in SpinCo without jeopardizing the tax-free characteristics of the transaction.
The sponsor has numerous exit opportunities. If the sponsor’s equity stake appreciates, it can quickly trade the appreciated SpinCo shares in the market. If the stocks diminish in value and the sponsor maintains to observe SpinCo as an excellent investment, the sponsor may obtain further shares at a moderate price and attain control of SpinCo following the 2-year waiting period, perhaps even bringing SpinCo private.
The sponsored spin-off may get alternatively structured as an expenditure in ParentCo, rather than SpinCo. In this instance, ParentCo would spin-off assets not needed by the sponsor before the sponsor’s stake in ParentCo. Since any following event compromising tax-free treatment of the original transaction would constitute a tax liability for ParentCo, the sponsor would be assured to incorporate a tax indemnification limitation in the transaction negotiation.