Mergers and Acquisitions: Break Ups

As mergers capture the imagination of many investors and companies, the idea of getting smaller might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders both in terms of the ongoing business and adding shareholder value.

According to the Wall Street Journal, the value of corporate spin-offs, which occurs when a company divests itself of a business unit to create a new standalone company, totaled over $250 billion in 2015, almost double the level of 2014.

Some reasons cited by FINRA that can motivate spin-offs include:

• Better management. Senior management of the corporation may be adept at managing the overall enterprise, but one particular business unit may be out of their scope of expertise. Spinning this unit off as a separate company allows the management of that business unit to drive strategy for the business unit as a separate, distinct company without worrying about the impact on the larger corporation they are a subsidiary of.
• Differing growth paths and strategies. The business unit might be growing slower than the parent corporation and could be a drag on the parent’s resources. Or the opposite could be the case. In either situation allowing the unit to function as an independent business can allow it grow at its own pace and potentially attract investors that are interested in direct ownership of the new company.
• Better analyst coverage for the parent. Divesting and spinning off a business unit can actually increase visibility among securities analysts resulting in better coverage of the parent company post-spinoff. The parent company is less complex with one less business unit and easier for analysts to understand and analyze.
• Unlocking shareholder value. Often spinning off a subsidiary can add value for shareholders. The spinoff as an independent company may be more valuable than as part of the parent.
• A spinoff can be a complex transaction for a whole range of reasons including how to handle employment contracts with key employees, pensions and retirement plans, technology and back-office services among other things. These and and a host of other issues require careful planning and execution to ensure a smooth transaction.

Beyond spinoffs there are some other methods companies rid themselves of business units:

Sell-Offs

A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn't fit into the parent company's core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.

Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders' method certainly makes sense if the value of the parts is greater than the whole. When it isn't, deals are unsuccessful.

Equity Carve-Outs

More and more companies are using equity carve-outs to boost shareholder value. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary.

A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent's shareholder value.

The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm's board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it's doing well, but because it is a burden. Such an intention won't lead to a successful result, especially if a carved-out subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

Tracking Stock

Tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. The stock allows the different segments of the company to be valued differently by investors.

Let's say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to have a fast-growing business unit. The company might issue a tracking stock so the market can value the new business separately from the old one and at a significantly higher P/E rating.

Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth business for shareholders? The company retains control over the subsidiary; the two businesses can continue to enjoy synergies and share marketing, administrative support functions, a headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company can use the tracking stock it owns to make acquisitions.

Still, shareholders need to remember that tracking stocks are class B, meaning they don't grant shareholders the same voting rights as those of the main stock. Each share of tracking stock may have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all.