Restructuring
through spin-offs, equity carve-outs, and tracking stocks can
create shareholder value
— PATRICIA L. ANSLINGER, STEVEN J. KLEPPER, AND
SOMU SUBRAMANIAM
The McKinsey Quarterly, 1999 Number 1, pp. 16—27
As large corporations
learn to handle the flow of capital and information in a more
sophisticated way, they are finding it easier to boost shareholder
value by restructuring the capital and assets that make up their
businesses. In the past decade, hundreds of corporations have used
tracking stocks, equity carve-outs, and spin-offs for this
purpose.
AT&T’s 1996 ownership restructuring provides a striking
example. Before the company announced that it would spin off
Lucent Technologies and NCR, its market value was just $75
billion. Little more than a year later, in January 1998, the
separately trading AT&T, Lucent, and NCR had a combined market
capitalization of $159 billion.
We wanted to see whether this level of value creation is the
exception or the rule. To that end, we studied the performance of
the large ownership restructurings — those in which the parent
company had revenues upward of $200 million at the time of
disaggregation — that have taken place in the United States
during the past decade. We found that such restructurings can
indeed increase shareholder value if properly carried out.
Our research looked at three ways of restructuring:
• Tracking stocks, also known as letter or targeted
stocks, are a class of parent company stock that tracks the
earnings of a division or subsidiary. Typically distributed as a
dividend to shareholders in the parent company, these shares can
also take the form of an initial public offering (IPO).
• Equity carve-outs are an IPO of a stake in a
subsidiary. The parent usually keeps majority ownership.
• Spin-offs occur when the entire ownership of a
subsidiary is divested as a dividend to shareholders.
In the case of tracking stocks, control remains in the hands of
the parent company’s board; in carve-outs and spin-offs, by
contrast, management reports to new and separate boards.
Similarly, the assets of companies with tracking stocks are not
physically separated from those of their corporate parents, though
they do have to report earnings separately. In carve-outs and
spin-offs, conversely, the subsidiary’s assets are transferred
to the new company’s balance sheet.
Carve-outs have assumed a prominent place in US
equity activity. In the past ten years, the US stock market has
seen an average of almost 50 carve-outs a year, or about 10
percent of all IPOs.
One recent example of a substantial carve-out is DuPont’s IPO of
Conoco, in October 1998. DuPont raised $4.2 billion for a 30
percent stake in its subsidiary.
The level of spin-off activity has also been high recently: more
than 300 spin-offs took place in the United States between January
1988 and September 1998. A notable example of a spin-off was the
1995 breakup of ITT into three businesses — diversified
industrial, insurance, and hotels and gaming.
By contrast, tracking stocks are few and far between. Since
General Motors issued the first of them with its acquisition of
EDS in 1984, a total of 23 have been listed in the United States.
Several more have been announced and subsequently canceled, and a
few others are pending.
CREATING
VALUE FOR SHAREHOLDERS
Companies that elect to restructure usually have one goal in mind:
creating value for shareholders. Empirical evidence in the form
both of price-to-earnings (P/E) multiples and total return to
shareholders (TRS) — the combined capital appreciation and
dividend yield of an equity — demonstrates that, on average,
each form of restructuring creates value.
Gains in stock prices flow from four changes. First, there is an
increase in coverage by analysts. This seems to support investment
bankers’ claims that floating equity in business units not
previously exposed to the market makes their operating performance
more transparent and raises shareholder returns by revealing
hidden value. This transparency, however, comes not from a greater
quantity of information provided by the company — it can freely
provide more information about business units without
restructuring ownership — but from an improvement in the quality
of analysts’ coverage.
Second, the restructured subsidiaries attract new investors.
Indeed, there is little overlap between people who invested in a
parent company and those who invest in its subsidiaries after a
restructuring. Third, the restructuring of ownership usually
improves a subsidiary’s operating performance through such means
as new incentives to management. Finally, restructuring can
improve corporate governance and increase strategic flexibility.
Our research on large restructurings of ownership
shows that the announcement of tracking-stock deals or spin-offs
tends to raise the price of the parent company’s stock by 2 to 3
percent. When we analyzed recent announcements of majority-owned
equity carve-outs, however, we found that they had no positive
effect on the parent company’s stock.
Issuing any of these new equities makes it
possible for a company to offer managers incentives tied to the
market performance of the divisions they run. John England, of the
compensation firm Towers Perrin, says, “With carve-outs,
companies have a once-in-a-lifetime opportunity to develop a new
executive and board compensation program. They can clearly
indicate to investors, executives, and other employees that
performance, ownership, risk, and reward are bound together.”
Increasing
strategic flexibility
The restructuring of ownership permits a company to push
management accountability deeper into the organization. For a
subsidiary that is newly exposed to the market, greater scrutiny
by investors and analysts creates a “second board” to which
management must respond. Operating performance generally improves
as a result. For management in poorly performing businesses, the
new accountability becomes tangible through lower compensation
when the stock falters.
Both tracking stocks and equity carve-outs increase strategic
flexibility by facilitating mergers and acquisitions. In our
sample, 22 percent of the tracking stocks were issued for use as
acquisition currency. Four carve-outs between 1988 and 1998 were
undertaken primarily to raise capital for future acquisitions.
Four spin-offs were motivated chiefly by this aim, and an
additional five were carried out to eliminate strategic conflicts
that prevented the parent or its subsidiary from completing a
merger or an acquisition.
Spin-offs can increase the strategic flexibility of businesses by
allowing a subsidiary to form relationships with companies that do
not want competitive information to flow to its parent. After
being spun off from AT&T, Lucent was better able to do
business with international telecommunications companies that
perceived its parent as a rival.
COMMON
CONCERNS
Sometimes a company hesitates to use these restructuring tools,
despite their evident advantages, because it is worried about the
new entity’s stability or fears that costs and complexity will
rise.
Stability
In the case of tracking stocks and carve-outs, some companies have
expressed fears that a subsidiary might be taken over by their
rivals or that analysts could exert pressure to spin it off
completely. In the case of spin-offs, the corporate parent may
doubt the ability of an enterprise to survive independently.
A look at the survival rate of new equities over the past decade
should allay such concerns. Of the 23 US-listed tracking stocks
issued since 1984, 19 are still trading as tracking stocks. Just
two have been sold (Ralston Purina’s Continental Baking Group
and USX’s Delhi Group) and two spun off (the Media Group from U
S West and EDS from GM).
The story is much the same for carve-outs and spin-offs. Fully 77
percent of the majority-owned equity carve-outs created between
1988 and 1993 were still trading as independent companies five
years after issue. Similarly, 76 percent of the 129 spin-offs
survived at least five years. Of those that are no longer trading,
25 were taken over and 6 delisted after filing for bankruptcy.
Although the business press sometimes views tracking stocks as a
poor alternative to complete spin-offs, we found that analysts
seldom exert any pressure to spin off these divisions. On the
whole, analysts’ reports mention a company’s tracking-stock
status only in passing, if at all. Those who discuss it tend to
regard it favorably; they do not treat it as the prelude to an
inevitable spin-off. Our research suggests that companies
considering any of the three forms of ownership restructuring
should regard them as stable tools for creating shareholder value.
Rising
costs and complexity
Senior managers at companies contemplating a tracking-stock or
carve-out structure must consider the greater complexity brought
by new equities. For one thing, the board of directors will have
to be responsive to more than one set of shareholders. Moreover,
the creation of equities to attract different types of investors
places a burden on senior management to communicate effectively
and consistently with each group.
The need to share resources within a tracking-stock or carve-out
structure adds another layer of complexity: R&D costs, for
example, may need to be divided between the income statements of
the parent and the subsidiary. Ownership restructuring also
creates the potential for conflicts of interest between the two
entities. A parent and a subsidiary may, for example, find
themselves on opposite sides of a regulatory issue, such as those
that bedevil the telecommunications industry. Or a subsidiary that
is vertically integrated with its parent might want to pursue
business with its parent’s competitors. The SABRE Group, for
instance, provides reservation systems not only for American
Airlines, its parent, but also for some of American’s rivals.
Companies incur transaction and overhead costs, too. The direct
transaction costs associated with raising new capital in the
market through an equity carve-out can represent 2-5 percent of
the transaction’s total value; for a spin-off or tracking stock,
the figure is around 2 percent. The higher percentage for
carve-outs may reflect the fact that their offerings often come in
the form of an IPO and not a stock distribution. On top of these
transaction costs, companies giving thought to restructuring must
take into account the costs of dual governance structures and
additional reporting requirements.
These expenses, both direct and reckoned in management time and
attention, must be weighed against the substantial benefits that
ownership restructuring brings to many companies and their
shareholders.
WHEN
TO RESTRUCTURE...
By posing a series of simple questions, senior executives can
determine when it might be appropriate to disaggregate by means of
a new equity issue, and which option to choose. Those who answer
“yes” to most of the following questions should seriously
consider an ownership restructuring:
• Do parent and subsidiary operate in different
industries?
• Is the subsidiary growing much faster or slower
than its parent?
• Do analysts seldom mention the subsidiary’s
future growth and earnings prospects?
• Are high-performing managers or key technical
staffers being lost to smaller competitors, or is there a risk
that this might happen?
...AND
HOW
Once a company has determined that restructuring may be advisable,
it must select one of the three options below.
A spin-off may make the most sense if the following
conditions prevail:
• The parent company is no longer in the best
position to create the greatest value from its business through
skills, systems, or synergies; in other words, it has ceased to be
the natural owner of the business. One reason for the 1996
spin-off of EDS from GM was the desire to free EDS from
constraints that prevented it from pursuing certain deals.
• The strategic interests of parent and subsidiary
conflict. When U S West issued tracking stock for its Media Group
in 1995, it expected the telecom services and cable businesses to
converge. But when the expected synergy did not materialize,
parent and subsidiary found themselves in opposite camps over
regulatory issues. The Media Group was spun off as MediaOne in
June 1998.
A majority-owned carve-out is the most appropriate choice
in three circumstances:
• When the parent or the subsidiary needs better
access to capital. In general, companies that take the carve-out
approach are more highly leveraged than their peers and perform
less well, so they are more likely to suffer capital constraints.
Carve-outs allow companies to raise capital at a fair price and to
fund projects that might otherwise depress earnings.
• When decision-making power in
an organization must be devolved to the people who know it best.
In companies with centralized capital budgeting, for instance,
division managers have an incentive to overstate their investment
needs and to waste time lobbying for bigger budgets. Carved-out
businesses, by contrast, can gain direct access to capital markets
— a key advantage for fast-growing enterprises that might
otherwise struggle to win funds. At Thermo Electron, for instance,
managers of carve-outs assume primary responsibility for financing
and investment decisions.
• When subsidiaries can readily be separated without
problems over the price of the transfer. Both boards will have to
review contractual agreements, including those establishing
transfer prices. Other issues include the sharing of R&D,
sales and marketing, and manufacturing resources. If the split can
be made without extreme complexity, equity carve-outs are an
attractive option.
Equity carve-outs may also be preferable to tracking stocks when
shareholders are expected to react adversely to a tracking-stock
deal. Carve-outs on average have the strongest TRS performance of
any restructuring option, while their effect on P/E multiples is
roughly comparable to the effect of the other possibilities. In
addition, carve-outs are much more common than tracking stocks, so
the market understands carve-outs better.
Either an equity carve-out or a tracking stock can create
value in the following circumstances:
• When equity is needed for use as an acquisition
currency, especially if the acquisition target is not interested
in the parent company’s shares. GM issued tracking stock when it
acquired EDS in 1984. As EDS began trading, its forward-looking
P/E was 38, as compared with 5 for GM. When U S West issued Media
Group tracking-stock shares in 1995, they traded at P/E multiples
of 76, as compared with 17 for the parent company, and were used
in the following year to acquire Continental Cablevision.
• When a subsidiary could take advantage of its
parent company’s capital structure to borrow at lower cost. USX
and Circuit City both chose tracking stock in part to maintain the
ability of the disaggregated entities to borrow at the debt rating
of the consolidated company.
• When the margins and growth of a subsidiary are on
a par with or better than those of its pure-play peers. If its
operating performance lags the industry average, a carve-out or
tracking stock probably will not create value and may even destroy
it. (By contrast, companies may choose to spin off their poorly
performing subsidiaries to improve their performance, even if the
subsidiary falters.) Ralston Purina’s Continental Baking Group
was issued as a tracking stock in 1993 to provide an incentive for
management to turn the unit around. By the time the group was sold
in 1995, the stock had sunk to one-third of its original value.
Tracking stocks, in two situations, are likely to be better
than either carve-outs or spin-offs, since both require at least
some separation of assets:
• If the parent or the subsidiary
of a US company has net operating losses that can be used to
offset taxable profits. More than 50 percent of the companies that
have issued tracking stocks take advantage of the parent’s or
the subsidiary’s net operating losses in this way.
Genzyme has used the losses flowing from the high R&D expenses
of its Tissue Repair tracking stock to reduce taxes at the
corporate level.
• If restructuring seems to be attractive, but the
parent and the subsidiary share synergies or use similar business
systems. The Delhi Group of USX operated gas-processing plants
jointly with Marathon Oil. A spin-off would have required what at
that time was an unnatural division of these assets, but the Delhi
tracking stock, which began trading in 1992, eliminated the need
for a separation.
~ ~ ~
Companies that restructure their ownership can often improve the
performance of business units by exposing them to the market and
thus attracting a more focused analyst community and new
investors. More important, such companies can improve their
operating performance by providing incentives for managers and
increasing their strategic flexibility. Used judiciously,
spin-offs, equity carve-outs, and tracking stocks are important
tools that help corporate management increase value.
|
