Alternative Restructuring Strategies

Alternative Restructuring Strategies

Experience is the name everyone gives to their mistakes.

—

Oscar Wilde

Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities

Part IV: Deal Structuring and

Financing

Part II: M&A ProcessPart I: M&A Environment

Ch. 11: Payment and Legal Considerations

Ch. 7: Discounted Cash Flow Valuation

Ch. 9: Financial Modeling Techniques

Ch. 6: M&A Postclosing Integration

Ch. 4: Business and Acquisition Plans

Ch. 5: Search through Closing Activities

Part V: Alternative Business and Restructuring

Strategies

Ch. 12: Accounting & Tax Considerations

Ch. 15: Business Alliances

Ch. 16: Divestitures, Spin-Offs, Split-Offs,

and Equity Carve-Outs

Ch. 17: Bankruptcy and Liquidation

Ch. 2: Regulatory Considerations

Ch. 1: Motivations for M&A

Part III: M&A Valuation and

Modeling

Ch. 3: Takeover Tactics, Defenses, and Corporate Governance

Ch. 13: Financing the Deal

Ch. 8: Relative Valuation

Methodologies

Ch. 18: Cross-Border Transactions

Ch. 14: Valuing Highly Leveraged

Transactions

Ch. 10: Private Company Valuation

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 long-tem liabilities

5. Decide to sell or retain the division by comparing the market value of the division (step 3) minus its long-term liabilities (step 4) with the after-tax proceeds from the sale of the division

Give examples of interdependencies that might exist among the operations

of a parent firm?

What is the appropriate discount rate for valuing a specific business unit within a

parent firm? (i.e., the parent’s cost of capital or the cost of capital of the

industry in which the business unit competes)

Potential Seller

Reactive Sale

Proceed to Negotiated Settlement

Pursue Alternative

Bidders

Public Sale or Auction

Private “One on One” or Controlled

Auction

Proactive Sale

Public Sale or Auction

Private “One on One” or Controlled

Auction

Divestiture Selling Process

Public or Controlled Auctions

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

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 1: Parent board declares stock dividend of subsidiary shares

Stage 2: Parent has no remaining interest in subsidiary

Parent Firm

Parent Firm Shareholders

Subsidiary

Parent Firm

Parent FirmShareholders

SubsidiaryIndependent

of FormerParent

Subsidiary StockPaid to ShareholdersAs Dividend

Parent Shareholders Own Both Parent & Subsidiary Stock

How might a spin-off create value for parent company shareholders?

How might a spin-off create value for spin-off shareholders?

Kraft Foods Breaks Up In 2010, Kraft acquired British confectionery company Cadbury for $19 billion. While the firm became the world’s largest snack company with the takeover, it was still entrenched in its traditional business, groceries, on the book’s at a low historical cost. The company now owned two very different product portfolios. Between January 2010 and mid-2011, Kraft’s share price grew faster than the S&P 500; however, it continued to trade at a lower price-to-earnings multiple than such competitors as Nestle and Groupe Danone. Expressing concern that Kraft was not realizing the promised synergies from the Cadbury deal, activist investors, Nelson Peltz’s and Bill Ackman, had discussions with Kraft’s management about splitting the firm.

To avert a proxy fight, Kraft’s board announced on August 4, 2011, its intention to divide the firm into two distinct businesses. The proposal entailed separating its faster-growing global snack food business from its slower growing U.S. centered grocery business. The separation was completed through a spin-off to Kraft Food shareholders of the grocery business on October 1, 2012. The split up was justified as a means on increasing focus, providing greater opportunities, and of giving investors a choice between the faster growing snack business and the slower growing but more predictable grocery operation.

Discussion Questions:

1. Speculate as to why Kraft chose not divest its grocery business and use the proceeds to either reinvest in its faster growing snack business, to buy back its stock, or a combination of the two?

2. How might a spin-off create shareholder value for Kraft Foods’ shareholders?

3. There is often a natural tension between so-called activist investors interested in short-term profits and a firm’s management interested in pursuing a longer-term vision. When is this tension helpful to shareholders and when does it destroy shareholder value?

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,

used to pay off parent or subsidiary debt, 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

In addition to generating cash, what other motivations may a parent firm have in undertaking an equity carve-out?

Equity Carve-Outs

Private Firm Sells A Portion of Its Equity

to the Public

Public/Private Equity Markets

Parent Firm SellsA Portion of Its

Subsidiary Stockto the Public

Public/PrivateEquity Markets

Subsidiary of Parent Firm

Initial Public Offering Subsidiary Equity Carve-Out

CashStock

Subsidiary Stock

Cash

How does an equity carve-out differ from a spin-Off?

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 FirmParent Common

Sub 1 Tracking StockSub 2 Tracking StockSub 3 Tracking Stock

Subsidiary 1 Subsidiary 2 Subsidiary 3

Tracking StocksIssued by the Parent Firm

Value of the Tracking StockDepends on thePerformance of Subsidiary

Split-Offs

• A variation of a spin-off in which parent company shareholders are given the option to exchange their shares in the parent tax free for shares in a subsidiary of the parent firm. (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 stake1 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;

– Increase the parent’s EPS by reducing the number of its shares outstanding; and

– Eliminate minority shareholders in a subsidiary1Minority 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-Offs

Stage 1: Exchange Offer Stage 2: Pro rata spin off of remaining subsidiary shares

Parent Firm

Parent FirmShareholders

Subsidiary

Parent Firm

FormerParent Firm

Shareholders

Subsidiary Independentof Former

Parent

Subsidiary Stock

• Subsidiary stocknow held by formerparent shareholders.• Parent has no relationship with former subsidiary

ParentStock

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.

How is value created for shareholders of the split-off business? How is value created for parent firm shareholders?

Kraft Foods Splits-Off Post Cereals in Merger-Related (Morris Trust)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 FoodsKraft

Shareholders

Kraft Sub (Post)

Post Assets& Liabilities Incl. $300 in Kraft Debt1

Kraft Sub Shares + $660 Million Note Payable to Kraft over 10 Years2

Kraft Shares

Kraft Sub (Post) Shares

RalcorpKraft Sub (Post) Owned by KraftShareholders

Ralcorp SubKraft Sub

Shareholders

Ralcorp Stock

RalcorpSub Stock

Ralcorp Stock3,4

Kraft Sub Assets & Liabilities

Kraft Sub (Post) Shares

1Kraft Foods retained the cash and Kraft Sub paid off the liability.2Kraft 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.3Ralcorp 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.4Cash received by Kraft was tax free (since it is viewed as an internal reorganization) as were the share exchange of Kraft Sub (Post) shares with Kraft shareholders and the subsequent exchange for Ralcorp stock.

Kraft Objective: Raise cash by selling Post Cereals in a tax free deal for Kraft and Kraft shareholders .

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