Merger and acquisition cycles are fueled by many forces, not least among them being the strategies promoted by activist investors and investment banking advisors. Once in favor, conglomerates dotted the industrial landscape. However, within the past several years, the scale, adjacent market synergies and potential integration benefits of an aggregation strategy have been counter-balanced by arguments for better management focus and clearer market / equity analyst communications.
Today, a disaggregation strategy promises rewards. High-growth divisions should command higher valuation multiples once separated from their stable earnings low-growth spouses. The market cap of A+B will exceed the market cap of AB, the consolidated entity (e.g., Altria’s spin-off of Philip Morris International).
Spin-off candidates tend to be vertically integrated businesses that have operations all along the value chain. The energy sector, for example, has contributed a number of transactions in this regard, with 2010 and 2011 seeing the separation of exploration from production, and 2013 and 2014 seeing the separation of refining from distribution.
During 2013, at least a dozen spin-off transactions were completed. Prospects for 2014 suggest a continuation of this trend with at least another 25 transactions rumored or on track for completion.
A Common Approach
A common approach is a tax free spin-off in which the company to be spun-off (“spinco”) is isolated (as a stand-alone legal entity), optimally capitalized, and then distributed to the pre-spin company’s (“remainco”) shareholders. The distribution can be accomplished either through a pro rata distribution of spinco shares to remainco shareholders or by issuing an exchange offer to current shareholders. Such transactions can be viewed as a proactive market strategy (as in the case of an integrated energy company that recently sought to disconnect its refining operations, a segment arguably valued at 3.5 – 5.0 times EBITDA, from its retail / petroleum marketing assets, a segment arguably valued at 7.0 – 8.0 times EBITDA). Increasingly common is a spin-off transaction where shareholder activists are the catalyst (e.g., Hess’ announced spin-off of its retail / petroleum marketing assets and potentially other segments). While the strategy is, by now, fairly well tested, execution risk certainly remains and, as with interpersonal relationships, separation is often easier said than done.
While the expected market capitalization benefits of such transactions generate most of the commentary about these deals, relatively little press is devoted to the potential pitfalls. Extracting a business from a consolidated group, even one that has been functioning as separate reporting unit, can be a challenging exercise.
Operationally, many businesses have adopted back-office consolidation with functions such as treasury, purchasing, finance, IT, research and development and human resources (HR) provided by cost centers to all operating units. Boyd Mulkey, a managing director with Alvarez & Marsal’s (A&M) Performance Improvement practice, who has advised companies on operational issues as they have spun-off divisions, observes that:
“Many businesses have very limited experience with the process of unraveling the extensive bonds that exist between its operations and its various support functions. Transition services arrangements can help relieve some, but not all, of the tension placed on an organization by disaggregation. Ideally, a specific blueprint and work plan is created for disconnecting a division to be spun-off with specific management roles, action steps and key milestone dates identified. Outside advisors are typically engaged to assist with any gaps in leadership created by the separation and to bring to bear appropriate expertise in handling any unusual or specific concerns associated with a given spin-off transaction. Major support functions such as finance and accounting, IT, procurement and HR typically all have a lot of heavy lifting to do as part of the spin-off process. All of this separation planning activity is generally underway at the same time financing, tax, regulatory and leadership discussions are in process.”
The Pressure is On
Further compounding the operational implications of a spin-off transaction are the resource demands placed on the company’s board, executive leadership, management teams and employees. By way of example, Ernest Brod, a managing director with A&M’s Global Forensics and Disputes practice, who advises organizations subject to intense activist shareholder pressure, explains that:
“Organizations subject to shareholder activists must progressively – and often simultaneously – shore up corporate defenses, monitor activist shareholding, develop and execute strategy, respond to provocations and conduct extensive due diligence of dissident nominees. These efforts cause distraction (and, sometimes, division), consume resources and may result in overly hasty corporate actions which can expose both the company and the personnel (board members) to reputational, financial and legal risk.”
Indeed, the risks faced by the board are notable. The spin-off transaction will, presumably, forever separate remainco from spinco. Potential synergies remaining from the association of the two companies will now be foregone, and possible dis-synergies may result from the separation (e.g., a separation agreement with limitations on future M&A activity).
Typically, concurrent with the spin-off transaction, each of remainco and spinco will adjust their respective capital structures which may include, 1) paying off existing debt, 2) incurring new debt, and /or 3) declaring some type of special distributions. Each of the foregoing capital structure actions may require board consideration and approval, but, taken together, will present some additional challenges for the board. In situations in which the board is authorizing new debt, as well as a special distribution (cash or shares), boards can be exposed to claims that they either impaired the capital of the enterprise or authorized a distribution which constituted a fraudulent conveyance. While an officer’s certificate regarding the solvency of the business, pro forma for the transaction, is a helpful management tool, it falls well short of a contemporaneous, third-party assessment of various dimensions or commonly accepted determinations of solvency. Many boards obtain just such advice.
Faye Wattleton, who leads A&M’s Corporate Governance advisory practice and has served on the boards of such companies as Estee Lauder, Empire Blue Cross and Blue Shield, and Columbia University, observes that:
“Fiduciaries are obligated to discharge their duty of loyalty and care with reasonable diligence. Business judgment protection is not impenetrable. Boards are increasingly expected to demonstrate diligence in basing strategic decisions on quality information. This often requires independent, expert advisors, which may be especially desirable for an unproven spinco board to assure sustained shareholder value. Boards are entitled to rely on such advice as part of their deliberations on material corporate events. The spin-off of a major operating unit certainly qualifies as a major corporate event.”
Avoiding the "Cookie-Cutter" Approach
The utility of independent advice is correlated with the experience of the provider. All too often, purely financial advisors apply the same set of "one size fits all" tools to vastly different circumstances. Take, for example, the spin-off by a major coal company of its eastern U.S. coal business. The spin-off and related recapitalization was approved by the board which, presumably, had the benefit of both an officer’s certificate of solvency and the solvency opinion of an independent advisor. The independent advisor’s opinion regarding solvency would typically include an assessment of the borrower’s ability to address debts (including contingent liabilities) as they become due. In this case, however, the failure of the board (and theoretically its independent advisor) to consider known or knowable costs related to healthcare and environmental liabilities called into question the board’s duty of care, as well as the value of the independent opinion provided to the board.
The case highlights the importance of engaging an independent advisor that has the requisite operational industry experience to understand the macro-economic and regulatory factors that would impact coal demand and pricing, required emissions control / reduction equipment investments, and an appropriate adjustment for post-retirement remediation costs. (Particularly given the fact that spinco subsequently declared bankruptcy, and claims of a fraudulent transfer were alleged.)
Clearly, the subtleties of remainco’s and spinco’s business model should be completely understood by the financial advisor preparing a solvency opinion. Possessing operational talent (e.g., team members that have actually run businesses in the relevant sector) would be a clear enhancement to the overall project. Using the utility sector as an example, one could leverage the operational experience of such team members to evaluate the management plan for modeling revenues as (or when) formal power purchasing agreements roll off. If the term structure of debt includes maturities beyond the period covered by contracted revenues, such forecast assumptions would be critical to understand. Failure to appreciate the relationship between debt maturity and the term of contracted revenue streams was certainly criticized in the bankruptcy of EBG Holdings (the parent of Boston Generating) after its recapitalization and the declaration of a substantial distribution to its equity investors.
While there seems to be no indication that spin-off transactions will be out of favor anytime soon, and candidates for such transactions are plentiful, the axiom “if you are going to do it, do it well” should apply. No doubt, executive leadership and the investment banking advisor will convey a sense of urgency, or window of opportunity, to complete the spin-off transaction. With an experienced set of advisors and a great deal of focus, there is no reason the organization cannot be both nimble and rigorous. Markets have demonstrated a willingness to reward those who execute well and punish those who do not.
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