FW moderates a discussion focusing on spin offs and carves outs between Thomas D. Williamson, a principal at Deloitte Consulting LLP, Peter E. Izanec, a partner at Jones Day, and Jane D. Goldstein, a partner at Ropes & Gray.
FW: How would you describe the current environment for spin off and carve out transactions? What activity trends have you seen in the last 12-18 months?
Williamson: Overall we see a healthy market that will likely continue. This past year was certainly a banner year, and especially so for the US. US M&A topped $1 trillion, returning to pre-crisis levels for the first time while divestiture activity represented a larger share than pre-crisis, driven by very favourable trends in both supply and demand of deal flow. Strong institutional demand for public equities and pre-crisis levels of cash and financing in the hands of sponsors contributed to strong valuations and ample supply of motivated buyers and sellers. Financial companies continue to drive the largest slice of the spin off market. The post-crisis reform process continues to play out as regulators and investors – sometimes one-and-the-same – seek to further mitigate financial and operational risk. Banking and Insurance firms are trimming balance sheets of risky pre-crisis assets and securities and jettisoning non-core or underperforming assets. Investor activism and a corporate governance mindset more akin to portfolio management also continues to be on the rise driving companies toward greater strategic focus. Strategic buyers have remained among the most active sellers as they continue to manage their portfolios. In addition, disruptive trends are impacting many markets and driving activity, especially in media and telecom, and technology.
Izanec: In general, the environment for spin off and carve out transactions continues to be positive. What is ‘fashionable’ in corporate structuring is something that changes over time. It wasn’t really all that long ago – in the 1970s and 80s, leading all the way up into the early 90s in some industries – that there was a wave of conglomeration. There were widespread beliefs at the time that synergies could be realised not only through scale on an intra-business level, but also through the application of superior management techniques to a diverse array of businesses. Plus, so the thinking went, owning a diverse array of businesses would help the overall enterprise smooth out the highs and lows, and reduce the overall ‘beta’ of the parent corporation. Obviously, times have changed. An emphasis on ‘heightened focus’ and ‘core businesses’ has been in vogue for at least 10 years, and continues to be to this day. With that being said, though, I think that there is a certain cyclicality to trends in business thinking – just as with fashion. I would not be shocked to see a move away from the focus on spin offs and break-ups in the future – it just hasn’t happened yet.
Goldstein: We are seeing a robust environment for spin off and carve out transactions and have seen an uptick in activity. We are seeing a correlation between increased shareholder activism and the uptick in carve out and spin off transactions. For example, Darden Restaurants Inc. has been exploring the spin off of certain of its brands, including Red Lobster, in response to shareholder pressure to return additional value to investors – it should be noted that those same shareholders have criticized Darden for choosing the wrong business to spin off in Red Lobster. Additionally, according to recent reports, Carl Icahn is calling for eBay to spin off its PayPal division. As significant shareholders are more frequently demanding returns from management and the board, companies are actively seeking ways to return value to shareholders. By carving out or spinning off an underperforming or non-core business segment, a company can both return value to shareholders and focus on its core strategy.
“Notwithstanding the stock market’s rough January, on the buy side – that is, from the perspective of the acquirer of a carved-out business – the conditions for M&A continue to be excellent.”
FW: What level of appetite are financial and strategic buyers demonstrating in the current market?
Izanec: Notwithstanding the stock market’s rough January, on the buy side – that is, from the perspective of the acquirer of a carved-out business – the conditions for M&A continue to be excellent. Interest rates continue to be at historic lows, and there is no immediately obvious shift away from that. Core economic indicators are not great, but they are slowly improving. The situation with sovereign debt in Europe and related austerity measures are not great, but I don’t think that anyone believes a major country-level default is imminent. These same things could have been said, however, about 2013, and 2013 was only a mediocre year for M&A. So, it remains to be seen whether the good conditions will result in more M&A in 2014.
Goldstein: As we have seen equity valuations rise over the last 18 months, potential buyers have been reluctant to pay higher prices to acquire an entire company. As a result, private equity buyers are acquiring assets in carve out transactions to use as a ‘platform’ from which to build larger companies. Further, they are focusing on creating additional value for their portfolio companies by purchasing synergistic assets in carve out transactions and unlocking hidden value from underperforming companies.
Williamson: Strategic buyers are definitely in the mix although traditional synergy-driven valuations can be weak competition against those coming out of the public and private equity markets. Looking at the deal flow coming out of the top 50 companies most active in divesting, public markets and PE buyers consume a lion’s share. Most large strategic buyers, many of whom have large cash balances accumulated outside of the US, are looking to deploy capital in emerging markets as a top priority. They are looking at acquiring or partnering to gain access or build scale, and thus are generally not key players in the market for carve out assets.
FW: Could you explain some of the main reasons why companies might consider carving out and spinning off parts of their business? Can you highlight any notably successful transactions in recent months?
Goldstein: As mentioned above, a recent increase in shareholder activism is leading to an increase in sales of non-core assets as an alternative means to return value to shareholders. Time Warner Inc. is in the process of its third spin off transaction since 2009 all in an effort to unload underperforming business units and focus on the company’s more lucrative businesses. Liz Claiborne, as one example, as part of its identity as Fifth & Pacific, Inc. spun off several of its long-time, underperforming brands in order to focus its efforts on certain of its ‘trendier’ and more lucrative businesses, including Kate Spade and Jack Spade. As part of this re-focus and re-branding, the company recently announced that it will be re-named ‘Kate Spade & Co.’ in February.
Williamson: Companies are increasingly looking for opportunities to better understand which parts of their businesses are driving or destroying shareholder value and to realign their portfolio accordingly. In addition, rising shareholder activism and the perception that management is not doing enough to boost shareholder value is generating pressure at many companies to thoroughly evaluate their portfolio of businesses. From the perspective of the seller, there’s a variety of motivations to part ways with a piece of their business. The business under review is typically a misfit within the larger organisation in some way – perhaps an inconsistent earnings cycle, excessive capital requirements, or a lack of complementary commercial strategies and so on. Even companies with the best discipline in allocation of resources eventually often determine that certain businesses are more valuable to another owner. Several recent food and consumer products spin offs have been successful, as measured by stock performance. Often dissimilar growth profiles and a lack of commercial synergies among different parts of a business have driven this spin off momentum.
Izanec: The traditional reasons given for spin offs are to enable ‘Spinco’ better to focus on its core competencies and to incentivise its employees for the performance of Spinco’s business. ‘Non-core’ businesses that are not given sufficient attention within a broader corporate enterprise are generally seen as good candidates for a spin off. With that being said, particularly in the case of a spin off to public shareholders – as opposed to a sale of division to another strategic buyer – the Spinco needs to be healthy enough to be a viable company as a standalone entity. You would not want to spin off a company and then have it fail – that would result in a wide array of problems, both from the standpoint of the shareholders in Spinco, who are the same as the shareholders of parent, as well as purely from the parent’s perspective, because of claims of fraudulent conveyance and other similar items.
FW: What are some of the common challenges and deal breakers that tend to surface during carve out and spin off deals? What steps can parties take to revolve or avoid such problems?
Williamson: Two common barriers to successful carve outs and spin offs are the target’s ability to operate independently and the seller’s potential tax liabilities. Both of these factors significantly influence the variety of buyers and their degree of interest. In order to be a candidate for a successful spin off the target must be capable of operating wholly independently from the seller. An experienced seller will invest appropriately to prepare the business for sale, creating distinct financial reporting, disintegrating core operations and establishing an aggressive but practical roadmap to complete the full separation mutually agreeable with the eventual acquirer. In addition, the seller’s tax liability is often a key barrier in achieving an agreed upon valuation. Both parties should understand the range of potential liabilities sooner than later in the negotiation and use the diligence process to provide the necessary information and perspectives to inform the valuation.
Izanec: Spin off and carve out deals are somewhat different animals because of the negotiating dynamic. Carve out transactions, where a parent is selling a division to a third-party, present issues like any other negotiated transaction. The parties have to come to an agreement on price, what assets and liabilities will be included, and risk allocation – through the representations and warranties, and so on. A spin off, on the other hand, is not really ‘negotiated’ in the same way – in that case the parent has a lot more autonomy in its ability to dictate what assets and liabilities will be in-scope and out-of-scope, and what, if any post-closing indemnification or other provisions will be available. In spin offs, however, the requirements for the desired tax-free treatment of the spin off must be satisfied, which means a lot more pervasive involvement by tax lawyers. In addition, from a purely economic perspective, in general a parent company will want to spin off a healthy Spinco. Parents will usually maximise value for their shareholders if Spinco is a well-capitalised, healthy entity that can stand on its own very comfortably – and will thus be given a higher stock price.
Goldstein: Often, the assets or divisions to be carved out are integrated with the seller’s retained business. Buyers are very focused on ensuring that they acquire all of the business’s core assets and that the acquired business can be operated in a standalone function. For example, the acquired business may share in the ownership or use of material intellectual property assets. Consequently, the buyer may confront an expensive and time consuming diligence process in order to confirm that it will have everything in place to run the business. As you might expect, the buyer is focused on having everything in place to run the business on day one, and the seller is focused on avoiding ongoing and costly obligations. Therefore, from a contractual and practical perspective, the provision by the seller of transition services to the buyer is often highly negotiated. To avoid these issues, sellers can prepare for a carve out sale by isolating the assets to be sold in standalone subsidiaries and mapping out a framework for the provision of necessary transition services to cover a brief transition period for the stand-alone company to get up and running.
FW: How important is it for buyers and sellers to establish appropriate protective rights, warranties and indemnities in these transactions? Are parties generally aware of the importance of these factors, or are they frequently overlooked or underestimated?
Izanec: As noted, spin offs and carve outs are different types of transaction in this respect. Carve out transactions are like other M&A deals – a core element of the negotiation between the seller and the buyer will focus on risk allocation, including representations, warranties and indemnities. Everyone is aware of this, and it is not the sort of thing that, in my experience is overlooked or underestimated. Quite the opposite, actually – I think that the danger with risk allocation provisions is that sometimes deals that would create significant value can founder on the shoals of minor disputes over some of the nooks and crannies of risk allocation. The expanding use of mechanisms like representation and warranty insurance is helping to bridge some of these gaps, and I think also having sensible counsel and business guidance can help avoid these problems. Spin offs, on the other hand, generally do not utilise representations and warranties in the same way. For the most part, the main issue in spin offs will be determining and then describing what assets and liabilities are in-scope and out-of-scope, and shaping the structure of the deal in a way that best meets the parent’s needs while still satisfying the applicable tax requirements.
Goldstein: We generally find that sophisticated buyers and sellers treat these issues with the same importance as they would in any merger or acquisition context. In particular, for some of the reasons mentioned earlier, for example, ensuring the buyer can operate the business on day one, the buyer will likely be focused on representations and warranties related to the ownership and sufficiency of assets and the handling of any shared assets or shared services among the retained businesses and the carved out or spun off business.
Williamson: We are business advisors, not lawyers. It is certainly important for both buyers and sellers to establish and protect their legal rights. The value of warranties and indemnities obviously varies with the financial strength of the buyers and sellers.
“Tax liabilities play a critical role for both buyers and sellers. If sellers engage their tax advisors and plan for the sale in advance, they can isolate the applicable assets in stand-alone subsidiaries and structure a carve out as a stock sale.”
FW: What role can tax liabilities play in making the deal more or less attractive for the parties involved? In your experience, what can companies do to structure a spin off or carve out in a tax efficient manner?
Goldstein: Tax liabilities play a critical role for both buyers and sellers. If sellers engage their tax advisors and plan for the sale in advance, they can isolate the applicable assets in stand-alone subsidiaries and structure a carve out as a stock sale. Buyers will often be focused on achieving a step-up in the basis of the assets to be acquired. Sellers will usually want to avoid a ‘double tax’ on the transaction. A spin off may sometimes be utilised as means of a carve out. However, US tax requirements for a tax-free spin off are stringent. For example, the distributing parent corporation must have at least 80 percent control of the to be spun-off corporation, both the spun-off and the distributing corporations must have conducted an active business for at least five years prior to the distribution, and certain other statutory and non-statutory requirements must also be met. Furthermore, because Congress believed that tax-free spin offs combined with acquisitions of the spun off or distributing corporation resemble taxable asset dispositions, the tax law now treats a spin off that is part of a plan pursuant to which one or more persons acquire stock representing a 50 percent or greater interest in either such corporation as taxable at the corporate level. Acquisitions during the period beginning two years before and ending two years after the distribution are presumed to be part of such plan. In the past, the IRS was willing to issue private letters regarding tax-free treatment, however, recently the IRS has declined to issue such private letter rulings on the overall tax-free treatment of a spin off. Consequently, parties have requested legal opinions from their tax counsel regarding the tax-free nature of the transaction.
Williamson: Many companies consider a tax-free spinoff for their planned disposition. However, not every potential disposition can meet the qualification requirements of a tax-free spinoff, and the IRS has recently tightened the rules on the types of transactions for which they will issue private letter rulings. If a spinoff isn’t possible, then the tax choices are often limited to either stock or asset sales. Depending on how the business was originally acquired, there may be a higher tax basis in stock than in the assets of the divested business. If so, it will be more advantageous for the buyer to sell the stock rather than the assets of the business. However, this can be a disadvantage to the buyer, who will not receive a stepped-up tax basis in the assets acquired, including goodwill. An asset transaction may be advantageous to the buyer from a tax perspective, since it may result in a stepped-up tax basis for all of the assets, including goodwill. But even if the buyer purchases stock, it may be possible for the seller and buyer to make a joint election to treat a stock purchase as an asset purchase for income tax purposes, which could also allow the buyer the same step-up opportunity.
Izanec: The whole point of spin offs is to achieve the divestiture of a business in a tax-free manner. In general, a parent company will want to receive a tax opinion from its tax counsel before proceeding with a spin off, and tax counsel will therefore be heavily involved with the structuring of the deal. The real negotiation in spin offs can be between the parent, who may have one set of transitional commercial arrangements in mind, and parent’s tax counsel, who may be leery of these arrangements – ongoing arrangements between the parent and Spinco can, in some circumstances, endanger the application of tax-free treatment. Tax counsel is in a tough spot in these situations, as it can be difficult to judge exactly where the line is that divides what is permissible and not permissible.
FW: When structuring the deal, what change of ownership considerations need to be made? What kinds of complications can arise when licensing agreements or asset distribution contracts are involved, for example?
Williamson: From a business advisor standpoint, there are certainly a wide variety of considerations in structuring. These include the fact that all change in ownership is heavily dependent on the structure of the deal which is typically most directly influenced by the tax implications; allocation of share talent and non-competes; and market access, customer lists, and non-compete in specific product domains. Further considerations include the dissection of balance sheets – especially for the spun entity; market registrations and licenses specific to respective industries; and interim operation as separate entities, including intercompany mark-ups, arm’s length transactions while under transition services agreements, and so on.
Izanec: One of the toughest parts of carve outs and spin offs is how to handle assets that are shared between in-scope and out-of-scope businesses. In large integrated companies –and most large companies are pretty highly integrated nowadays, as technology has made it much easier for companies to share resources across business units – a surprisingly vast array of supporting functions are provided at the corporate level. These shared assets are often not easily divided, and a key problem to solve will be how to treat them – either the parent or the business being divested will ultimately need to replace the asset, and that can take time and be expensive. Transitional arrangements are often the solution to this problem, but those arrangements can present issues of economics – how much will they cost and how long will they be available, for example – and, in the case of spin offs, need to be compliant with the tax rules.
Goldstein: The change of ownership considerations are similar to those that need to be considered in any merger or acquisition. In the diligence process, the parties will want to identify any contracts containing change of control or anti-assignment provisions, which may trigger consent or notification rights of a third party. As part of the legal due diligence, it is critical to identify the contracting party on material contracts. To the extent that the entities party to those contracts are being retained by the seller, it will be necessary to assign those contracts as to the acquired entity or to the buyer at closing.
“The fundamental drivers of carve out and spin off activity are accelerating on most fronts as investor activism and evolving corporate governance further elevate how companies make decisions on how best to allocate resources across their portfolio.”
FW: What developments do you expect to see going forward? Will there be more spin offs and carve outs in the M&A market?
Izanec: ‘Increased focus’ continues to be a byword in the investment community, and that is going to continue to drive transactions of this nature.
Goldstein: In light of the trend of increasing shareholder activism – and the pressure that comes from having an activist approach a board of directors – we think we will continue to see companies considering different ways to return value to shareholders. In addition, private equity buyers will continue to focus on creating additional value for their portfolio companies by purchasing synergistic assets in carve out transactions and unlocking hidden value from underperforming companies.
Williamson: We believe the overall M&A market will continue to be strong although we recognise certain risks on the horizon mostly related to the overall health of the economy. Buoyant public equity valuations may be challenged by additional tapering by the US Federal Reserve, although the investible assets of private equity remain significant. That said, the fundamental drivers of carve out and spin off activity are accelerating on most fronts as investor activism and evolving corporate governance further elevate how companies make decisions on how best to allocate resources across their portfolio. As a result, we will likely see an increased rate of spin offs and carve outs in the international market.
Tom Williamson is a principal in Deloitte Consulting LLP with over 27 years of consulting experience. Mr Williamson works in the firm’s M&A practice, which provides a wide variety of strategic, operational and financial services to companies considering mergers, acquisitions, and divestitures. He works primarily with clients in the consumer and industrial products industries. Mr Williamson can be contacted on +1 312 486 2659 or by email: twilliamson@deloitte.com.
Peter E. Izanec is a partner at Jones Day. He represents public and private companies, private equity funds, and hedge funds in a wide variety of mergers, acquisitions, spin offs, joint ventures, financings, pension de-risking transactions, proxy contests, activist investments, and governance matters. Mr Izanec works with clients in many industries, including consumer goods, financial services, mortgage-related industries, pharmaceuticals and medical devices, food and beverage, heavy manufacturing, and restaurant chains. He has been recognised in various legal publications, including most recently The American Lawyer’s 2013 ‘Dealmaker of the Year’ issue. Mr Izanec can be contacted on +1 216 586 1042 or by email: peizanec@jonesday.com.
Jane D. Goldstein is co-head of Ropes & Gray’s mergers and acquisitions group as well as the technology, media & telecommunications group. She is also head of the firm’s retail & consumer brand practice group. She advises a wide range of public and private companies and their boards of directors with respect to corporate governance, securities regulation and general legal matters. Ms Goldstein has extensive experience counselling US companies in the retail and consumer products industry. She is also the Chair of the Firm’s Women’s Forum and a member of the Diversity Committee. Ms Goldstein can be contacted on +1 212 596 9230or by email: jane.goldstein@ropesgray.com.
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