Spin-offs have surged in popularity in recent years, with U.S. total volume increasing from $17 billion in 2010 to $123 billion in 2013. It appears that 2014 is on track for another significant year. For private equity firms, the core philosophy of the spin-off – the separation of a distinct business line of a larger corporate entity – is a logical fit with the classic PE pure-play business model. Spin-offs allow companies to focus on their unique strengths, and align the performance of a business managed by a particular management team more directly with the value of the equity owned by that team.
Spin-offs are often driven by the beguiling math of multiple expansion. When fast-growing businesses are held in the same entity as mature businesses, the market may accord the combined entity a blended multiple that is less than the sum of its parts. Separating the businesses can allow investors to own the companies that best meet their investment goals and risk tolerances, which – at least on paper – should increase the prices at which they are willing to invest.
Spin-offs can be conceptually straightforward but challenging to execute. In determining the overall desirability and structure of a particular spin-off transaction, boards, sponsors and investors must consider not just the business case, but also (1) compliance with tax law, (2) attention to dividend, fraudulent conveyance and other solvency limitations and related considerations and (3) compliance with applicable contractual requirements, particularly funded debt covenants.
Types of Spin-Offs
Spin-offs take a number of forms. In the simplest variation, the operating assets and liabilities of a business line comprising a portion of a larger corporate entity (“ParentCo”) are separated and contributed into a distinct legal subsidiary of ParentCo (“SpinCo”). The stock of SpinCo is then distributed to ParentCo’s shareholders as a dividend, pro rata, based on each shareholder’s respective ownership of ParentCo. As a result, immediately following the spin-off, ParentCo’s shareholders own identically proportionate equity interests in two separate entities. These types of spin-offs are often coupled with SpinCo consummating, sometimes concurrently with the spin-off, another transaction such as a stock offering or a borrowing by SpinCo and a cash dividend to ParentCo., in each case immediately prior to the spin.
There are several variations on this theme. For example, ParentCo may pursue a partial spin-off, in which (usually) it distributes a controlling stake (at least 80% of the voting power) of SpinCo to its existing shareholders but keeps a portion of SpinCo stock for some valid business purpose (subject to various IRS and other limitations). Spin-offs can also be combined with M&A transactions such as a “sponsored spin-off,” in which ParentCo distributes shares of SpinCo in a tax-free spin-off while an acquirer – the “sponsor” – simultaneously acquires up to 49% of either ParentCo or SpinCo, either for cash or as part of a combination transaction.
Use of Spin-Offs
While all spins, at their core, have the goal of separating businesses to increase aggregate value for ParentCo’s existing shareholders, they can serve other business purposes as well. For example:
- Control of Disaggregation. A divesture of assets and liabilities constituting a portion of a business of a larger company can raise tricky disaggregation issues, particularly when the business to be sold has historically been operated as a division – not a subsidiary – of ParentCo and shares important assets or liabilities with ParentCo. Positioning such a business for a merger, IPO or other sale through a carefully planned spin-off can obviate the need for a bilateral negotiation of the separation issues, thereby allowing ParentCo to better control the contours of the disaggregation.
- Improve ParentCo’s Position for Sale or IPO. If one business within ParentCo is a disproportionate drag on performance, removing the underachiever may allow more concentrated and effective management of ParentCo and substantially improve ParentCo’s financials, better positioning it for an IPO or sale – and may provide the underachiever with better opportunities and more focused management to improve its own business.
- Greater Operational Focus on Core Businesses. Dividing distinct businesses, particularly those in discrete industries or driven by different industrial or macroeconomic trends, may facilitate operational improvements by allowing each management team to focus on its own core business and invest capital accordingly, without diverting resources to other businesses.
- Facilitate Follow-on Exit or Bolt-on Acquisitions. Follow-on transactions may include partial exits in the form of partial sales or partial IPOs (separation increases the transparency of businesses with unique investment identities, unlocking sum-of-the-parts value), or bolt-on acquisitions (separation of the businesses creates separate acquisition currency in the form of SpinCo equity that may be more attractive to the target’s shareholders than equity of the combined group).
- Reduce Impact of Litigation Overhang. When one business in a combined group faces litigation overhang, such as potential mass-tort liability or environmental issues, separating that business may improve the remaining group’s valuation and capital markets attractiveness.
Spin-offs give U.S. corporations the unique opportunity to dispose of a business without triggering tax at the corporate level. Favorable tax treatment is available only if the transaction complies with the Internal Revenue Code requirements, including:
- If 50% (or more) of the stock of a portfolio company was purchased by a PE fund, the portfolio company generally cannot effect a tax-free spin-off for five years.
- ParentCo and SpinCo must each operate an active business that has been held by ParentCo, directly or indirectly, for at least five years.
- In general, the shareholders of ParentCo and SpinCo cannot sell their shares in a taxable transaction if the sale was contemplated at the time of the spin-off or the sale occurs relatively close in time to the spin (sales by the public are excluded). While ParentCo or SpinCo can combine with another company immediately after a spin-off in a tax-free transaction, the former shareholders of ParentCo generally must receive at least 51% of the stock of the combined company.
Countervailing Business Considerations
A spin-off is not the right solution in every situation. Boards and investors should carefully evaluate potential drawbacks as well as potential advantages. Operational and management considerations include costs and dis-synergies associated with operating separate companies going forward, as well as restructuring and administrative costs associated with the transaction itself. Dis-synergies may not be limited to additional overhead costs, but may include the loss of revenue synergies of operating the businesses together (e.g., from having a combined sales force where the product offerings are complementary). Moreover, because spin-offs produce smaller and less diversified companies than the combined entity, they may experience different business risks, including cash flow volatility, reduced capital markets access, and greater volatility in credit ratings.
Spin-offs must make sense not only strategically, but also legally. Assessing a potential spin requires close attention to (1) applicable laws concerning the declaration and payment of dividends, as well as solvency and capitalization requirements; (2) contractual obligations, particularly funded debt covenants; and (3) documenting the transaction to maximize operational efficiencies for both companies going forward.
Fiduciary Duties, Legal Dividends, Solvency, etc.
Broadly speaking, the decision to spin off an operating division is similar to other strategic business decisions and implicates similar corporate governance requirements, including adherence to the directors’ fiduciary duties (including the obligation to act on an informed basis). In the context of a spin-off, the fiduciary duties of ParentCo’s directors continue to run to the pre-spin shareholders (as long as ParentCo is solvent at the time of the transaction), and not to SpinCo.
Since a spin-off involves a dividend by ParentCo, ParentCo’s board must comply with applicable state law governing the legality of dividends or potentially risk personal liability for any noncompliant dividend. In Delaware, state law generally requires that dividend value be paid from “surplus,” meaning that, after giving effect to the dividend, the fair value of ParentCo’s assets must exceed the fair value of its liabilities, including all contingent liabilities. In addition, spin-offs are subject to unwind or claw-back risk under fraudulent conveyance and other similar theories if either ParentCo or SpinCo is later determined to have been insolvent at the time of, or rendered insolvent by, the transaction and if the transaction is held to have been an exchange of less than reasonably equivalent value (which will necessarily be true in the context of a dividend for which no value was exchanged).
For these reasons, before approving a spin-off, the ParentCo board should confirm that, at the time of the transaction, each entity will be solvent (taking into account not merely book value but the “fair value” of each company’s assets and liabilities, including contingent liabilities) and will have adequate capitalization (taking into account a stress-tested cash flow scenario) after giving effect to the transaction. In this context, the board is often well advised to obtain the advice of outside professionals regarding valuation or solvency, including a third-party solvency opinion, particularly where significant contingent claims are an issue. Failure to establish solvency and adequate capitalization may increase the risk of future claw-back or unwind litigation.
Contract Compliance Analysis
Any company considering a spin-off should make sure the transaction is consistent with its contractual obligations. It is essential to evaluate contracts such as loan agreements or indentures covering funded debt obligations early in the process to ensure that the spin-off is fully compliant, or to allow time to seek authorization or amendments where appropriate. Among other things, restricted payment covenants and asset transfer restrictions may provide guidance as to when and whether a spin-off is an available option.
On the surface, spin-offs are not complicated: operating assets are transferred from ParentCo to SpinCo, and SpinCo shares are distributed as a dividend to ParentCo’s shareholders. The devil is in the details. It is important to ensure that the documentation governing the separation of assets is clear and takes into account all business separation issues, including the allocation of assets and liabilities, personnel and systems, and any shared services or transitional services. The allocation of liabilities is customarily supported by indemnities to ensure that each business will bear the liability assigned to it. If the goal is to position one or both of the separate businesses for sale or IPO, the success of the follow-on transaction may depend on the clarity and practical effectiveness of these types of separation agreements.
Spin-offs are popular for a reason: when well executed, they unlock equity value for companies when the sum of its parts is worth more than the whole. Unlocking trapped value is also, of course, a core goal for PE sponsors. For PE sponsors, executing a spin-off or acquiring a SpinCo, or some share of it, can also provide the classic pure-play opportunity to align the interests of management and ownership.