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A Comparison of Spin-Outs versus Carve-Out IPOs: Part I

Spin-Out of Non-Core Assets

For many corporates, there will be talk about non-core assets and their role under the broader company umbrella.

These non-core assets may be divisions that do not fit into the business thesis that investors are looking for. As a very simple example, if a chain of coffee shops owned a skating rink, this could be seen as non-core, even if the skating rink included one of their coffee franchises inside.

Less obviously, there are non-core assets that fall in the same line of business but may be geographically disparate. For example, if an oil and gas company has all of their acreage in the Permian Basin in Texas with a robust growth capital expenditure program there and then have a random offshore project off the coast of Malaysia, this could be seen as non-core.

Senior management will often reevaluate non-core assets to see whether or not they would be worth more outside of the firm. Sometimes, it serves the firm to exit these investments at the right price. However, sometimes non-core assets can be cash cows that can fund core operations, so management is happy to sit on them until an attractive unsolicited bid appears.

When management does decide to retain the services of an investment banker to work out some corporate finance wizardry and get rid of the asset, public flotation options can include an Initial Public Offering or a Spin-Out. Of course, the other way would be to sell it to an acquirer.

Examples of Carve Outs and Spin Outs

In recent memory, many of the large Chinese internet firms (Alibaba and Tencent) have been IPOing and spinning out divisions left and right to realize cash proceeds now to redeploy to other up and coming ventures and to focus on core operations. Divisions have included Ant Financial and iQiyi. IPOs in the hopper include Tencent Music.

A few years back, the hot real estate trade was Canadian retailers spinning out their real estate assets as real estate investment trusts (REITs, that do not pay corporate tax) in massive sale-leaseback transactions. The real estate assets traded at a far higher multiple outside of the corporation due to the steady nature of cash flows. This allowed the retailers to realize large cash flows without needing to find new places to rent.

Other major examples that I can remember include EBay getting rid of Paypal and Kraft splitting into Kraft Foods and Mondelez (a terrible name). Yet another example was a major Canadian energy company, EnCana, keeping its gas producing entity and spinning off its oil sands assets into Cenovus. Ironically, EnCana is now almost entirely an oil company.

Sometimes activist shareholders will come out and demand corporate unit reshuffling in order to “crystalize” value while investment bankers who are looking for a fee event may also push corporates in a similar direction.

Why Divest of Non-Core Assets?

Streamlining Operations

Equity research analysts often speak about a “conglomerate discount”. As an example, a retail conglomerate that includes bookstores, bakeries, fashion retailers and an online sales channel, would trade at a group multiple or be analyzed through a sum-of-the-parts analysis where each business line gets a different valuation methodology. Let us say that bookstores are dead and everyone reads PDFs or uses eBooks on their Kindle (or just does not read) – 3x EBITDA multiple. The bakery is popular and expanding – 7x EBITDA multiple. The online business is growing rapidly but not cash flow positive – 2x Sales multiple.

Not everyone has time to figure this out – so they may just peg the company down closer to the weakest link – the bookstore. Maybe the company ends up trading at 4x when an appropriate blended multiple would be 5x EBITDA.

The most prominent example was General Electric before John Flannery was selected as CEO – no one knows what was going in energy, power, healthcare, aviation, industrials, finance – so you end up penalizing them as an investor because its not worth trying to decipher a tangled web. And often, these tangled webs end up looking very messy when unwoven.

Pure play businesses can take away a layer of investment complexity and you can expect companies to trade higher outside a conglomerate. An IPO can accordingly be a way to “crystalise value” while a spin-out could be beneficial to shareholders as the value of their companies split apart is greater than the single share they owned before.

Just from an operational perspective, business theory (and practice) usually implies that leaner is better. If a company has a bakery division and a bookstore division, they are going to be fighting for capital from the top or corporate treasury. They are fighting for resources from the same pool of money.

Having managers that can focus on their units can be much better for shareholders in this regard.

Of course, this is less applicable when separate divisions have great synergies and cross-sell opportunities – such as in today’s concept of the universal bank. The commercial banking clients grow into investment banking clients while multiple relationship managers service them across sales and trading and debt capital markets.

For successful conglomerates with totally unrelated businesses however, they can avoid these problems by just operating alone – with complete separation, like how Warren Buffett’s Berkshire Hathaway is set up.

Redeploying Proceeds from an IPO

Assuming that a non-core division is more mature and can generate stable cash flows, maybe the parent company perceives that division would capture sufficient market demand as a standalone company. Investment banks will confirm what this NewCo would trade at via their comparable companies analysis. If the proceeds are meaningful, the parent may want to explore an IPO further.

The larger corporate receives cash which can be redeployed into growth initiatives, debt repayment or distributions to shareholders. They can also choose to keep a portion of the SpinCo/NewCo, which may possibly pay a dividend. Alternatively, they can choose to exit entirely over time and realize all cash proceeds.

A spin-out does not give cash proceeds to the parent, but could be rewarding to shareholders as a standalone entity. A spin-out could also right size the capital structure of both companies. For example, if the company was underlevered, the spinning out of a business unit (and accordingly the cash flow associated with it) could give the OldCo an appropriate balance sheet. The NewCo could then issue debt at their level.

Equity Capital MarketsWhat is a SPAC – Special Purpose Acquisition Company or Blank Cheque Company · Preferred Shares Primer · A Comparison Of Spin-Outs Versus Carve-Out IPOs: Part II · Subscription Receipts in Acquisition Finance · Investment Bankers Love Equity · Acquisition Finance: Equity Consideration · Block Trades/Block Sales · Dividend Reinvestment Plans (DRIP) · Introduction to Convertible Securities · Investment Banking Road Shows: Marketing and Distribution · Regulatory Regimes and Execution Bankers in Investment Banking ·
Corporate FinanceLooking at Capital Expenditures for Investment Bankers · Understanding a Merger and Understanding a Merger Model · Spreading Investment Banking Comps: Net Debt · Spreading Investment Banking Comps: Calculating Fully Diluted Market Capitalization · How to Answer “What Two Companies Do You Think Should Merge?” · A Comparison of Spin-Outs versus Carve-Out IPOs: Part I · Dividend Policy and Return of Capital · Accretion/Dilution Analysis – Part IV: Synergies and Source of Funds for M&A · Accretion/Dilution Analysis – Part III: Using Debt for Acquisitions · Accretion/Dilution Analysis – Part II: Accretion/Dilution Math and Breakeven Premium · Accretion/Dilution Analysis – Part I: EPS, Earnings Yield and All-Stock Transactions · Purchasing a Company via Cash or Stock · WACC and Optimal Capital Structure Reviews · Reasons for Mergers & Acquisitions · Early Bond Redemption Analysis · Hedging Interest Rate Risk ·
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