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A Comparison Of Spin-Outs Versus Carve-Out IPOs: Part II

Comparison Between Spin-Off and IPO

There are reasons why a company may choose a spin-off versus an IPO. Depending on what shareholders prefer, this can either can be a good or bad option.

An IPO results in cash proceeds for the parent. So if Alibaba carves out and IPOs Ant Financial, the money raised from primary Ant Financial investors goes straight into the coffers of Alibaba. A spin-off does not raise any capital for Alibaba.

Fees on IPO and Spin-Off

As the IPO means that shares will have to be issued to new shareholders, it is like any other IPO where the deal must be underwritten by investment bankers (the equity capital markets team handles this) who must be paid fees commensurate with the risk of the transaction.

So as per usual, investment bankers will take their standard advisory fees for the transaction as well as an underwriting issue discount to compensate them for the risk they take when they buy all the shares off of the parent and sell it to the market. The deal must be priced below intrinsic value (underpricing – at least hypothetically), otherwise the deal may be in danger of not clearing. Underpricing is a very theoretical concept, however, and it is more like finding a price where the order book is covered sufficiently by institutional investor demand.

A spin-off does not hold the same sort of price risk for the ParentCo – the shares of SpinCo are distributed pro-rata to the existing shareholders of ParentCo. As such, the investment bankers will simply have an execution fee as a percentage basis for the size of the transaction (as well as any subsequent fees from debt issuance to recapitalize the SpinCo).

IPO and Spin-Off Size Considerations

Sizing has to be a consideration for an IPO as well – there may not be enough liquidity in the market to soak up all of the shares issued (not enough demand). If the parent forces the IPO anyway, they will have to take a gigantic haircut in the IPO price possibly below what the company is worth. Most likely, the parent will have to keep a stake while 15-25% of its ownership is sold off and then the rest of the ownership dumped via subsequent secondary market offerings.

This is not a concern with the spin-off. There is no need to sell as shareholders of the parent will immediately receive shares of the spin-off.

If the market anticipates the ParentCo will sell down the rest of their shares overtime, this will create an overhang on the stock price (also applicable if the spin-off sees some retained interest by the ParentCo – possibly to collect dividends from the SpinCo initially).

IPO and Spin-Off Process Considerations

An IPO is a large, well covered event where banks will have to arrange a large marketing campaign to sell the shares to prospective shareholders – no different from any other IPO of a company owned by insiders or a private equity firm. This takes up considerable management time as bankers shuffle them from one road show to the next to speak to prospective equity investors from coast to coast.

With a spin-off, marketing is not necessarily required to be a success per se because ParentCo is simply dumping the stock on their existing shareholders. However, a marketing campaign beyond the regulatory documents may be considered so to avoid short term share recycling because investors who have purchased ParentCo for certain characteristics may not see them in SpinCo.

Despite being a larger effort from the marketing front, IPOs are technically less complex than spin-offs as tax advisors do not have to be brought on to shuffle assets in the financial statements so that the spin-off is not a taxable event for the new shareholders.

Parent Retains Interest in SpinCo

Investors should always be cautious when the parent/RemainCo retains a significant interest in SpinCo – especially when they hold a minority share or unitholding but continue to retain control over the larger group umbrella.

And investors should be even more cautious still when ParentCo/RemainCo operates a General Partner/Limited Partner relationship with the SpinCo whereby they will get disproportionate distributions to ownership should performance at the LP exceed some thresholds outlined in a GP/LP arrangement. This happens a lot when the LP or SpinCos are structured as S-Corps (non-corporate tax paying entities, such as REITs) while the ParentCo retains a C-Corp (normal corporation) structure.

This is almost always advantageous to the ParentCo, which may intend on using the SpinCo or controlled affiliate as a financing vehicle without regard to the best interests of the shareholders or unitholders of the SpinCo – and they openly write about this in the Risk Factors sections of the SpinCo 10-Ks/Annual Reports.

Ultimately, the SpinCos become far too levered while distributing favorably back to the parent and destroy shareholder value by issuing equity to purchase assets from the parent.

As such, a clean corporate split spin-off may be far more alluring than these complex structures where new entities are still very much tied to the parent (and investment banks will cover them as part of the same relationship group).

There are legal protections in place for minority shareholders under these structures, however, so for certain actions the ParentCo cannot just force a repurchase of the SpinCo entity later after destroying value. There will be provisions such as the majority of the minority for approval and the need for fairness opinions/MI 61-101 to ensure that a third-party valuator (i.e. not the investment bank that is advising on the transaction) considers the transaction to be fair for the minority shareholders.

Major Spin-Offs in History

Altria spin-off of Philip Morris International – giant smoking firm splits in two. Both consumer staples were cash cows and major dividend paying entities but suffered from low multiples due to views that they were in a dying industry. Noise now is that they are looking into marijuana.

Kraft – Split into Kraft Foods and Mondelez – New Kraft merged with Heinz in a Warren Buffet and 3G Capital backed mega-firm

Technology – EBay – Paypal – EBay, an e-commerce site, spun off its payments platform. Paypal insiders had argued the corporate would be worth far more outside of EBay.

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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