Spin or Sell: The M&A/Spin-Off Dual-Track Process
By Stuart E. Leblang, Michael J. Kliegman and Amy S. Elliott
The following article addresses various tax aspects of spin-offs and strategies associated with spin-offs, attempting to synthesize the interplay between various building blocks. We believe the following spin versus sale analysis will be very informative for traders in special situations and will provide the kind of strategic focus needed to understand valuations and predict outcomes.
It was recently reported that Eli Lilly & Co. (NYSE: LLY) was considering a spin-off or sale of its Elanco animal health business; it is estimated that a sale could command a price of $14-$16 billion. 1 Also recently, Pfizer Inc. (NYSE: PFE) announced that it was considering the sale or spin-off of its consumer healthcare business, coincidentally estimated to be worth approximately $15 billion. In Pfizer’s case, the company is reportedly beginning an auction process, with several industry players as likely bidders.2
Our focus is not on either particular deal, but on the “spin or sell” issue and the phenomenon of companies pursuing a dual-track process that takes them down the road toward a spin-off while also pursuing a simultaneous M&A process.
In September 2011, McGraw-Hill announced that it was commencing a process to spin off its education business to shareholders. Nearly a year later, even as it continued to pursue a private letter ruling on the spin-off from the Internal Revenue Service and shared with the market its plans for allocating corporate debt and other details of the planned spin-off, 3 the company had begun a parallel M&A process, 4 which culminated in the sale of the business to Apollo Global Management for $2.5 billion.5
More recently, United Technologies Corp. (UTC) (NYSE: UTX) announced the sale of its Sikorsky Helicopter subsidiary to Lockheed Martin Corp. (NYSE: LMT) in July 2015 after having previously declared its intent to either sell or spin off the business. 6
In the public company arena, it long ago became the norm for spin-off transactions to be based on a motivation that is virtually identical to that of a sale. Call it competing strategies, sharpening management focus or enhancing shareholder value, the necessary action is a divestiture of the subsidiary or division. In tax parlance, the catchall phrase is “fit and focus,” a broad but nebulous term that essentially requires only that it be management’s supportable view that one or the other business will be enhanced as a result of separation, and that it is sufficient from a business purpose standpoint that management of one business believes it will be free to soar if it gets out from under the other. 7
What are the principal considerations for a company to decide between a sale or spin-off of an “unwanted” division? To a tax advisor, where there is significant unrealized gain, and assuming approximately the same value for the division between a sale or spin-off, it is a “no-brainer” in favor of the spin-off. Nevertheless, as the McGraw-Hill and UTC transactions illustrate, company management not only often seriously considers a sale, it often pursues it. Below is a summary of factors that may argue in favor of a sale rather than a spin-off:
Maximizing Value
In announcing the company’s decision to sell McGraw-Hill Education, CEO Harold McGraw III stated, “After carefully considering all of the options for creating shareholder value, the McGraw-Hill board of directors concluded that this agreement generates the best value and certainty for our shareholders.” 8
This statement breaks down into two points:
- Certainty—A cash purchase price is, by definition, a fixed number, whereas the value of the stock of a spun-off company (Spinco) is inherently uncertain and volatile.
- Ensuring top value—While, in theory, the public securities markets should ensure that the stock of Spinco is fully valued, it is more likely that a well-run auction process can best ensure that the business to be divested will bring in top dollar to the company, and (taxes aside) indirectly to the shareholders. An important aspect of this is the control premium that is built into the price a purchaser pays, which is not ordinarily found in the trading price of a public company. We discuss below the question of whether a company must forgo the benefit of an auction in order to enjoy the tax benefits of a spin-off and vice-versa.
Cash to the Company versus Distribution to Shareholders
Arguably, a decision to divest a division may be evaluated differently depending on whether management wishes to put the value directly into the hands of the shareholders or convert that value to cash that may be used to de-lever the parent company or fund acquisitions or other investments. We defer to others the question of which is better from a shareholder value perspective. However, we do point out that there continues to be a fair degree of flexibility under the tax laws to allocate capital and debt between the Parent and Spinco, and to provide liquidity in connection with a generally tax-free spin-off.
Challenge of Carving Out Stand-Alone Public Company
The UTC-Sikorsky transaction offers an unusual glimpse at a post-mortem on the spin versus sale issue. After announcing the sale to Lockheed, UTC CEO Gregory Hayes explained to analysts why the company made the surprising decision to bear the tax cost of a sale rather than spin the company out to shareholders. 9 One thing he pointed out was that, as a stand-alone public company, Sikorsky would have had to spend an additional $100 million per year on information technology, finance and other functions; this presumably compares to an allocation of corporate overhead incurred by the UTC parent company. This would reduce earnings on which valuation is based from $600 million to $500 million. At a multiple of 10 times earnings, this would reduce the value from $6 billion to $5 billion. Even with some market premium, he suggested, the resulting post-spin market value would be less than $6 billion.
Switch to an M&A deal, and the word for this is “synergy.”
Beyond the hard numbers, Hayes pointed out (after announcing the sale), “Sikorsky will have a tough couple of years in front of it” because of challenges in developing new projects. He noted that, looking beyond the immediate post-spin stock price, there could be bumps in the road adversely impacting the share values.
Though he did not directly address this, companies encounter varying degrees of challenge in carving out a truly free-standing company from within a larger organization. Challenges and limitations of existing management of the business to be spun may be underappreciated in the initial phases of the spin-off process, but, as time goes on, the investment bankers’ offer of an alternative to this painful birthing process through M&A may offer welcome relief.
These problems and costs can be largely avoided through a sale to an industry buyer. But, what about a private equity buyer, such as in the case of McGraw-Hill Education? Indeed, private equity deals historically do not offer synergy in the ordinary sense of eliminating duplicated costs and achieving other efficiencies from intra-industry consolidations. The various overhead costs enumerated by UTC’s CEO must be duplicated in the typical private equity deal, perhaps initially handled through a transition services arrangement with the seller. Just the same, some of those costs are lower in the private than the public context; experienced PE sponsors are adept at addressing them, and increasingly have taken steps to leverage their purchasing power across portfolio companies. Also, as private equity has matured as an industry, sponsors increasingly bring industry experience to the table. Equally important, they provide important adult supervision to management of the fledgling stand-alone business.
Combining Auction Benefits with a Tax-Free Spin-off
We noted earlier that a benefit of the M&A process is that it does a good job of ensuring that the pre-tax value realized on the disposition of the divested business represents the top-dollar valuation on that business. Unfortunately, where management engages in a fully taxable sale of the business in order to realize the benefit of an auction, it may sacrifice a very large portion of that value in taxes to the government. We suggest that the “top dollar” benefits of an auction may, alternatively, be obtained in connection with a spin-off transaction in one of several ways.
Reverse Morris Trust
Of course, the transaction that most directly combines a sale process with a tax-free spin-off is the so-called Reverse Morris Trust (RMT) transaction. An RMT involves a tax-free spin-off combined with a prearranged merger between Parent or Spinco and an unrelated merger partner. The classic Morris Trust transaction, named for an old court decision, 10 may involve a merger partner that could be considerably larger than Parent or Spinco. Section 355(e), enacted in 1997, imposes taxable gain recognition on the distributing corporation if there is a plan resulting in Parent’s shareholders owning 50 percent or less of both companies (or successors); as a result, only the “reverse” Morris Trust spin-off/merger can be done tax-free, whereby Parent’s shareholders receive a majority of the stock in the post-merger company. 11
A current example of an RMT transaction is CBS Corp.’s (CBS) (NYSE: CBS) planned distribution of CBS Radio Inc. (CBS Radio) to its shareholders, followed by a pre-arranged merger of CBS Radio with Entercom Communications Corp. (Entercom) (NYSE: ETM). The distribution will actually be a split-off to CBS Class B shareholders at a 7 percent discount to CBS trading value, with the value of the CBS Radio stock determined by reference to the value of the Entercom stock to be received in the merger.
Post-Spin (Eventual) Sale
The trading price of Spinco in the short term following a spin-off may be diminished by a transition period before there is an equilibrium in the shareholder base for the Parent and Spinco stand-alone companies. In many valid spin-off situations, following an adjustment period, the value of both companies may increase, thus realizing the promised benefits to the shareholders. Beyond this, after a reasonable period of time, once Parent and Spinco have been separated, potential buyers for one or the other may emerge, and ultimately an M&A transaction will take place with “top dollar” paid in cash or shares and no leakage from corporate taxes.
In July 2015, Baxter International Inc. (NYSE: BAX) spun off Baxalta, formerly its BioSciences division. Shire PLC (NASDAQ: SHPG) expressed interest in acquiring Baxalta very shortly after consummation of the spin, resulting in an acquisition in January 2016. 12
While no transaction has been consummated or even initiated, it has been speculated that, after Delphi Automotive PLC (NYSE: DLPH) spins off its powertrain systems division, the remaining company may be an attractive acquisition candidate. 13
Pre-Spin IPO
One reason that a Spinco’s initial stock price may disappoint is the absence of an underwriter running a process to “sell” the investment. This can be addressed by first taking Spinco public while still a subsidiary of Parent, which retains the requisite 80 percent voting power stock interest to allow for a subsequent tax-free spin-off.
After a market has been established in Spinco’s stock, it may be preferable to distribute the remaining Spinco stock through a non-pro-rata split-off, rather than a pro rata spin-off. Either through a prescribed exchange offer or a Dutch Auction approach, by “selling” Spinco stock to Parent shareholders, competitive market forces may be harnessed.
In 2014-2015, General Electric Co. (NYSE: GE) executed a two-step IPO-spin-off of its Synchrony Financial credit card business. It began with a sale to the public of 15 percent in Synchrony in July 2014. According to a company report, “This allowed GE to establish Synchrony as a separately traded stock and allowed Synchrony to raise capital to stand on its own. Following the IPO, GE and Synchrony spent more than a year building the infrastructure needed to separate.” A split-off of the remaining 85 percent was effected by way of an exchange offer. 14
The 2014 CBS Outdoor transaction was similarly executed in a two-step process. In June 2014 newly created CBS Outdoor Americas Inc. (now Outfront Media Inc., NYSE: OUT) issued 19 percent of its stock in an IPO. In June 2014, CBS distributed the remaining 81 percent interest to its shareholders via an exchange offer tax-free split-off. 15
Most recently, Ashland Global Holdings Inc. (NYSE: ASH) completed a two-step IPO-spin-off this past spring. Having taken its Valvoline Inc. (NYSE: VVV) subsidiary public in September 2016 by issuing 20 percent of the company’s stock in an IPO, Ashland distributed the remaining 80 percent to its shareholders on a pro rata basis this past May. 16
Sponsored Spin
Opportunity for the most direct marriage of an M&A auction and a tax-free spin-off arises where the group of bidders includes at least a few private equity sponsors. While there are varying approaches, the core theme is that, after selecting the PE sponsor that places the highest enterprise value on the table (the Sponsor), the company structures a spin-off of the auctioned business coupled with a cash investment by the Sponsor, providing it with an effective controlling position with Parent’s shareholders receiving a majority of the Spinco stock so as to avoid running afoul of the anti-Morris Trust rules under Section 355(e).
Sponsored spin transactions have been surprisingly infrequent. Nevertheless, there are a few examples, one of which is a 2006 transaction involving Alberto-Culver Co.’s spin-off of its Sally Beauty Supply subsidiary. In that transaction, Alberto-Culver distributed to its shareholders the shares of Sally Beauty, along with cash funded by Sally Beauty debt and an equity infusion from Clayton Dubilier & Rice in exchange for a post-spin percentage ownership of 47.5 percent. 17
A sponsored spin transaction offers several benefits. One, as we have said, is that it establishes a value for the divested business arrived at through a competitive auction process. In addition, in many cases Spinco will benefit from having an experienced private equity sponsor as an anchor investor, providing much the same kind of direction and discipline that the industry at its best has so often provided in classic private equity investments.
Tax Benefits from Taxable Sale
In many instances, selling a subsidiary instead of spinning it off can offer tax benefits to the buyer that, properly negotiated in a competitive auction, can largely come back to the seller in increased purchase price.
UTC’s CEO made one more important point making the mathematical case for the decision to sell rather than spin Sikorsky. Apparently referring to the fact that the sale qualified for a Section 338(h)(10) election, he said that the purchaser increased its purchase price because it stood to receive $1.9 billion in tax benefits.
When a U.S. company sells a primarily domestic business, it is often possible to structure the sale as an actual asset sale or as a stock sale treated as an asset sale for tax purposes by making a joint election under Section 338(h)(10). In such a case, the purchaser achieves the benefit of enhanced depreciation and amortization deductions that will reduce its tax bill during subsequent years.
Impact of Lower Corporate Tax Rate
We cannot conclude this topic without mentioning the prospect of reduced corporate tax rates as part of tax reform. Indeed, all of the above considerations otherwise weighing in favor of a sale should be strengthened with less forgone corporate tax offered by the spin-off option.
[1] Loftus, Peter and Cara Lombardo, Oct. 24, 2017, “Eli Lilly Exploring Spinoff of Elanco Animal-Health Business,” The Wall Street Journal (https://www.wsj.com/articles/eli-lilly-exploring-spinoff-of-elanco-animal-health-business-1508845968).
[2] Barbaglia, Pamela, Martinne Geller, Ben Hirschler, Oct. 25, 2017, “Exclusive: Pfizer to launch consumer health sale in November – sources,” Reuters (https://www.reuters.com/article/us-pfizer-divestiture-exclusive/exclusive-pfizer-to-launch-consumer-health-sale-in-november-sources-idUSKBN1CU2RW).
[3] Stride, Megan, July 11, 2012, “McGraw-Hill Reveals Debt Plan For Spinoff Of Education Unit,” Law360 (https://www.law360.com/articles/358994/mcgraw-hill-reveals-debt-plan-for-spinoff-of-education-unit).
[4] Kosman, Josh, Nov. 24, 2012, “Apollo to buy McGraw-Hill’s education business,” The New York Post (http://nypost.com/2012/11/24/apollo-to-buy-mcgraw-hills-education-business/).
[5] De La Merced, Michael J., Nov. 26, 2012, “McGraw-Hill to Sell Education Unit to Apollo for $2.5 Billion,” The New York Times (https://dealbook.nytimes.com/2012/11/26/mcgraw-hill-to-sell-education-unit-to-apollo-for-2-5-billion/?_r=0) .
[6] Cameron, Doug, July 20, 2015, “Lockheed Martin to Buy Sikorsky for $9 Billion,” The Wall Street Journal (https://www.wsj.com/articles/lockheed-agrees-to-buy-sikorsky-for-9-billion-1437392758) and Dana Mattioli and Dana Cimilluca, March 11, 2015, “United Technologies May Spin Off Sikorsky Helicopter Unit,” The Wall Street Journal (https://www.wsj.com/articles/united-technologies-may-spin-off-sikorsky-helicopter-unit-1426115370).
[7] See Rev. Proc. 96-30, 1996-1 CB 696, Appendix A, modified by Rev. Proc. 2013-32, 2013-28 IRB 55. While the “fit and focus” term was not codified in IRS terminology until a number of years later, we believe that the private letter ruling endorsing this business purpose for a public company spin-off was in PLR 8405017, issued October 28, 1983.
[8] De La Merced, Michael J., Nov. 26, 2012, “McGraw-Hill to Sell Education Unit to Apollo for $2.5 Billion,” The New York Times (https://dealbook.nytimes.com/2012/11/26/mcgraw-hill-to-sell-education-unit-to-apollo-for-2-5-billion/?_r=0 ).
[9] Lee, Mara, July 22, 2015, “Merger Math: Sikorsky Sale to Lockheed Beats Spinoff,” Hartford Courant (http://www.courant.com/business/hc-sikorsky-lockheed-0722-20150721-story.html) and July 21, 2015, “Sikorsky Sale vs Spinoff? Simple Math,” Rotor & Wing International (http://www.rotorandwing.com/2015/07/21/sikorsky-sale-vs-spinoff-simple-math/).
[10] Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4thCir. 1966).
[11] https://www.cbscorporation.com/2017/10/cbs-corporation-launches-exchange-offer-to-split-off-cbs-radio/
[12] Naso, Chelsea, June 7, 2016, “Anatomy Of A Merger: Grit Helps Shire Seal $32B Baxalta Buy,” Law360 (https://www.law360.com/articles/802890/anatomy-of-a-merger-grit-helps-shire-seal-32b-baxalta-buy).
[13] Abuelsamid, Sam, May 3, 2017, “With Delphi Spinning Off Powertrain To Focus On Autonomy, Is Intel Acquisition Next?” Forbes (https://www.forbes.com/forbes/welcome/?toURL=https://www.forbes.com/sites/samabuelsamid/2017/05/03/with-delphi-spinning-off-powertrain-to-focus-on-autonomy-is-intel-acquisition-next/&refURL=https://www.google.com/&referrer=https://www.google.com/).
[14] https://www.ge.com/reports/ge-completes-the-separation-of-synchrony-financial/
[15] http://investor.outfrontmedia.com/who-we-are/investor-relations/investor-news/press-release-details/2014/CBS-Outdoor-Announces-Completion-of-Separation-from-CBS-Corporation-and-REIT-Conversion/default.aspx
[16] http://investor.ashland.com/releasedetail.cfm?releaseid=1026281
[17] June 19, 2006, “Alberto-Culver to Spin Off Sally Beauty Unit,” The New York Times (https://dealbook.nytimes.com/2006/06/19/sally-beauty-sets-spinoff-with-private-equity-assist/) and https://www.sec.gov/Archives/edgar/data/3327/000119312506132721/dex99.htm.
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