August 2022 Issue
Spin off and carve out transaction activity was adversely impacted by the coronavirus (COVID-19) crisis and the resulting business disruption. Like many M&A transactions during the initial phase of the pandemic, divestiture processes were largely put on hold due to the uncertainty gripping the global economy.
According to Wachtell Lipton, the total global volume of completed spin offs decreased from $179bn in 2019 to $94bn in 2020 as the COVID-19 pandemic took hold. Last year, however, saw an increase in spin-off transactions. In the first 11 months of the year there were 205 spin offs, according to Bloomberg, the highest number of deals since 2011, when 227 deals were completed. Large corporates, including Vivendi SE, Dell Technologies Inc., Prudential Plc, Daimler AG, Meredith Corp., L Brands Inc., General Electric Co. and Johnson & Johnson announced spin off transactions through the year.
Carve out and spin off deals continued to accelerate as companies emerged from the worst of the pandemic and into the start of the economic recovery. Companies are looking at alternative strategies to boost their competitiveness, increase their profits and create value for shareholders, with many turning to spin offs and carve outs to achieve these aims.
But this year, a culmination of factors has quelled transaction activity to an extent. “While the market for carve out and spin off transactions was very active in 2021, it has slowed a little in 2022 as a result of the broad decline in the stock markets in 2022 and its underlying causes, including worries about inflation, continued supply chain issues, and uncertainty related to new COVID-19 variants and Russia’s invasion of Ukraine,” observes Stephen I. Glover, a partner at Gibson Dunn.
Deal drivers
A number of factors are driving the rise in spin-off activity. Perhaps the most telling has been pressure from shareholder activists, many of whom are keen to break-up large conglomerates so the company can focus on operational improvements rather than maintaining control over a sprawling, diverse organisation.
“One of the main reasons for a carve out or spin off is when the company has concluded that the business is no longer part of its core strategic plan,” notes Mr Glover. “Perhaps the business has different growth potential, capital needs, customers or workforce requirements than the rest of its businesses. Companies often decide to divest businesses non-core to their strategic plan, to focus resources, including management attention, on the businesses that are key to the strategic plan.
“Selling the non-core businesses to a third party in a carve out transaction could also generate cash that the company could use to invest in its strategic plan,” he continues. “In addition, activists sometimes pressure companies to divest underperforming businesses.”
For Dario de Martino, a partner at Allen & Overy LLP, typically the top three reasons driving a spin off are growth constraints, a desire to refocus on core assets, and the need to deleverage and generate cash. “In addition, there are often significant opportunities to increase the tax efficiency of the carved-out business, potentially increasing the transaction’s long-term value,” he adds. “Finally, antitrust and other regulatory concerns often create opportunities for financial buyers to uncover unique opportunities.”
“Though spin offs and carve outs have increased over the last 18 months, geopolitical and economic challenges are impacting the global economy in the post-COVID-19 landscape.”
Value creation is often at the heart of a spin off. Senior management are freed up to focus on core issues and improve the margin, growth profile and valuation multiple of remaining lines of business. Ultimately, though, these transactions usually come down to price. “The most significant potential deal breaker relates to value,” says Mr Glover. “If the company is unable to obtain an acceptable price for the business in a sale, or if it believes the market will not value the newly spun off company’s stock at an attractive level in a spin off, the transaction will not go forward.”
Typically, the percentage of carve out and spin off transactions as a proportion of total M&A tends to grow during economic downturns. In the current market, lingering uncertainty associated with the pandemic, inflationary trends, rising interest rates, commodity prices, and disruption flowing from Russia’s invasion of Ukraine, has caused many companies to consider carve outs.
“This is true specifically for some industries such as upstream oil and gas, chemicals, automotive, heavy industries and other capital-intensive industries where deleveraging is key,” suggests Mr de Martino. “On the other hand, strategic buyers, particularly tech companies, have continued to eye targets with high growth rates and focused on long-term synergies, while financial buyers have positioned themselves to take advantage of regulatory-driven divestitures.”
Despite prevailing negative factors, deals are still happening at a steady pace, according to Mr Glover. “Increasing borrowing costs have not significantly reduced interest from financial sponsors,” he says. “Strategic buyers have been a bit more hesitant, but are still likely willing to jump in if they see opportunities to buy at valuations that are now more attractive. On the sell-side, the market downturn has given activists additional power to stir the pot and encourage companies to generate value by streamlining their business portfolios.”
Devil in the detail
A number of challenges are unique to carve out and spin off transactions, particularly around the structure of arrangements between the parent company and the spun-off unit, the execution of the spin off with respect to its scope, as well as the reallocation of resources and capital. Failure to adequately address these issues, among many others, can be damaging for both entities. To that end, successfully spinning off a unit requires the parent company to clearly understand the priorities of the transaction, and a commitment across all levels of the company to focus on them. Careful and thoughtful planning is needed for the process to be successful.
According to Mr Glover, the biggest challenge in any spin off is defining the perimeter of the transaction. “After deciding which businesses will be divested, the company needs to determine which assets and liabilities relate to those business and will be included in the transaction,” he says. “However, the businesses to be divested are likely to be entangled in numerous ways with the retained businesses. As a result, various arrangements, including potential licence, supply, sublease and service agreements, will need to be entered into in order to allow both the divested businesses and retained businesses to continue to operate following the transaction.”
Once the perimeter of assets and liabilities captured by the transaction has been defined, and financial statements have been prepared for the business being divested, parties will need to agree on what to do in the event a necessary component of the business is inadvertently not transferred, explains Mr de Martino. “Often, the carved-out business has only recently, or has never, operated independently of the parent company, and so it could be analysing all of its business components for the first time in the context of the transaction. In addition, there are typically issues related to tax, antitrust and other regulatory matters, such as the Committee on Foreign Investment in the United States (CFIUS), foreign direct investment, sanctions, export control, and so on, as well as intellectual property, information technology, human resources, and transition service agreements for shared services.
“In a spin off, a company must do that same critical analysis and ensure it is not setting the spun-off business up for failure with insufficient resources or too much debt,” he continues. “A spin off is not an opportunity to simply hive off all a company’s underperforming or non-key units. Finally, these transactions tend to be cross-border, which means that careful coordination among counsel in several jurisdiction is key to a successful transaction.”
Issues around culture and talent retention can also be critical. Every company wants to retain its best performers, particularly at times of great change, so parent companies must have a good understanding of the assets, capabilities and contribution of individual employees. There may be a need to fill key vacancies, perhaps through external recruitment or retraining existing staff.
Risk management dynamics
In any transaction, risks need to be mitigated, and spin offs are no exception. Accordingly, companies must establish appropriate protective rights, particularly through warranties and indemnities, which provide a degree of security. “Buyers typically expect comprehensive representations & warranties (R&W) regarding the target company,” says Mr de Martino. “In addition, where a buyer is acquiring the assets of an ongoing business or where the target company shares services or assets with the seller’s other businesses, a buyer would demand a sufficiency of assets representation to ensure it can operate the target company as it is being conducted by the seller without the excluded assets.
“Moreover, while buyers typically request that the representations and warranties be backstopped by an indemnity, sellers, especially in this market or in competitive auctions, will push back and request that the buyer obtain R&W insurance,” he adds.
According to Mr Glover, in addition to a ‘sufficiency’ representation stating that the assets being acquired include everything they will need to operate the business, a buyer will also seek an absence of liabilities representation stating that no liabilities are being transferred except for specified liabilities. “Buyers will request an indemnity with generous baskets and caps to backstop these representations,” he notes. “Sellers typically want to limit any ongoing liability related to the divested business and will forcefully push back, demanding a ‘public company’ style deal where the sellers have no post-closing liability. To bridge the gap, parties often turn to R&W insurance, which buyers are agreeing to more and more frequently, but which may be unavailable if the transaction size is too small.”
Plausible strategy
Though spin offs and carve outs have increased over the last 18 months, geopolitical and economic challenges are impacting the global economy in the post-COVID-19 landscape. However, present market conditions are unlikely to completely dissuade businesses from exploring these transactions. Regardless of potential speedbumps, spin offs will remain a plausible strategy.
As such, Mr de Martino expects spin offs to continue, despite certain countervailing trends. “Companies will continue to think critically about which aspects of their business do and do not fit their business plan, especially during a rapidly changing economic landscape in which companies feel pressure to respond to evolving conditions, and are pushed by shareholder activists to improve returns,” he suggests. “I also expect tech driven spin offs and carve outs to continue to generate growth, and strong interest from financial and strategic buyers in acquiring these businesses.”
Going forward, spin offs are likely to remain a prominent feature of the dealmaking environment. “If the lower valuations reflected by the stock market decline continue, buyers are likely to become more acquisitive to take advantage of multiples that are lower than they have been in recent years,” believes Mr Glover. “For sellers, turbulent capital markets will encourage companies to continue to re-evaluate their strategic plans and consider whether to sell or spin off non-core or underperforming assets. Stock price declines also may empower activist investors to demand companies spin off businesses to unlock value and improve shareholder returns.”
© Financier Worldwide
BY
Richard Summerfield