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This article has been written by Esha Barua Chowdhury, pursuing the Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho. This article has been edited by Tanmaya Sharma (Associate, Lawsikho) and Smriti Katiyar (Associate, Lawsikho).

Introduction

Corporate entities go through various phases of restructuring which requires separating the additional business units. It is essential that such restructuring happens for a definitive goal and is for the benefit of the entity. Corporate actions also tend to affect the operations of the market therefore, market participants and investors need to make sure of the effects of such corporate restructuring and divestitures. As a matter of fact, both equities carve out and the spin-off is divestitures, meaning, by such action, the parent company tends to dispose of the subsidiary business unit through sale, exchange, or closure. A company restructures, either to strategically gain more than what it was already making or, to hive off a subsidiary that might have become a liability, more than an asset. 

Reasons for divestitures

Divestitures happen by way of partial or full disposal of a subsidiary, the reasons being the need to focus on the main business or to strategically earn profits by way of separating two competent businesses. Attachment with the subsidiary might at times undermine the value of the parent company and therefore separation becomes imperative. Divestiture might be essential to achieve the full potential of each business as opposed to a consolidated entity. The reasons for divestiture can be as under:

  1. To address financial or liquidity issues,
  2. To separate operations for better management,
  3. To scale up profits,
  4. To focus on core operations,
  5. To gain tax advantages,
  6. To emerge out of a faulty acquisition.

Removal of subsidiary or disinvestment is required when it is: 

a) Not contributing, 

b) Destroying value, 

c) Loss-making, 

d) Expensive, or 

e) is more profitable individually. 

At times, the reasons can be any number of combinations of the mentioned points. Divestitures can take the form of a spin-off, split-off, or equity carve-out. This article is concerned with analysing and discussing the difference between a spin-off and an equity carve-out to find out which is the better.

What is a spin-off?

A spin-off refers to the process in which a parent company sells/ distributes all of its existing shares within a subsidiary company to its existing shareholders as a result of which a completely new and independent company is formed out of it. This distribution of shares is done on a pro-rata basis, i.e., the shareholders would get an equivalent ratio of shares that they already own within the parent company. The spun-off company will have a new management structure with a new name and would be an entirely new entity altogether. It would, however, have the same or similar assets, same human resources, and intellectual property that it used to have earlier, before the spinoff. In most cases, the parent company still continues to provide financial and advisory support to the spun-off entity.

Besides the distribution of shares,  the parent company can also offer the shareholders the shares of the subsidiary company at a discount price. This is done through the process of exchange where the shareholders purchase a higher amount of stock in the subsidiary company while exchanging it with a lower value of stock in the parent company.  

Example: – An investor can exchange Rs 100 of stock in the parent company for Rs. 110 worth of stock in the subsidiary company. When a division is converted into a separate entity, the existing shareholders of the parent company get all the benefits of owning the shares of the subsidiary company. The parent company, at times, does something similar to buyback of its shares from the shareholders by offering them shares of the new company in exchange.

Features of spin-off

  • The parent company does not receive cash considerations for undertaking the spin-off.
  • The shareholders enjoy the dual holding.
  • The Spun-off company has a distinct and independent identity altogether.
  • A parent company can spin off 100% or less of the interest up to 80% of voting and non-voting shares.  Minority interest of the holding is kept back at times.

What is the purpose of corporate spin-off?

During the process of a spin-off, a completely new independent company is formed which retains its identity as being different from that of the parent company as a result of which, the work, management, and assets of such get differentiated from that of the parent body. The main reason for a spin-off by the parent company is because it thinks that the divestiture would be lucrative. The work of the parent company gets limited to financing and providing advice to the company. As the company becomes independent, spin-off tends to increase the returns for the shareholders as the subsidiary as well as the parent company both focus on their own products/services.

The parent company spins off due to 2 main reasons:-

a) To improve the performance of the parent company.

b) To improve the performance of the subsidiary company.

1) Improved performance of the parent company

A parent company may conduct a spin-off so that it can focus better on the complete utilization of its resources. As a result, when the subsidiary becomes a new independent entity, the resources that are present with the parent company are better utilised by it resulting in growth and improved performance of the parent company. Additionally, companies that aim at streamlining their businesses or wish to venture into new areas, often separate their existence from the less performing or low productive or subsidiaries that have reached their complete potential by the mode of spinoff where the subsidiary becomes a completely different entity from that of the parent company.

2) Improved performance of the subsidiary company

A spin-off creates a company with a new name though with the same human resources and the same intellectual properties as that of the parent company. Establishing the subsidiary as a completely new company requires the parent company to take a reduced role in providing finance and advice on how to run the subsidiary. This in turn increases the returns of the subsidiary company and provides for its growth as the subsidiary can now focus on their individual products and items independent from that of the parent company.

Types of spin-off

There are 2 types of spin-off which are as follows:-

  1. No ownership retained (pure spin-off)

A pure spin-off refers to a process of corporate restructuring in which a parent company distributes 100% of its owned shares in the subsidiary among its shareholders. The spun-off company gets more autonomy as the parent company no longer holds any form of shares in the subsidiary.

  1. Minority ownership retained

In this type of spin-off, the parent company only retains 20% of its owned shareholdings in the subsidiary company and the remaining 80% of the shares held are distributed among the parent company’s shareholders at a pro-rata basis. By using such a form of spin-off the parent company still retains some shareholdings and some form of decision making power in the subsidiary company. Sometimes the parent company can also act as an advisor to the subsidiary company.

Impact of spin-off on a company

Immediately after a spinoff, share prices of the parent company go down as it involves the transfer of assets from the parent company. It reduces the book value of the parent company, thus resulting in a fall in share price.

Pros and cons of spin-off

Pros

  1. Certain subsidiaries of the parent company might have promising business goals and strategic priorities. To understand their true potential and streamline their business, companies choose a spin-off.
  2. It helps the parent companies in cutting off/ removing underperforming, non-promising subsidiaries.
  3. A company may go for a spin-off when it fears that any of its subsidiaries are underperforming and has a chance of going into debt. In such cases, to prevent the parent company from bearing the burden of their debt, spins  off are opted.

Cons

  1. Share  prices of spin-offs  tend to be highly volatile and chances exist that  they may suddenly drop even though the company may be promising.
  2. A spin-off is usually very costly as there are many legal and institutional matters involved.
  3. The shareholders may be dissatisfied as they might not want the shares of the spun-off company as they may not match their investment standards.
  4. There are a lot of uncertainties of employment associated with employees in case there is a spin-off. 

Examples of spin-off:

A lot of well-known companies have spun off which led to the growth of the subsidiary. Some examples are:

  • Hewlett-Packard Co spun-off Agilent technologies Inc (1999)
  • Viacom created spinoff company Viacom Inc (2006)
  • Expedia created spinoff company TripAdvisor (2011)
  • Kraft Foods Inc created spinoff company Kraft Foods Group Inc (2012)
  • eBay created spinoff company PayPal (2017)
  • Alcon, an eye care business was created and spun off by Novartis 

Spinoff can be beneficial to the company if it is planned minutely. In 1991 HCL enterprise had spun off HCL Technologies and made it into an IT services firm, which has shown greater growth in later years. Aditya Birla Group spun off its financial services to Aditya Birla financial service services. There is no transfer of cash.

Another term that is similar to spin-off is split off. Shareholders in the parent company are offered the shares of the subsidiary company and can hold shares of either company. The distribution of subsidiary shares is not on a pro-rata basis. Subsidiaries should go for IPO and based on the market price the shares can be exchanged. The main difference between a spin-off and a split-off is that in a split-off, shareholders must exchange their existing shares for the new company whereas, in a spin-off, the existing shareholders are given shares in the new company. Now that we have understood spin-offs, let us know what an equity carve-out is.

What is carved out?  

A carve-out also called equity carve out refers to the divestiture of a business unit in which a parent company sells a minority interest of its share in the subsidiary company to investors outside of the company. Such sale of shares is done by way of an Initial Public Offering (IPO) where the shares of the divested unit are sold to the public. As a result, the subsidiary company becomes a standalone company with a new set of investors and a completely new financial statement. However, since only a minority share of the subsidiary is offered via IPO, the control still remains within the hand of the parent company. The parent company, subsequent to carve out, takes the stand of an advisory body and advises the standalone company upon its further dealings.

In general parlance, a Carve-Out usually precedes a complete spin-off, however, to satisfy the conditions of the 80% divestiture of shares to the shareholders no more than 20% of the shares held in the subsidiary company by the parent company can be offered through IPO.

Features of carve-out

  • The parent company does not sell all of its shares in the subsidiary company.
  • The subsidiary company so carved out becomes a public company with its own set of teams, management, human resources etc.
  • A completely new set of shareholders (public) are introduced within the company.
  • The parent company retains its controlling interest.

What is the purpose of equity carve-out?

Either purpose of the process of equity carve-out or spin-off or any other divestiture strategy is to completely divest the shares of a particular company and become independent however, it is not often possible to find a single buyer who would follow up with the entire transaction and to find and do so might often take years. Sometimes companies want to commission certain shares in their subsidiaries while retaining control, in such cases, companies often revert to the strategy of equity carve-out. Through such a process the parent company could easily get the money in return for the already released shares in the market while retaining their control.

Deloitte Corporate Finance finds 64% of companies engage in carve-outs for cash or capital requirement and such carve-outs can be done because the entity is “not considered core to the [parent] company’s business strategy.” 

Impact of equity carve-out

Equity carve-out amounts to the establishment of the Subsidiary as an independent public entity as a result of which the shares of the company become listed in the stock exchange and they can now be publicly traded. Carveout might precede spin-off. But such future spin-offs need to have 80% control, meaning, no more than 20% of the subsidiary’s stock can be offered in an IPO.

Pros and cons of equity carve-out

Pros

  1. The control of the subsidiary company still lies with the parent company as only a part of the shares are divested to the public through IPO.
  2. Carve-outs help the existing companies in focusing on their own activities and simultaneously help the subsidiaries to stabilize themselves.
  3. It improves the overall capital strength of the parent company.

Cons

  1. Divestiture or dilution of ownership of the parent company in the subsidiary company does not change the controlling power even though the subsidiary becomes independent. Since only a minority share held by the parent company is offered during the IPO, the controlling power still remains in the hand of the parent company and the subsidiary cannot function in a completely independent manner.
  2. A conflict of interest could arise between the two management teams of both companies  due to differences in their management style, goals and operations.
  3. It involves some restructuring costs which sometimes makes its implementation a costly affair.

Examples 

  • Las Vegas Sands carved out its Sands China subsidiary to raise capital over $3 billion.
  • GlaxoSmithKline sold its consumer healthcare business, including its health food drinks portfolio, to Hindustan Unilever.
  • L&T’s has hived off its electrical and automation business by selling it to Schneider Electric. Kalpataru’s power transmission assets were sold to CLP for debt reduction and to focus on strategic diversification 
  • Indiabulls carved out commercial office business into a separate firm under the name of Indiabulls commercial assets limited.

Difference tabulated

Sl.NoSpin-OffCarve Out
The parent company dispenses 100% of its interest in the holding.Parent Company dispenses only 20% of its interest in the holding.
Shares of the subsidiary business unit are provided to the existing shareholders on a pro-rata basis (proportionate to their shareholding in the parent company).Shares of the subsidiary are given to the public by way of an Initial Public Offering  (IPO).
Shares are enjoyed by the shareholders in the parent as well as in the subsidiary company. No exchange of shares.Shares of the subsidiary are publicly traded and no obligation of holding such shares is created within the parent company.
A spin-off is aimed at establishing the subsidiary’s identity independent of the parent company.A carve-out does not aim at accomplishing the parent company’s main objective but aims at achieving its organizational and capital objectives.
Spin-off aims to provide the benefit of progress to shareholders in both the parent and the subsidiary company.Carve out aims to provide the benefit of enjoyment of increasing the value of the shareholders.

Equity carve-out v. spin-off : which to choose?

The better mode of divestiture or the mode of right corporate restructuring depends upon the goals a promoter wishes to achieve. Equity Carve-out is opted for when the parent company is searching for an opportunity to “sell” the subsidiary company through total divesture or by selling shares within the subsidiary without giving up complete control. 

As mentioned above, fulfilling the first mentioned condition, which is to find a single buyer who will make a purchase in its entirety at one go, is fairly impossible. The parent company, therefore, goes for a Carve-Out by offering partial shares through IPO. If any promoter has such goals, then, carve out is the suitable option to choose.

On the other hand, promoters who choose to go for Spin-off, look at creating a separate existence of the parent from the subsidiary company as doing so would be lucrative for them both. It is done when the parent company realizes that the subsidiary company has no further scope of growth being associated with the parent or it has reached its complete potential and both the companies can now only grow further if they are separated. 

The goal of the spin-off, initially, is not to make money but to sell or buy equity creating a distinct independent identity of the entities. This is done by offering shares of the subsidiaries by the parent company to its shareholders on a pro-rata basis. Pro-rata allocation also allows for a non-taxable event. If any promoters’ goals are aligned to such a cause, then spin-off is the most suitable option for them to choose.

Conclusion

In such kinds of divestitures, non-core businesses are hived off/sold from the parent resulting in more and more merger & acquisition activity. Generally, a holding company holds shares of a subsidiary company from 50 to 100 percent. The holding company sells the shares of the subsidiary to the public or to its existing shareholders to restructure. Therefore, the question, whether to spin off or carve out can only be answered depending on the progress of the company and the condition of its core business. Primarily, the focus should be on the core business. If a business unit or asset is not performing, it can cause a hindrance to the growth of the core business. Hence, companies find it imperative to sell off non-synergistic businesses. It might also be the case that the subsidiary is performing better than the main business. In such a scenario it is prudent to separate it from the parent in order to focus on both the businesses strategically. When management becomes difficult and the holding company is not economically doing well, they are given to the public to raise capital. In the end, it’s the ultimate call of the promoters to decide whether to spin off or to carve it out.

References


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