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Some three year ago,
the ground-breaking deal in Holland was the splitting up of
conglomerate Vendex through spin-offs of two major divisions. It
spun off its recruitment division, Vendior, and two years ago also
spun off its retail interests in a new company called Laurus.
Vendex itself was left as a focused department-store business. In
the course of privatization IPOs, the old Dutch state PTT was also
restructured into separate post and telecoms companies. KPN was
effectively a spin-off of the former state monopoly.
Now, it is the turn of the spin-offs to restructure
themselves. This may increasingly be done by partly splitting-off
divisions through equity carve-outs, which allow parent companies
to retain a significant equity interest. Last November, KPN and
Qwest Communications International chose to float their fibre-optic
cable joint venture company, KPN Qwest, by way of a public sale of
20% of the equity. Buoyed by investor enthusiasm for all things
related to cable and the internet, KPN Qwest's share price quickly
rose from a listing price of e20 to e43. The joint-venture partners
will receive value from this performance through their retained
stakes. KPN is also listing a minority stake in its mobile-phone
subsidiary.
Unlike a spin-off, where the shareholder structure remains
intact, an equity carve-out is a partial floatation, whereby the
parent retains the majority of the shares and exercises control
from a distance. In common with spin-offs, equity carve-outs are
still rare on the Dutch stock market. Only Philips preceded KPN,
with its public sale of 40% of silicon-chip making subsidiary ASML
in 1994 and its earlier carve-out of music publisher Polygram,
which Seagram acquired in 1997.
In the Anglo Saxon world, a company's board regards creating
extra value for shareholders as its primary objective. Should the
directors fail to realize this, it will soon be pointed out to them
by professional investors and/or investment banks. This trend of
shareholder activism is rapidly making itself felt in the
Netherlands and in other countries in continental Europe. Led by
the Algemeen Burgerlijk Pensioenfonds (ABP), the world's largest
pension fund, a group of leading Dutch pension funds formed a year
ago have begun to increase their influence in company boardrooms,
pressing companies to change strategy and create value and, in the
case of temporary staff recruitment business Brunel, ousting the
chief executive.
An active market for corporate control in both medium to
large companies and world-wide conglomerates clearly now operates.
However, until now this has been mainly limited to traditional
forms of corporate restructuring such as mergers, takeovers and
alliances. Increasingly the associated emphasis on transparency and
flexibility will lead to different types of equity market
transactions. The splitting up of Vendex and KPN are good examples
of how companies with multiple businesses have managed to eliminate
the discount that investors traditionally apply to conglomerates or
holding companies.
Developments in this field are very rapid. In the US, next to
spin-offs and equity carve-outs, tracking stocks are increasingly
seen as a serious alternative to having a subsidiary activity
introduced separately on the stock exchange. This autumn, DuPont
announced its intention to list its life-sciences activities as a
separate entity on the stock exchange by means of tracking stocks.
Every DuPont stockholder is being issued pro rata with new, freely
negotiable tracking-stock shares. The value and dividend from a
tracking stock follows the profit potential and growth
characteristics of these life-sciences activities in the same way
as DuPont's ordinary shares follow the economic performance of the
company's other activities. There is, however, one big difference
with DuPont's ordinary shares. The holder of DuPont's life sciences
tracking stock is not a an owner or part owner of the life-sciences
division. DuPont's management and, as a natural progression
DuPont's ordinary shareholders, retain complete ownership control
of life-sciences activities.
Recent research carried out by Patricia Anslinger, Steven
Klepper and Somu Subramaniam (
Breaking up is good to do, McKinsey Quarterly 1999 Number 1)
indicates that spin-offs and equity carve-outs have been especially
successful on the American stock markets, while tracking stocks are
moderately successful. This study is limited to measuring the
performance of companies quoted on the stock exchange with an
annual turnover in excess of $200 million during the 1990s. It must
be said that not all spin-offs and equity carve-outs have been
runaway successes. Building up an effective organization combined
with clear independent strategic intentions for both the parent
company and the new subsidiary is crucial to success. It sounds
logical, but in all too many cases this condition is not met. For
example, when Racal carved out Vodafone, Vodafone's share price
initially fell and only began to recover after Racal relinquished
ownership by selling its controlling stake.
What spin-offs, equity carve-outs and tracking stocks have in
common is that they increase the transparency of the company for
the outside world. Investors increasingly demand insight when
business activities within a diversified corporation show major
differences in growth, risk and profitability. A separate profit
and loss account that concentrates on one specific company activity
offers investors more insight than a consolidated publication from
a diversified company. Profit figures and other financial ratios
have more significance when they represent one company activity
instead of a diversified company. They can be better compared with
other investments available on the stock exchange. There is a
growing demand for what is called pure play. Increased insight into
a company's individual activities leads to removal of the
conglomerate discount. This discount, often attributed to
information risk in professional journals, can amount to 20%.
The market often complains that the diversified company's
price/earning ratio does not represent the true worth of the
company. The fact is that more and more often these companies have
a lower value than would be expected from the normal P/E ratio for
individual activities. DuPont's P/E ratio fluctuates around the 18
mark, a valuation more in line with basic chemical activities than
with life-sciences activities, which the market values at 30 to 50
times earnings. Based on this, there is speculation that Microsoft
is planning to launch its internet activities onto the stock market
by way of a tracking stock and so take advantage of the internet
hype now gripping the securities markets: a plan that Microsoft
continues to deny. And just last month, UK media group Pearson
announced that it too was considering issuing a tracking stock for
its internet-related assets.
It's too simplistic to say that the market wrongly values
diversified companies. Certainly the market takes a negative view
of a lack of transparency and focus. Announcing a split-up is
usually the result of a strategic reorientation process with clear
independent plans for the activities being split off. Removing
uncertainties about a diversified company's strategic orientation
can raise its valuation to more "normal" levels
Improving transparency for the investors is one side of the
coin. The other side, and perhaps the crux of the matter, is to
improve the company's effectiveness. Listing a company activity
independently on the stock exchange can significantly improve that
company's effectiveness in many ways. Most important, delegating
investment decisions improves the efficiency of capital allocation.
Several studies have revealed that broadly diversified
companies are valued 15% to 20% lower than their counterparts,
which are more focused on their activities. This loss of value is
attributed to the inefficient allocation of new investment and
maintaining value-destructive activities through cash cows.
Investment capital fails to reach the part of the business with the
most value-creation potential. This problem can, of course, be
solved by the holding company itself, by "objectively" assessing
the potential value creation of each of the company activities.
However, the problem lurks in the word "objective". It is
inevitable that the holding company's directors will make personal
choices in matters of attention and the allocation of the
investment budget.
It is more effective to leave these matters to the external
market. The idea that growing activities can best be financed
through cash cows is superseded by the idea of pure play, which
states that growing activities realize their maximum potential when
they themselves have to attract the capital they need from the
market. By listing them independently on the stock exchange and
delegating investment control, a spin-off or an equity carve-out is
an attractive option, especially when the company activity in
question has hidden growth and acquisition ambitions. However, in
the case of a tracking stock, the holding company's directors are
still left with the dilemma of choice. Or perhaps even worse, the
dilemma is out there in the streets.
As soon as an activity is listed on the stock exchange, the
management of the activity concerned comes under pressure to trade
in the interests of shareholders. Recent research has shown that
whereas, at the beginning of the 1990s, only 8% of the senior
managers of Dutch stock-exchange securities regarded corporate
goals as their most important policy, this percentage has now
increased to well above 50%
This requires capable management with entrepreneurial skills
which is closely aligned with the interests of investors. The best
way to achieve this is to turn managers into owners with rewards
linked directly to the company's market performance. In the case of
a stock-exchange listing, management can be rewarded with share
options directly related to their performance. Opinions differs as
to the effectiveness of share options. There is no direct
relationship between providing share options on their own and the
performance of a listed company. VNO/NCW, two Dutch employers
associations, have already launched far-reaching proposals to cut
out share options and provide shares instead.
An acquisition strategy is more credible for a company with
one clear core activity.
This is a big consideration in markets where survival seems
to be synonymous with acquisition. A company with various core
activities on the lookout for takeovers, can cause confusion with
regard to its strategic orientation. This can result in reluctance
on the part of external capital providers to finance the
acquisition strategy. A listed company with one core activity has,
by definition, already partly proved itself to be clearly focused
on strategic orientation.
After the spin-offs of the Vendex concern, Vendex, Laurus and
Vedoir have, with very clear intentions, been proactively seeking
acquisitions. The same is true of the PTT concern, which spawned
the TNT Post Group and KPN. To a large extent, these four companies
have directed their strategies towards growth through focus. The
equity carve-out of the mobile-phone subsidiary can be regarded as
preparation for KPN carrying out an expansion strategy in the
mobile-phone market by way of takeovers and alliances, as
illustrated by its recent acquisition of Germany's third-largest
wireless phone company, E-Plus.
The partial floating of activities on the stock market
inevitably results in the directors of the holding company losing a
measure of control. The price of control is the ultimate
determining factor in the choice between a spin-off, an equity
carve-out and a tracking stock. The position the floated subsidiary
has in the company's total strategic plan is crucial. Does it
concern a core activity that is completely separate from other core
activities or does it concern a core activity that is clearly
related to other core activities? An unrelated core activity lends
itself the most to a spin-off, which effectively takes away all
control. The post division and the telecom division were two of the
PTT's unrelated core activities, as were the Vendex concern's
retail and temporary employment businesses. In the long term, we
cannot expect any strategic synergy between two unrelated core
activities.
With related core activities it is a completely different
story. Operationally, it is possible to split mobile-phone
activities and traditional telephone activities. However, in the
long term, having a mobile telephone subsidiary could have
strategic value for a parent company with a portfolio that includes
traditional telephone activities. This is an ideal situation for
retaining control at a distance. A public flotation gives the
mobile subsidiary freedom to grow, invest and acquire. But the
retained majority interest is an important bargaining chip for the
KPN parent company in the merger and takeover games now
transforming the European telephone market.
Technically, the parent company's control is restricted to
that of a majority shareholder. Because the related core activities
can be operationally separated and can determine their own
strategic courses, direct control is not of any great value. The
parent company may be able to exercise its control in the future by
reacquisition or complete sale, if it undergoes further strategic
reordering. The equity carve-out subsidiary has given KPN a
strategic option. This option does not compromise KPN's strength in
the market for corporate control. Rather the opposite is true. It
keeps all its strategic options open while at the same time
building up a strong telephone subsidiary by substantially
increasing the company's effectiveness.
An added advantage of an equity carve-out is the cash that is
received from the partial flotation. KPN can use these additional
funds to invest in the infrastructure of the mobile network and
fibre-optic network in Europe. The consideration between the size
of the sum required and the importance of strategic control
ultimately determines which part of the company will be floated.
One of the main reasons for DuPont's decision to issue a
tracking stock was to create a pure-play currency, enabling it to
more effectively make acquisitions in the life-sciences sector by
means of share transactions. Ordinary DuPont shares are relatively
cheap and are not a comparable means of exchange in share
transactions. This could make acquisitions by means of (partial)
share transactions very expensive. It is expected that the tracking
stock will have a value in conformity with the market and will be
better accepted by a counterparty in acquisitions in the
life-sciences sector. Moreover, it is expected that DuPont's total
market value will grow as a result of its increased transparency.
DuPont could have used the same arguments to justify choosing
an equity carve-out or spin-off to carry out the acquisition
strategy it had in mind for the life-sciences activity. One reason
why DuPont wishes to retain overall control is the strategic
synergy it envisages between the life-sciences activities and the
core chemical activities. The growth of life sciences will have to
be partly financed by funds from the chemical activities. Possibly
DuPont management's sees life sciences growing to become DuPont's
main core activity in the future. The time is, therefore, not yet
ripe to definitely or irreversibly split up the company.
Another reason for opting for a tracking stock instead of an
equity carve-out is that it enables you to shut out the
competition. In the case of an equity carve-out, a majority
shareholder always has to take some account of minority
shareholder's interests, and these could be competitors. In the
case of a tracking stock, the interests of the tracking stock
shareholder are legally less substantial, because they do not own
the company. This last statement is pure speculation on our part,
because, to date, there are no examples of Dutch companies having
issued tracking stocks.
Not everything is suitable for a spin-off, carve-out or
tracking stock. Leaving legal and fiscal barriers to one side,
there are two conditions that must be met. First, the activity to
be floated on the stock exchange must have financially healthy
prospects and be large enough to profit fully from the advantages
listed above. The activity must be self-supporting and, ideally,
have substantial growth potential. Obviously this makes demands on
the management team a crucial factor to the success of the
enterprise. From business unit manager to CEO of an equity
carve-out or a spin-off is an enormous step.
Not only will the newly floated activity have to do well on
the stock market, all the other activities will also have to
inspire the confidence of the stock exchange. After the heralded
KPN equity carve-out, not only did the performance of the two crown
jewels the mobile phone subsidiary and the KPNQwest joint venture
come into the limelight, but also the company's traditional
telephone activities became more transparent at a time when there
has been no growth in traditional telephone activities in the
Netherlands.
The floated activities as well as the other activities must
be financially sound in order to justify a flotation. Healthy
profitability as well as a sufficiently high stock-exchange value
is a basic condition. Funds with a stock-exchange value below Fls1
billion are plagued by discounts reflected in the current
substantial undervaluation of the mid-cap and small-cap funds on
the Amsterdam stock exchange.
Second, the advantages of a flotation must outweigh the costs
in the broadest sense of the word. These include the costs actually
involved in dividing the company's activities, the costs of setting
up a new financial administration, the management costs involved in
solving and managing cost-allocation problems, etc.
In the case of a tracking stock, the conditions for building
an effective organization can suffer as a result of expected
management dilemmas. How can you as senior management avoid one
activity being favoured over others or even creating the impression
that you are doing this? The board has to more or less walk on
eggshells and divide its attention and investment equally among the
activities in order to reassure all shareholder groups. What's more
conflicts between the holding company and business unit are fought
out in the open. This dilemma can be solved reasonably by strictly
dividing the financial activities linked to the tracking stock from
the other activities and by appointing two general managers to sit
on the board of supervisory directors. This management dilemma has
led to AT&T shelving its plans to issue tracking stocks. It
will be interesting to see how DuPont copes with this dilemma.
In conclusion
Certainly in view of the nature of the present flood of
mergers and takeovers being stimulated by the slogan "focus, growth
and acquisition" we expect a wider spectrum of choices in the
continuing restructuring of Dutch companies. If one sheep leaps
over the ditch, all the rest will follow...
There is no lack of opportunities: Akzo Nobel could issue
tracking stocks in its Pharma activities, and DSM in its fine
chemicals business; Philips has a raft of possibilities suitable
for equity carve-outs (Lighting, Medical Systems, Origin); Unilever
could consider tracking stocks for its deep-freeze activities, and
Wessanen for its American activities (Food Distribution); and Shell
has a barrel-load of restructuring possibilities. Not to mention
Stork, Internatio Muller, CSM, Reed Elsevier, and Wolters Kluwer.
One barrier for Dutch companies would appear to be their
partial or total loss of control. The interminable corporate
governance discussion regarding the use of barriers to takeover,
for example, special classes of preferential shares, makes you
wonder if Dutch management is willing to take such drastic steps in
the interests of shareholders.
On this question in the long term we are not too pessimistic.
Certainly the larger Dutch companies with a dominant international
orientation are leaning towards a more Anglo-Saxon business
culture, a style that has become the "required" standard for
"global companies". Moreover, equity carve-outs possibly offer KPN
the best barrier to takeover; a higher stock-market value leading
to a stronger position in the merger and takeover market as a
bidder.
In view of the significant advantages of equity carve-outs,
you could speculate about future organization: a holding company
with separate core activities spread over a portfolio of equity
carve-outs. The task of the holding company is then "limited" to
playing the market for corporate control.
Steven Wilson is principal consultant and Leo van de Voort is
director at Twynstra Corporate Strategy and Finance
Share price performance of Vedior versus the Dutch market
Share price performance of Vendex versus the Dutch market
Share price performance of Laurus versus the Dutch market
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