In devising ways of unlocking equity value as in so many other developments the US leads, the UK picks up the theme almost simultaneously and continental Europe follows on more or less tardily. So it is with the equity technique presently in vogue with investment bankers and business managers in Europe the spin-off.
In its most basic form, a spin-off enables a company to reorganize its corporate structure by initiating a separate stock market listing for a subsidiary or subsidiaries. The UK aside, the technique has not been widely used in Europe and there it has some rather formidable models from the US to live up to. One US firm, ThermoElectron, exists solely to seek out realtively obscure companies, suck them in, restructure them and spin them off. Typically it spins off between 15% and 49% of the value of a subsidiary, and to date has spun off six companies, which have themselves spun off a further 16.
Such an institutionalized approach to spin-offs is still a long way down the road for corporate Europe. But the technique is gaining in popularity and, says Dante Roscini, managing director, equity capital markets at Goldman Sachs, is becoming “a very important trend, and a useful tool for firms to achieve what has become a leitmotiv in the mid-nineties to focus on one’s core business”.
From a management perspective, restructuring business interests to focus on the core makes sense because it allows senior executives to concentrate their resources on running just one industry, rather than spreading themselves thinly across several related but distinctly separate concerns. As one management consultant put it: “Being a generalist is not the way to make money these days.”
One way or another multi-business conglomerates seem to be falling out of favour. One approach to dismantling them is the straight demerger, for example, UK-listed multinational Hanson’s split into five: Hanson, Energy Group, Millennium Chemicals, US Industries and Imperial Tobacco. Another is the sale of a subsidiary to a trade rival. But it is spin-offs that experts expect to dominate this process. “For the moment at least, recourse to the public market is the most obvious and immediate choice,” says Roscini. “And even if the equity markets do head for a correction, I’d be surprised if it had much negative impact on the use of spin-off IPOs.”
As well as offering efficiency gains to managements, cutting back to core businesses usually helps increase a company’s share price. As investment bank research departments concentrate more and more of their attention on sector analysis rather than analyzing conglomerates, the share price of a multi-business company can easily get dragged down because of its lack of focus. Spinning off a subsidiary can release the inherent asset value of the company by making a distinction between what is and what is not a core concern. A separate share listing for the subsidiary should also, if conducted thoroughly, release the relative value of its asset base and allow it to prosper.
If approached rationally, the choice between the options for restructuring is likely to be determined by assessing which will achieve the best price and realize the most value for shareholders while not leaving the parent company bereft of a good asset or providing competitors with too much of an advantage. The decision can be affected by factors that are not matters of business logic. One is fiscal under some regimes, some of the forms of restructuring may be tax-disadvantageous. “The worst-case scenario is to execute a restructuring programme which hands a large portion of prospective value for the shareholders to the tax man,” says Conor Killeen, global head, equity capital markets, at UBS. Environmental concerns may also play a role a parent company may want to dispose of the liabilities inherent in a subsidiary’s environmental risk.
There is little doubt that bullish equity markets have brought the spin-off to the fore, since the stock market tends to value a company more highly than would a trade buyer. It can also offer the parent company more flexibility. “A spin-off transaction allows the parent company to sell off a relatively small proportion of the subsidiary,” says Nigel à Brassard, chairman, equity capital markets, at Dresdner Kleinwort Benson. “Trade sales normally want a larger slice of the cake.”
Continental shift
This does not preclude a parent company keeping open the possibility of a trade sale or a spin-off IPO until the last moment, although this is likely to be a ploy to push up prices. A prime example was when Swiss pharmaceuticals group Sandoz spun off Clariant in 1995. “Usually the company has already decided which way it wants to jump,” says à Brassard. “But the other option is both kept in reserve and used as a stick to increase the price of the shares or the trade offer.”
The spin-off is by no means a new concept. Ten years ago bankers in London were drawing up lists of companies which they thought were ripe for spinning off. But whereas the first wave in the 1980s was primarily in the US and the UK, continental western Europe is now getting in on the act. “There was a significant gap between Europe on the one hand and Britain and America on the other in that restructuring on the continent had not spread beyond the initial few,” says Mike Young, director of European investment strategy at Goldman Sachs. “I would include in that companies such as Veba, Hoechst, Daimler, Swiss Re and Novartis.” This is changing. One banker suggests waking up the chief executives of the top 50 firms on the continent in the middle of the night and asking them what they think of their corporate structure. “I’ll wager that the vast majority of them express some dissatisfaction and are considering a spin-off or similar type of rationalization.”
Analysts cite two reasons for this. The first has become something of a cliché the globalization of the markets. “When you are being constantly compared to your peer group on a global basis, it is almost inevitable that you will have to consider restructuring your business in some way or other,” says Goldman Sachs’s Young. As long as competition came only from domestic firms, the impetus to change was minimal. Now matters are very different. “One of our western European clients puts it this way,” says Stephen Phillips, principal at management consultants CSC Index. “‘We’re fighting the Indians and the Chinese on the beaches’.”
The second reason is more about refocusing investor interest within individual countries. Says Lucinda Riches, executive director in the equity capital markets division at SBC Warburg: “The whole approach to the concept of value is changing. It’s interesting to compare, for example, the German financial press today to five years ago. Then the focus was firmly on management objectives and employee interests; it is only recently that you can see more focus on shareholder value.”
Institutional investors, like companies, are increasingly seeking to focus on what they do best, not least because new demands are being imposed on them. “The world’s investment community is saying that they want to take on portfolio and hedge fund management and leave Mr Enterprise to concentrate on running his business,” says Phillips at CSC Index. In tandem with this is the gradual ascendancy in Europe of personal pension provision over state or company pensions. This has led major continental fund managers to look beyond their traditional investments in the quest for yield. “Cash inflow into pension funds is likely to increase with pension reform,” says Warburg’s Riches. “This fund flow will probably result in diversification away from fixed income towards equity in search of higher returns. The continental funds will move closer to the UK and US models.”
Some bankers urge caution in the face of the trend. Goldman’s Young is not convinced by those who pay lip service to restructuring: “I’d imagine that the investor relations teams in most of Europe’s top corporates would admit they’re looking at a spin-off or a demerger. But you’ve got to look for those who walk the walk, not just talk the talk.” And Paul ffolkes Davis, managing director, equity capital markets, at NatWest Markets, while acknowledging the importance of corporate restructuring, is wary of pushing it as a necessity: “Trends are very compulsive on the continent, and given the success of some recent exercises we’re likely to see some copycat transactions in the future,” he says.
European companies that have opted for spin-offs have generally tended to spin off most or all of a subsidiary, whereas US ones have developed to a point where all strategies are possible ThermoElectron’s being just one of many. In some countries there are regulations governing the proportion of a subsidiary that must be listed: in a spin-off in the UK, for example, at least 25% of a subsidiary has to be listed, in the Netherlands 10%.
Often a spin-off will be structured as a straightforward rights issue in the newly independent subsidiary offered to the existing shareholders of the parent firm. While this has advantages, it can also raise problems, most notably the difficulty of establishing an fair trading price at the outset, and a possible lack of liquidity in the secondary market.
Spin-off strategies
A partial or full IPO avoids these problems since the market sets a trading price for the shares and therefore a tangible value for the spin-off. The problem with this approach comes from the shareholder side existing shareholders may feel the cash compensation from the IPO is not a sufficient representation of the underlying value of the subsidiary. And where the authorities regard compensation from the issue of new shares as a form of dividend, the tax man will want his cut.
In these cases there are several alternatives. One seen at the end of last year involved the spinning off from Swedish company Investor of commercial vehicle maker Scania. Existing shareholders were given warrants only exercisable three years after the IPO of 50% of Scania. The warrant issue was equivalent to 20% of the company.
More complex was the route taken by Ciba Specialty Chemicals in its spin-off from Swiss company Novartis last month. The company’s directors, along with global coordinators UBS and Credit Suisse First Boston, opted for a three-pronged strategy. First, there was a rights issue for existing Novartis shareholders, who received a proportion at the discounted price of Sfr10; had they received them for free the rights would have been taxable. The shareholders then had the option to exercise these over a period of 12 days. The final piece in the jigsaw was an IPO worth a minimum of Sfr300 million ($208 million) plus any rights not exercised. In the event the IPO was for just over the minimum amount.
The fears of some bankers that the deal was too complex for investors proved misplaced, although there were some minor gripes: “Investors and traders weren’t so happy with the size of the public tranche,” says a banker close to the deal. “The former because they wanted more exposure to what is a good success story, and the latter because they couldn’t make as much money. But it was a successful deal for Ciba.” It was so successful that the offer price for the IPO was set at Sfr110 nearly Sfr30 above the upper end of the indicated range during the roadshow.
The driving force behind such a transaction is usually the parent company’s wish to realize the value of its own core assets; the success of the spin-off, though important, is a secondary consideration. This was true to some extent in Ciba’s case: “When we agreed to the merger of Ciba-Geigy with Sandoz in December 1995, it quickly became apparent that the specialty chemicals business was dragging us down somewhat,” says Rudolf Meyer, chief executive officer at Ciba Specialty. “Ciba-Geigy constituted 42% of the market value for the new company, Novartis. Spinning off the specialty chemicals business increased the share to 45%, and gave more value to existing investors.”
But the executive board of Ciba also pushed for the spin-off, and its members are confident of a rosy future for their new company each has invested a year’s salary in the company according to a banker close to the deal. But this might not be enough to guarantee the company’s continued independence analysts expect little significant growth in specialty chemicals. Perhaps Clariant serves as an apt example of what might lie ahead for Ciba. Itself spun off in its entirety from Sandoz in 1995, Clariant entered into a business-for-equity exchange with Hoechst for its speciality chemicals businesses at the end of last year. By this arrangement Clariant has taken over Hoechst’s chemicals business, and Hoechst received a 45% stake in Clariant. “We’re now seeing a more tightly focused chemicals industry coming into being,” says Phillips at CSC Index. “And I’d expect companies such as Ciba to follow this route, too. There will have to be a recombination of specialty chemicals spat out in spin-offs.”
The pharma-chemicals industry as a whole has undergone a great deal of restructuring over the last five years as previous doctrines have been rejected. As the pharmaceuticals side has grown in importance, so senior executives have questioned the role and place of the chemicals divisions. “The chemicals companies have been hiding behind rich pharmaceuticals conglomerates for a while now,” says CSC Index’s Phillips. “The restructuring we have seen is the latter unbundling their poor relations to create value.” The two industries initially came together for economies of scale; “There was a belief that there was a certain degree of synergy between the two, especially in research and development,” says Killeen at UBS. “That’s not the case any longer. The pharmaceuticals side makes a much larger contribution to the business now, so it makes more sense to split the two up.”
This is an excellent example of the difficulty faced by analysts and investors alike when assessing conglomerates: “The pharmaceuticals business has good, strong growth ahead of it as it takes advantage of technological developments,” says an analyst with a US investment bank in London. “Chemicals, on the other hand, is much more of a cyclical industry, so we often find that when one half is doing well, the other is dragging it down. By nature people tend to be swayed by the bad news rather than the good.”
A matter of momentum
The greatest danger facing companies after announcing the intention, or even the hint of an inclination, to restructure is the market pressures it unleashes. A company wishing to devolve more responsibility to its subsidiary’s managers while still retaining a stake often faces questions and receives advice that imply it should go beyond its initial plans. “Say a company has a subsidiary with an implied market capitalization of $400 million, and wants to spin off 25% in an IPO, it will almost certainly be faced with a dilemma,” says Riches. “One of the big problems is size: 25% of $400 million might not be liquid enough for a decent performance in the secondary market. In addition, whenever the plan is to spin off a significant minority of up to 50%, then the inevitable question which follows is ‘now you’ve divested yourself of one half, what are you going to do with the rest of it?’ You can get into a situation where a plan for a partial spin off snowballs into enormous pressure to sell the whole thing.”
This has been increasingly the case as European corporates have begun moving away from the traditional route of selling off most or all of a subsidiary in favour of partial spin-offs to raise investor awareness and shareholder value. To some extent this is also because governments have tended to sell off state organizations in tranches, such as Spain’s telecoms company Telefonica, a method also adopted by some of the larger spin-offs. German chemicals company Hoechst, for example, spun off SGL Carbon in three tranches, and EVC is halfway through a multi-tranche spin-off. The advantage of this approach is that the first spun-off tranche sets a standard and a price for the subsidiary. If market conditions are right, both the subsidiary’s and the parent company’s share prices will benefit from the split, allowing the companies and the shareholders alike to reap greater value from the other tranches.
Unfortunately, spin-offs that are planned to have just a partial IPO can suffer from market expectations that further tranches will be undertaken: “We had a lot of queries from investors about Fiat’s intentions regarding [farm machinery maker] New Holland after we and Mediobanca coordinated their 30%, $1 billion spin-off from Fiat last November,” says Goldman Sach’s Roscini.
There was another example of the effects of market momentum last month. Hoechst has been one of the prime movers in the latest round of restructuring in Europe, devolving power to nine legally separate companies under the umbrella of a holding company. As part of these plans, Hoechst’s chairman, Jürgen Dormann, said his company might spin off one of these nine, pharmaceuticals wing HMR. In mid-March Dormann announced that HMR would in fact be kept as one of the integral units of the overall company. Market reaction was severe: with the announcement coming on the same day as poorer than expected results, Hoechst’s share price fell 8%. Many seem to agree with the assessment of SBC Warburg’s Riches: “Tantalizing the market by saying that they were going to do a spin-off, and then backtracking a few months later, can easily affect the share price, even if the decision not to go ahead is sound. Traders will have already focused on the positive aspects of the spin-off.”
Others take an opposite view: “I’d say that the market was a bit too fast in its expectations,” says Young at Goldman Sachs. “I got the impression from my conversations with Hoechst that it was a possibility for the future, but only after they had first built it up. And Hoechst has done at least as good a job as other firms in restructuring, and is well positioned for the future.”
And there were others who were delighted at the news: “It would have been a daft thing to do,” says a fund manager responsible for investing in continental European corporates. “You don’t sell off pharmaceuticals businesses at the moment they’re the most promising of the lot. You’ve only got to look at the relative performance of ICI and its spin-off Zeneca.” Following the spin-off in 1993, pharmaceuticals company Zeneca’s share value has shot up to three-and-a-half times its issue price; Chemicals rump ICI, while not quite the “basket case” described by the fund manager, has had a virtually flat share-price performance since divesting itself of Zeneca.
With HMR now destined to be a separate entity within Hoechst, which is due to seek a listing on the New York Stock Exchange towards the end of the year, the pressure from bankers, investors, and even HMR’s management, to spin off the subsidiary is likely to subside. Other companies, however, might feel compelled to opt for a spin-off, often because they want to jump on the bandwagon. “The event of a spin-off can act as a catalyst, and create a lot of energy for change,” says Tim Koller, director and a leader of consultant McKinsey’s European corporate finance team in Amsterdam. “But I think it’s true to say that a few of our clients could have achieved some of this within a larger group.”
Overzealous investment bankers might be partly responsible for this as well. But often the momentum in such cases comes from managers who hope that their part of a company will be spun off. Once they have tasted a degree of managerial freedom, it is difficult to stifle it.
There is a whole set of potential pitfalls in a spin-off transaction. Some involve decisions about how jointly shared assets should be split up. “Practical matters of dividing up the assets can set us back a fair bit at times,” says UBS’s Killeen. “This can be anything from which staff go where, who owns which part of which building even dividing up the car park spaces can be problematic. Occasionally these matters can delay the timetable to a point that it needs recasting.”
Investors usually welcome a spin-off. A company’s share price tends to rise after one is announced because a spin-off usually increases shareholder value, and many of the ideas for restructuring come from investor meetings. But reconciling the different classes of shareholders can be awkward. “A company can have individual shareholders, strategic shareholders such as institutional investors, and even the government might own some of the shares,” says John Jensen, managing director of global client products in the equity capital markets division at Merrill Lynch. “Each different class might have different interests and expectations from a spin-off, even though they all agree on the ultimate aim.”
One aspect of restructuring that investors dislike is a spin-off that is used as a way of raising cash that is then not put into investment or acquisitions. Again this comes down to their preference for a simple division of labour. Institutional investors prefer to make their own decisions about how they invest cash; if a company has cash on its balance sheet, it is discounted, whereas if that same cash were handed back to shareholders as a dividend or share buy-back, the value of the shares would go up. Raising cash to lower gearing is equally unpopular. “Increasingly shareholders are not keen on low debt levels,” says Riches at SBC Warburg. “They will often prefer to see higher gearing and a higher payout to them.”
Spin-offs that do a wobbly
There is also the occasional blip in spin-offs. In 1994, French steel company Usinor Sacilor spun off 40% of its stainless-steel arm, Ugine. Just under a year later Usinor tendered to buy it back, paying a premium to do so. “I sat down and did a quick calculation of what it cost them,” says a banker not involved in the transactions. “If you treat the sale and buyback as a way of raising debt over the nine-month period, then Usinor paid an effective borrowing rate of 33%.”
Such mishaps are not that common, and one banker involved in the Usinor deal insists that both ends of the transaction are justifiable given market conditions at the time. All those involved in spin-offs are keen to promote the benefits that a well-structured spin-off can offer to all parties. The parent company has the opportunity to release potential value by specializing in its core competencies; shareholders can reap the share-price rewards of a more transparent corporate structure; analysts feel at ease with a company that is more focused; and investment banks can make more money on a spin-off IPO than they can on a trade sale.
And there are still many suitable candidates. The banker’s comments about the top 50 corporate executives being unhappy with their firms’ structures might have been somewhat tongue-in-cheek, but judging by the sentiments of others in the markets it’s not far from the truth, although no-one interviewed was prepared to single out companies by name
“If we look at the FTSE 100, the prospects for corporate restructuring are quite limited compared to some continental markets,” says Riches. “If we look at the DAX in Germany, there are plenty of candidates.” Germany is still awash with large conglomerates, industrial and otherwise. These include engineering groups such as Mannesman and Daimler-Benz, which have already started restructuring but, according to one banker, still have a fair way to go. Automotive and mobile telecommunications industries were also pointed out as likely contenders for spin-offs.
“Tangled holding groups in France, Italy and Belgium” are favoured by McKinsey’s Koller as probabilities, but he also mentions another manner of spotting the next spin-off : “I’d look at new CEOs to see where they’re coming from. If they’re creating value, and not an empire, then restructuring, with spin-offs as a possibility, might no be far behind.
