Methods of Corporate Restructuring

The important methods of Corporate Restructuring are:

  1. Joint ventures
  2. Sell off and spin off
  3. Divestitures
  4. Equity carve out (ECO)
  5. Leveraged buy outs (LBO)
  6. Management buy outs
  7. Master limited partnerships
  8. Employee stock ownership plans (ESOP)

Methods of Corporate Restructuring

1. Joint Ventures

Joint ventures are new enterprises owned by two or more participants. They are typically formed for special purposes for a limited duration. It is a combination of subsets of assets contributed by two (or more) business entities for a specific business purpose and a limited duration. Each of the venture partners continues to exist as a separate firm, and the joint venture represents a new business enterprise. It is a contract to work together for a period of time each participant expects to gain from the activity but also must make a contribution.

For Example:

  • GM-Toyota JV: GM hoped to gain new experience in the management techniques of the Japanese in building high-quality, low-cost compact & subcompact cars. Whereas, Toyota was seeking to learn from the management traditions that had made GE the no. 1 auto producer in the world and In addition to learn how to operate an auto company in the environment under the conditions in the US, dealing with contractors, suppliers, and workers.
  • DCM group and Daewoo motors entered in to JV to form DCM DAEWOO Ltd. to manufacture automobiles in India.

Reasons for Forming a Joint Venture

  • Build on company’s strengths
  • Spreading costs and risks
  • Improving access to financial resources
  • Economies of scale and advantages of size
  • Access to new technologies and customers
  • Access to innovative managerial practices

Rational For Joint Ventures

  • To augment insufficient financial or technical ability to enter a particular line or business.
  • To share technology & generic management skills in organization, planning &       control.
  • To diversify risk
  • To obtain distribution channels or raw materials supply
  • To achieve economies of scale
  • To extend activities with smaller investment than if done independently
  • To take advantage of favorable tax treatment or political incentives (particularly in foreign ventures).

Tax aspects of joint venture.

If a corporation contributes a patent technology to a Joint Venture, the tax consequences may be less than on royalties earned though a licensing arrangements.

Example:

One partner contributes the technology, while another contributes depreciable facilities. The depreciation offsets the revenues accruing to the technology. The J.V. may be taxed at a lower rate than any of its partner & the partners pay a later capital gain tax on the returns realized by the J.V. if and when it is sold. If the J.V. is organized as a corporation, only its assets are at risk. The partners are liable only to the extent of their investment, this is particularly important in hazardous industries where the risk of workers, production, or environmental liabilities is high.

2. Spin-off

Spinoffs are a way to get rid of underperforming or non-core business divisions that can drag down profits.

Process of spin-off

  1. The company decides to spin off a business division.
  2. The parent company files the necessary paperwork with the Securities and Exchange Board of India (SEBI).
  3. The spinoff becomes a company of its own and must also file paperwork with the SEBI.
  4. Shares in the new company are distributed to parent company shareholders.
  5. The spinoff company goes public.

Notice that the spinoff shares are distributed to the parent company shareholders. There are two reasons why this creates value:

  1. Parent company shareholders rarely want anything to do with the new spinoff. After all, it’s an underperforming division that was cut off to improve the bottom line. As a result, many new shareholders sell immediately after the new company goes public.
  2. Large institutions are often forbidden to hold shares in spinoffs due to the smaller market capitalization, increased risk, or poor financials of the new company. Therefore, many large institutions automatically sell their shares immediately after the new company goes public.

Simple supply and demand logic tells us that such large number of shares on the market will naturally decrease the price, even if it is not fundamentally justified. It is this temporary mispricing that gives the enterprising investor an opportunity for profit.

There is no money transaction in spin-off. The transaction is treated as stock dividend & tax free exchange.

Split-off:

Is a transaction in which some, but not all, parent company shareholders receive shares in a subsidiary, in return for relinquishing their parent company’s share. In other words some parent company shareholders receive the subsidiary’s shares in return for which they must give up their parent company shares

Feature of split-offs is that a portion of existing shareholders receives stock in a subsidiary in exchange for parent company stock.

Split-up:

Is a transaction in which a company spins off all of its subsidiaries to its shareholders & ceases to exist.

  • The entire firm is broken up in a series of spin-offs.
  • The parent no longer exists and
  • Only the new offspring survive.

In a split-up, a company is split up into two or more independent companies. As a sequel, the parent company disappears as a corporate entity and in its place two or more separate companies emerge.

Sell-off:

Selling a part or all of the firm by any one of means: sale, liquidation, spin-off & so on. or General term for divestiture of part/all of a firm by any one of a no. of means: sale, liquidation, spin-off and so on.

Strategic Rationale

Divesting a subsidiary can achieve a variety of strategic objectives, such as:

  • Unlocking hidden value – Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value
  • Undiversification – Divest non-core businesses and sharpen strategic focus when direct sale to a strategic or financial buyer is either not compelling or not possible
  • Institutional sponsorship – Promote equity research coverage and ownership by sophisticated institutional investors, either of which tend to validate SpinCo as a standalone business.
  • Public currency – Create a public currency for acquisitions and stock-based compensation programs.
  • Motivating management – Improve performance by better aligning management incentives with Spin Co’s performance (using Spin Co’s, rather than Parent Company, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance.
  • Eliminating dissynergies – Reduce bureaucracy and give Spin Company management complete autonomy.
  • Anti-trust – Break up a business in response to anti-trust concerns.
  • Corporate defense – Divest “crown jewel” assets to make a hostile takeover of Parent Company less attractive

3.Divestures

Divesture is a transaction through which a firm sells a portion of its assets or a division to another company. It involves selling some of the assets or division for cash or securities to a third party which is an outsider.

Divestiture is a form of contraction for the selling company. means of expansion for the purchasing company. It represents the sale of a segment of a company (assets, a product line, a subsidiary) to a third party for cash and or securities.

Mergers, assets purchase and takeovers lead to expansion in some way or the other. They are based on the principle of synergy which says 2 + 2 = 5! , divestiture on the other hand is based on the principle of “anergy” which says 5 – 3 = 3!.

Among the various methods of divestiture, the most important ones are partial sell-off, demerger (spin-off & split off) and equity carve out. Some scholars define divestiture rather narrowly as partial sell off and some scholars define divestiture more broadly to include partial sell offs, demergers and so on.

Motives:

  • Change of focus or corporate strategy
  • Unit unprofitable can mistake
  • Sale to pay off leveraged finance
  • Antitrust
  • Need cash
  • Defend against takeover
  • Good price.

4. Equity Carve-Out

A transaction in which a parent firm offers some of a subsidiaries common stock to the general public, to bring in a cash infusion to the parent without loss of control.

In other words equity carve outs are those in which some of a subsidiaries shares are offered for a sale to the general public, bringing an infusion of cash to the parent firm without loss of control. Equity carve out is also a means of reducing their exposure to a riskier line of business and to boost shareholders value.

Features

  • It is the sale of a minority or majority voting control in a subsidiary by its parents to outsider investors. These are also referred to as “split-off IPO’s”
  • A new legal entity is created.
  • The equity holders in the new entity need not be the same as the equity holders in the original seller.
  • A new control group is immediately created.

Difference between Spin-off and Equity carve outs:

  1. In a spin off, distribution is made pro rata to shareholders of the parent company as a dividend, a form of non cash payment to shareholders. In equity carve out; stock of subsidiary is sold to the public for cash which is received by parent company
  2. In a spin off, parent firm no longer has control over subsidiary assets. In equity carve out, parent sells only a minority interest in subsidiary and retains control.

5. Leveraged Buyout

A buyout is a transaction in which a person, group of people, or organization buys a company or a controlling share in the stock of a company. Buyouts great and small occur all over the world on a daily basis.

Buyouts can also be negotiated with people or companies on the outside. For example, a large candy company might buy out smaller candy companies with the goal of cornering the market more effectively and purchasing new brands which it can use to increase its customer base. Likewise, a company which makes widgets might decide to buy a company which makes thingamabobs in order to expand its operations, using an establishing company as a base rather than trying to start from scratch.

In a leveraged buyout, the company is purchased primarily with borrowed funds. In fact, as much of 90% of the purchase price can be borrowed. This can be a risky decision, as the assets of the company are usually used as collateral, and if the company fails to perform, it can go bankrupt because the people involved in in the buyout will not be able to service their debt. Leveraged buyouts wax and wane in popularity depending on economic trends.

The buyers in the buyout gain control of the company’s assets, and also have the right to use trademarks, service marks, and other registered copyrights of the company. They can use the company’s name and reputation, and may opt to retain several key employees who can make the transition as smooth as possible. However, people in senior management may find that they are not able to keep their jobs because the purchasing company does not want redundant personnel, and it wants to get its personnel into key positions to manage the company in accordance with their business practices.

A leveraged buyout involves transfer of ownership consummated mainly with debt. While some leveraged buyouts involve a company in its entirety, most involve a business unit of a company. Often the business unit is bought out by its management and such a transaction is called management buyout (MBO). After the buyout, the company (or the business unit) invariably becomes a private company.

What Does Debt Do? A leveraged buyout entails considerable dependence on debt.

What does it imply? Debt has a bracing effect on management, whereas equity tends to have a soporific influence. Debt spurs management to perform whereas equity lulls management to relax and take things easy.

Risks and Rewards, The sponsors of a leveraged buyout are lured by the prospect of wholly (or largely) owning a company or a division thereof, with the help of substantial debt finance. They assume considerable risks in the hope of reaping handsome rewards. The success of the entire operation depends on their ability to improve the performance of the unit, contain its business risks, exercise cost controls, and liquidate disposable assets. If they fail to do so, the high fixed financial costs can jeopardize the venture.

Purpose of debt financing for Leveraged Buyout

  • The use of debt increases the financial return to the private equity sponsor.
  • The tax shield of the acquisition debt, according to the Modigliani-Miller theorem with taxes, increases the value of the firm.

Features of Leveraged Buyout

  • Low existing debt loads;
  • A multi-year history of stable and recurring cash flows;
  • Hard assets (property, plant and equipment, inventory, receivables) that may be used as collateral for lower cost secured debt;
  • The potential for new management to make operational or other improvements to the firm to boost cash flows;
  • Market conditions and perceptions that depress the valuation or stock price.

Examples:

  1. Acquisition of Corus by Tata.
  2. Kohlberg Kravis Roberts, the New York private equity firm, has agreed to pay about $900 million to acquire 85 percent of the Indian software maker Flextronics Software Systems is the largest leveraged buyout in India.

6. Management buyout

In this case, management of the company buys the company, and they may be joined by employees in the venture. This practice is sometimes questioned because management can have unfair advantages in negotiations, and could potentially manipulate the value of the company in order to bring down the purchase price for themselves. On the other hand, for employees and management, the possibility of being able to buy out their employers in the future may serve as an incentive to make the company strong.

It occurs when a company’s managers buy or acquire a large part of the company. The goal of an MBO may be to strengthen the managers’ interest in the success of the company.

Purpose of Management buyouts

From management point of view may be:

  • To save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team.
  • To maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves.
  • To ward off aggressive buyers.

The goal of an MBO may be to strengthen the manager’s interest in the success of the company. Key considerations in MBO are fairness to shareholders price, the future business plan, and legal and tax issues.

Benefits of Management buyouts

  • It provides an excellent opportunity for management of undervalued co’s to realize the intrinsic value of the company.
  • Lower agency cost: cost associated with conflict of interest between owners and managers.
  • Source of tax savings: since interest payments are tax deductible, pushing up gearing rations to fund a management buyout can provide large tax covers.

7. Master Limited Partnership 

Master Limited Partnership’s are a type of limited partnership in which the shares are publicly traded. The limited partnership interests are divided into units which are traded as shares of common stock. Shares of ownership are referred to as units.

MLPs generally operate in the natural resource (petroleum and natural gas extraction and transportation), financial services, and real estate industries.

The advantage of a Master Limited Partnership is it combines the tax benefits of a limited partnership (the partnership does not pay taxes from the profit – the money is only taxed when unit holders receive distributions) with the liquidity of a publicly traded company.

There are two types of partners in this type of partnership:

1. The limited partner is the person or group that provides the capital to the MLP and receives periodic income distributions from the Master Limited Partnership’s cash flow

2. The general partner is the party responsible for managing the Master Limited Partnership’s affairs and receives compensation that is linked to the performance of the venture.

8. Employees Stock Option Plan (ESOP)

An Employee Stock Option is a type of defined contribution benefit plan that buys and holds stock. ESOP is a qualified, defined contribution, employee benefit plan designed to invest primarily in the stock of the sponsoring employer. Employee Stock Option’s are “qualified” in the sense that the ESOP’s sponsoring company, the selling shareholder and participants receive various tax benefits. With an ESOP, employees never buy or hold the stock directly.

Features:

  • Employee Stock Ownership Plan (ESOP) is an employee benefit plan.
  • The scheme provides employees the ownership of stocks in the company.
  • It is one of the profit sharing plans.
  • Employers have the benefit to use the ESOP’s as a tool to fetch loans from a financial institute.
  • It also provides for tax benefits to the employers.

The benefits for the company: increased cash flow, tax savings, and increased productivity from highly motivated workers.

The benefit for the employees: is the ability to share in the company’s success.

How it works?

  • Organizations strategically plan the ESOPs and make arrangements for the purpose.
  • They make annual contributions in a special trust set up for ESOPs.
  • An employee is eligible for the ESOP’s only after he/she has completed 1000 hours within a year of service.
  • After completing 10 years of service in an organization or reaching the age of 55, an employee should be given the opportunity to diversify his/her share up to 25% of the total value of ESOP’s.

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