An Equity Carve-Out (ECO) is a partial public offering of a wholly owned subsidiary. Unlike spin-offs, ECOs generate a capital infusion because the parent offers shares in the subsidiary to the public through an Initial Public Offering (IPO), although it usually retains a controlling interest in the subsidiary. Like spin-offs, ECOs have become increasingly popular in the last several years.
An equity carve-out involves conversion of an existing division or unit into a wholly owned subsidiary. A part of the stake in this subsidiary is sold to outsiders. The parent company may or may not retain controlling stake in the new entity. The shares of the subsidiary are listed and traded separately on the stock exchange. Equity carve-outs result in a positive cash flow to the parent company. An equity carve-out is different from a spin-off because of the induction of outsiders as new shareholders in the firm. Secondly equity carve-outs require higher levels of disclosure and are more expensive to implement.
Benefits of Equity Carve-Out
The potential benefits of equity carve-out include:
- “Pure play” Investment Opportunity: Pure plays have been in much demand by investors in recent years. An ECO, especially for a subsidiary that is not involved in the parent’s primary business or industry, increases the subsidiary’s visibility as well as analyst and investor awareness. This enhances its overall value. Investors also like ECO pure plays because separating the parent and subsidiary minimizes cross-subsidies and other potentially inefficient uses of capital.
- Management Scorecard and Rewards: Management is evaluated on a daily basis through the company’s stock price. This immediate, visible scorecard can boost performance by spurring managers to make timely strategic decisions and concentrate on the factors that contribute to better shareholder value. Correspondingly, managers are also more likely to be rewarded for improved results.
- Capital Market Access: An ECO typically improves access to capital markets for both the parent and the subsidiary.
Process of Equity Carve-Out
A typical equity carve-out scenario in the US begins with the parent publicly announcing its intention to offer securities in a subsidiary or division through an ECO. Since an ECO is a type of IPO, companies must file an S-1 registration statement with the SEC. Registration requires three years of audited income statements, two years of audited balance sheets, and five years of selected historic financial data. The ensuing process – including the preparation of financial and registration statements, SEC review, responses, and amendments, and offering marketing – normally takes up to six months. Once the SEC reviews and declares it effective, the parent can sell the offering, either listing the spin-off on an exchange or providing for trading over the counter.
Either the parent or the carve-out (or both) can receive the IPO proceeds. If the subsidiary sells the shares, the IPO represents a primary offering. Over 70 percent of the companies in the researchers’ sample reported handling the ECO in this manner. If the parent sells the shares (known as secondary shares), it must recognize the difference between the IPO proceeds and its basis as a gain or loss for tax purposes. If the subsidiary sells the shares in the IPO, neither the parent nor the carve-out incurs a tax liability. When the ECO sells the shares, it often uses some of the proceeds to repay loans to the parent or pay a special dividend. A relatively small number of ECOs are handled as joint offerings of the parent and subsidiary.
A study has found that 50 percent of the ECOs used for the proceedings of primary offerings to repay loans to the parent, 30 percent to be retained, and 20 percent pay to creditors. In secondary offerings, 50 percent of the parents ECOs retain the proceeds, while 50 percent pay to creditors. The research indicates that the initial stock market reaction to an ECO announcement is more favorable if the subsidiary retains the funds.
After the IPO, all transactions between the parent and the subsidiary must be conducted on an arm’s-length basis and disclosed in the registration statement. The parent typically continues to perform certain corporate services, such as investor relations, legal and tax services, human resources, data processing, and banking services, on a contractual basis.
Characteristics of Equity Carve-Out Candidate
Strong potential equity carve-out candidates have some or all of the following characteristics.
- Strong Growth Prospects: If the subsidiary is in an industry with better growth prospects than the parent, it will likely sell at a higher price/earnings multiple once it has been partially carved out of the parent.
- Independent Borrowing Capacity: A subsidiary that has achieved the size, asset base, earnings and growth potential, and identity of an independent company will be able to generate additional financing sources and borrowing capacity after the carve-out.
- Unique Corporate Culture: Subsidiaries whose corporate culture differs from that of the parent may be good ECO candidates because the carve-out can offer management the freedom to run the company as an independent entity. Companies that require entrepreneurial cultures for success can especially benefit from this transaction.
- Special Industry Characteristics: Subsidiaries with unusual characteristics are often better suited to decentralized management decision-making, which may allow management to respond more quickly to changes in technology, competition, and regulation.
- Management Performance, Retention, and Rewards: Subsidiaries that compete in industries where management retention is an issue and targeted reward systems are required can benefit from an ECO.
Scenario after Equity Carve-Outs
While analyzing a sample of ECOs, researchers found important increases in sales, operating income before depreciation, total assets, and capital expenditures. However, they believe these improvements owe less to newly gained efficiencies than to the carve-out’s growth after going public. This is because the relative growth rates were not positive or statistically significant.
Note that ECOs, like spin-offs, are subject to a great deal of takeover activity. In the sample, 50% of the ECOs were acquired within three years. An analysis of returns for these companies suggests that ECOs that are taken over perform better than average, while those that are not perform worse than average. Nonetheless, even the latter outperform, on average, in other types of firms. Overall, it is clear that ECOs earn significantly positive abnormal stock returns for up to three years after the carve-out. Parents, on the other hand, earn negative stock returns.
As with spin-offs, these higher-than-normal stock returns are associated with better operating performance and corporate restructuring activity. As a restructuring device, ECOs clearly seem to lead to better operating performance (on average) and greater increases in shareholder value.
In a study of equity carve-outs by J P Morgan, it was found that carve-out firms in which the parent firm announced that a spin-off would follow at a later date, outperformed the market by 11% for a period of 18 months after the initial public offering, while carve-out firms without spin-off announcements under performed the market by 3%. Equity carve outs involve the sale of an equity interest in a subsidiary to outsiders. This sale may not necessarily leave the parent in control of the subsidiary. Post carve-out, the partially divested subsidiary is operated and managed as a separate firm.
Disadvantages of Equity Carve-Outs
The biggest disadvantage of equity carve-outs is the scope for conflict between the two companies as operation level conflict occurs because of the creation of a new group of financial stakeholders by the mangers of the carved-out company. The requirements of these stakeholders differ from those of the original stakeholders. This conflict can hinder the performance of both firms. The stock performance of a company that has carved out 70 to 100 percent is better than that of a company that has carved-out less than 70 percent. This indicates that lack of separation between the two entities prevents the carved-out entity from reaching its potential.