Introduction to Spin-Off Investing
What is a Spin-Off?
RYAN CASEY: A spin-off is a company that starts as a subsidiary of a larger parent company and comes public via a distribution of shares to the parent company shareholders. Pure spin-offs, as we define them, are cases in which that distribution is done passively, meaning that the shareholders of the parent don't have to take any action or make any election. They simply receive the distribution of shares. That distinction is important because there are other types of corporate restructurings such as carve-outs, for example, in which a portion of a subsidiary comes public via an IPO. In this case shareholders have to subscribe to the IPO at a certain price. In split-offs or share exchanges shareholders have to forfeit shares of the parent in exchange for shares of the subsidiary. Both of those types of transactions involve capital raising to the parent and a degree of price discovery that is different from what we're looking for in pure spin-offs.
Why Spin Off a Company?
SALVATOR TIANO: Spin-offs can happen for a variety of reasons. One of them is competition for capital internally. For example, a company may have projects with superior returns and thus may not allocate the appropriate capital to a specific segment. By spinning off the new company, it has independent access to equity and debt capital and can fund its own growth and projects. Another reason can be that the company is not fully understood by investors. It may have a complex structure and management may feel that the company is undervalued. By separating a segment of the company, the full value may be realized. This is an exercise that discovers and unearths the full value of the company. Another reason is that a segment of the company may be in a very different sector. For example, you can have companies in different industries or in different sectors and it might not make any sense to have them under the same umbrella; they may not deliver any synergies. In fact, there is a word called "dis-synergy" exactly for this, i.e., when it's better to have a company as a separate entity. Thus it's preferable to separate two companies and distribute the shares to shareholders.
Can Companies Offload Poor Assets?
CASEY: I think there is a perception out there among some investors that spun-off companies are not good businesses and that can be true on occasion. However, even in those instances – say, if a company has margins that are in the lower quartile or revenue growth that is slowing – there still can be significant opportunity to right-size the expense structure and create meaningful revenue growth. If you think about it, if a company has net margins of only 1%-2% and it’s able to grow that to 3%-4%, that's as much as a 200%-300% bump in earnings. The impact on share price can be significant.
Post Spin-Off M&A Activity
TIANO: Our research has shown that approximately 10% of the companies that have been spun-off have been acquired within the first five years following the spin-off for an average premium of 20%. Usually the M&A activity in spin-offs is limited within the first few years. One main reason for that is that in the U.S. there are usually certain restrictions on M&A activity for the first two years of the subsidiary's life. We also usually see increased M&A activity after year two (from years three to five). Regarding international spin-offs, every country has its own regulations; some have restrictions on M&A activity but generally we may see some more M&A activity within the first three years.
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