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1. - - - - - - - - Chapter 12- - - - - - - - Restructuring Organization and Ownership Relationships ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1

2. Spin-Offs • Company owns or creates a subsidiary whose shares are distributed on a pro rata basis to shareholders of parent company • Subsidiary becomes publicly owned corporation ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 2

3. Parent company often will retain from 10% to under 20% of shares of the new subsidiary • Spin-off often follows the initial sale of up to 20% of the shares in an initial public offering (IPO) — transaction known as an equity carve-out ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 3

4. Event return studies of spin-offs • Significant positive 3-5% abnormal return to parent shareholders • Size of announcement effect positively related to size of spin-off • Spin-offs to avoid regulation experienced abnormal returns of 5-6% as compared to 2-3% for the remainder of the sample • No adverse effect on bondholders ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 4

5. Tax effects • No positive abnormal returns for taxable spin-offs • Positive abnormal returns for nontaxable • Controlling for size, tax effects disappear • Both spin-offs and their parents are more frequently involved in subsequent takeovers • Firms which engage in no further restructuring activity earn only normal returns • Firms which engage in subsequent takeovers account for positive abnormal returns ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 5

6. Performance studies of spin-offs • Bregman • Annualized returns were 31.8%, 18 points better than S&P 500 • Karen and Eric Wruck • Spin-offs outperformed overall stock market • Few spectacular performances dominated results • Forbes study • Combined stock performance of parent and spin-off • 40% did better than S&P 500 • 60% underperformed ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 6

7. Anslinger, Klepper, and Subramaniam (1999) • Sample of 12 spin-offs achieved returns over a two-year period of 26.9% compared to 17.2% for the S&P 500 • 8 spin-offs underpeformed index • Mixed results may reflect characteristics of industries • Firms in industries with excess capacity or low sales growth underperform broader indexes • Results should be related to industry peers ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 7

8. Tax aspects of spin-offs • Spin-off qualify for tax-exempt status if parent company own 80% of voting subsidiary stock • Spin-off transactions • Companies spin off with two classes of stock • Parent sells nonvoting class of stock in public offering and then spins off voting stock tax free • Parent can do an equity carve-out of 20% of the voting stock, spin off remainder and entire spin-off transaction is tax free ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 8

9. Companies create new subsidiary • Parent company creates subsidiary • Subsidiary has two classes of shares: Class A non-voting, Class B voting • Parent company owns all B shares • Parent company distribute A shares to its shareholders • Parent company may have option to buy back proportion of subsidiary's stock it does not now own • Parent company is not required to buy back shares or to put more money into subsidiary • Creation of subsidiary allows parent to separate risk of subsidiary business from its core operations — shareholders decide whether to increase or decrease their own risk ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 9

10. Equity Carve-Outs • Equity carve-out is an IPO of some portion of the common stock of a wholly owned subsidiary • Also referred as "split-off IPOs" • Resembles seasoned equity offering of the parent in that cash is received from a public sale of equity ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 10

11. Other changes when subsidiary equity is "carved out" • IPO of common stock of subsidiary initiates public trading in a new and distinct set of equity claims on assets of subsidiary • Management system for operating the assets is likely to be restructured • Public market value for operations of subsidiary becomes established • Financial reports are issued on the subsidiary operations ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 11

12. Equity carve-outs can be used by a firm to raise equity funds directly related to the operation of a particular segment or industry • Equity carve-outs also used as first step in spin-off and split-ups ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 12

13. Comparison to spin-off • Similar to voluntary spin-off in that it results in subsidiary's equity claims traded separately from the equity claims on the parent entity • Differences • In spin-off a distribution is made pro rata to shareholders of parent firm as dividend; in equity-carve-out, stock of subsidiary is sold in public markets for cash which is received by parent • In spin-off, parent firm no longer has control over subsidiary assets; in carve-out, parent generally sells only minority interest in subsidiary and maintains control over subsidiary assets and operations ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 13

14. Comparison to divestitures • Similar in that cash is received • Differences • Divestiture is usually to another company • Control over assets sold is relinquished by parent-seller and trading of subsidiary is not initiated ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 14

15. Transaction examples • GM-Delphi • In August 1998, the GM board of directors voted to separate Delphi from GM • In February 1999, Delphi completed its IPO of 100,000,000 shares of common (17.7% equity carve-out) while GM held remaining 465,000,000 (82.3%) of Delphi's outstanding stock • In April 1999, board of directors approved spin-off of 452,565,000 of GM's Delphi shares through a dividend of 0.7 shares of Delphi for one share of GM common stock • Remaining 12,435,000 of GM's shares were contributed to the General Motors Welfare Benefit Trust • Delphi became a fully independent, publicly traded company (split-up) after the spin-off ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 15

16. DuPont-Conoco • DuPont bought Conoco in 1981 • On May 12, 1998, DuPont announced it would divest itself of 20% of its Conoco oil subsidiary and subsequently spin-off remainder • In initial IPO, DuPont sold 150 million A shares which carried one vote • Spin-off of remainder of Conoco was accomplished by a share exchange in which for each share of DuPont stock, holder could receive 2.95 shares of class B stock of Conoco • Class B stock was identical to class A stock except that each share carried 5 votes • GM paid Delphi's shares as a dividend; to obtain Conoco shares, DuPont shareholders had to exchange their DuPont shares • Share exchange method allowed DuPont's shareholders to choose whether they wanted to invest in the chemical industry versus petroleum industry ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 16

17. Carve-out event returns • Market reaction not easily predictable since equity carve-outs have characteristics in common with spin-offs, divestitures, and seasoned equity issues • Spin-offs — abnormal returns to parent firm of 2- 3% on average • Divestitures — gains to selling firm of 1-2% on average • Seasoned equity issues — negative residuals of 2-3% on announcement • Event returns +2 - +5% ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 17

18. Performance studies of carve-outs • Vijh (1999) • Compared performance of carve-outs to several benchmarks — carve-outs did not underperform benchmarks • Carve-outs earned an annual raw return of 14.3% during first three years — contrast to poor performance of IPOs which have annual return of 3.4% • Average initial listing-day returns for carve-outs of 6.2%, with median of 2.5% — much smaller than 15.4% for IPOs ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 18

19. Possible performance explanations • Parent firms tend to be relatively unfocused — carve-outs are an opportunity to improve focus • Subsidiaries gain partial freedom to pursue own activities • Allen (1998) • Examined performance of equity carve-outs at Thermo Electron • Thermo Electron has performed well since program implementation • $100 invested in firm in 1983 would have appreciated to $1,667 by end of 1995 • Contrast to industry index which grew to $524, and S&P 500 which grew to $381 ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 19

20. Tracking Stock • Tracking stocks are separate classes of common stock of parent corporation • First issued in 1984 by GM in connection with its acquisition of EDS • Also known as letter stock, targeted stock, and designer stocks ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 20

21. Company's business operations are split into two or more common equity claims, but businesses remain as wholly owned segments of single parent • Each tracking stock is regarded as common stock of consolidated company and not of subsidiary • Tracking stock company is usually assigned its own distinctive name ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 21

22. Tracking stock trades separately from parent company so that dividends paid to shareholders can be based on cash flows of tracking company alone • Compensation of tracking company's managers can be based on financial results and stock price of tracking stock • 80% of firms issuing tracking stocks use a dividend process but some firms use the issuance of tracking stock as a source of cash ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 22

23. Comparison to dual-class stock and spin-offs • Dual-class stocks • In dual-class stocks, class A generally has one vote per share versus five or more per share for class B, but class A has higher allocations of dividends • Tracking stock has same voting rights as shareholders who hold stock in parent ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 23

24. Spin-off • Similar to spin-off in that financial results of parent and subsidiary are reported separately • Different in that spin-off is a separate entity with its own board of directors and shareholders who can vote for board of their separate company but not for the parent • In spin-off, initial assignment of assets and other relationships are defined, thereafter they are independent entities • In tracking stock, board of parent continues to control activities of tracking segment ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 24

25. Benefits and limitations • Benefits • Tax-free issuance • Financial markets can value different businesses based on their own performance • Analysts' coverage likely to be improved • Stock-based management incentive programs can be related to each tracking business unit • Investors are provided with quasi-pure play opportunities • Increase flexibility in raising equity capital • Provides alternative types of acquisition currency ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 25

26. Limitations • Tracking stock subsidiary is generally subject to will of parent • Potential conflict of interest over cost allocations or other internal transfer transactions • Tracking stock subsidiary may command less takeover interest because of blurred relationship with parent ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 26

27. Price performance • Main determinant is economic characteristics of businesses in which tracking stock subsidiary have been established • Combined parent/tracking stock performance has been, with exceptions, superior to performance of their peer groups ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 27

28. Split-Ups • Companies split into two or more parts • Accomplished usually by initial carve-outs, followed by spin-offs of individual parts ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 28

29. Examples • Hewlett-Packard and Agilent • Bring more focus • Avoid overlap of capabilities • AT&T restructuring • Avoid conflicts from AT&T’s role as supplier and competitor in long distance business • Improve valuation multiples for core business • ITT Corp • Attempt to improve share price • Separate poor performers • Resulted in takeover ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 29

30. Rationale for Gains to Sell-Offs and Split-Ups • Information • Subsidiary true value hidden • Preference for pure-play (single-industry) securities • Increased availability of information ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 30

31. Managerial efficiency • Management's inability to manage complex organizations • Sell-offs sharpen focus, get rid of poor fit subsidiaries, eliminate negative synergy ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 31

32. Management incentives • Bureaucracy and consolidation of financial statements stifle entrepreneurial spirit — hide good (bad) performance • Conflict of objectives between parent and subsidiary • Tie compensation directly to subsidiary performance ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 32

33. Tax and/or regulatory factors • Subsample of spin-offs citing tax benefits have higher abnormal returns • Tax motives — subsidiaries can take forms that shelter income • Regulatory motives — spin-offs can free parent from regulatory scrutiny ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 33

34. Bondholder expropriation • Spin-off reduces bondholder collateral • Unsupported by evidence • Bondholders can anticipate spin-offs and write protective covenants • Subsidiaries have their own debt or take on a pro rata share of parent debt • Bondholders may benefit if junior debt of parent becomes senior debt of subsidiary • No evidence of bond price or ratings decline at spin-off announcements ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 34

35. Changing economic environment • Major shifts in economic environment alter parent and subsidiary opportunity sets such that separate operations become optimal • Avoiding conflicts with customers • Spin-off can deal more effectively with customers • Spin-off can avoid conflict if customer is a competitor of parent firm ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 35

36. Provide investors with pure winners • Separate segments that lower valuation multiple on overall company • Option creation • Common stock is an option on underlying technology of firm • Spin-off creates two options on same assets, therefore more value ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 36

37. Increase market spanning • Expanded opportunity sets to appeal to different investor clienteles • Improve completeness of markets — increased number of securities for given number of possible states of the world • Enable more focused mergers • Facilitate more focused mergers where bidder is interested in only a subset of target assets ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 37

38. The Choice of Restructuring Methods • Spin-offs • Parent's potential position to create value through skills, systems, or synergies is weak • Parents and subsidiaries have conflicts of interest ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 38

39. Equity carve-outs • Firms can easily separate subsidiaries • Bring added attention to subsidiaries with high margins and growth • Provide capital for acquisitions or other investments • Allow division managers to take primary responsibility for financing and investment decisions ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 39

40. Subsidiaries may have better access to capital • Take advantage of parent's debt rating • Seek funding from capital markets instead of overstating budgeting needs to parent • Fund projects that otherwise would depress parent's earnings ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 40

41. Tracking stocks • Provide capital for acquisition or other investment programs • Bring attention to subsidiaries with high growth or margins • Subsidiaries can take advantage of capital structure of parent • Reduce taxes — net operating losses of parent or subsidiary can be used to reduce overall corporate taxes • Useful for firms with divisions that share significant synergies so full separation not desirable ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 41

42. Limitations • Parent still controls • Potential conflicts of interest with parent • Value depends on its performance ©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 42