VideoIt was an initial public offering to make any dealmaker drool. When EMC Corp. raised $1.04 billion last August by carving out a 10 percent stake in VMware — the computer "virtualization" business that EMC had acquired just three years earlier for $625 million — it instantly created America's fourth most valuable public software outfit.
While that kind of payday is not easily duplicated, EMC's success in taking a slice of VMware public suggests that carve-outs, in which a parent sells a minority stake in an operation through an IPO or rights offering, are again gaining favor after a sluggish few years. The trend is getting a boost from slower corporate earnings growth and today's weaker merger-and-acquisition market, which make selling shares seem more attractive by comparison, says Bob Profusek, chair of the M&A practice at law firm Jones Day. "I think you are going to see a lot of these deals," he says, as Wall Street increasingly identifies corporations in which "the whole is worth less than the sum of its parts."
The benefits to both the carved-out entity and its parent are many. They include access to relatively cheap capital and the creation of a new stock — often with a higher multiple — that can be especially valuable in offering incentive to employees of the smaller company. Further, the parent may reap future tax benefits if the minority-owned subsidiary is later completely divested. (Unlike a classic spin-off, which separates a unit completely from its former owner, a carve-out or "partial spin-out" is taxable to the parent.)
Doubling the Overhead
The tax hit didn't stop many large companies from capitalizing on the selling of minority interests of units in the late 1990s. AT&T took Lucent public that way in a $2.3 billion IPO, while other carve-outs included DuPont's of Conoco, News Corp.'s of Fox Entertainment, and General Motors's of Delphi Automotive. Brick-and-mortar retailers, meanwhile, often used the technique to achieve high dotcom trading multiples for their Internet operations.
Success varied widely then, and that's still the case with today's crop. Of the dozen IPOs from carve-outs over the past 12 months, according to IPO research firm Renaissance Capital, at year-end 4 were "broken," the term for cases in which shares trade below their initial offering price. That was a little better than the results across the broader market; of last year's 234 IPOs, 45 percent were broken, according to Renaissance.
Even if stock prices boom in a carve-out, though, there can be other negatives. The task of separating two businesses may be sizable, says Al Cardilli, an analyst with Spin-Off Advisors LLC. "You're duplicating overhead," he notes. "You have two sets of financials along with the related Sarbox-compliance requirements to worry about, and you have to add the cost of compensating another executive team to run a public company."
Because so much depends on the vagaries of the stock market, adds Bingham McCutchen LLP partner John Utzschneider, co-leader of the law firm's corporate, M&A, and securities practice, "issuers have to think long and hard [about] why they're doing this kind of transaction."
Economically it might be a good time for equity carve-outs, given what could be a difficult year for raising money by peddling businesses to financial buyers, and the higher cost of debt financing for noninvestment-grade companies. But most experts discourage using a market-timing approach for such deals. "It's very shortsighted to measure the results based on stock price," says Cardilli.
Piece Plans
For EMC, selling 10 percent of VMware to the public made sense on several fronts, says EMC finance chief David Goulden. In terms of raising capital, the IPO tapped the high market value for virtualization software (which maximizes a company's investment in computer services by enabling the machines to support multiple applications). VMware's revenue growth topped 90 percent each quarter last year, compared with 20 percent for EMC. But Goulden also saw value in having separately traded VMware shares available to compensate employees and prospective engineering talent in competitive Silicon Valley. The shares, he notes, directly reflect their contribution at VMware, rather than at the Hopkinton, Massachusetts-based EMC parent.
"Not surprisingly," says Goulden, "in conjunction with the IPO VMware has been able to hire a number of high-quality engineers, plus a new CFO." VMware's finance chief is Mark Peek, a former senior vice president at Amazon.com. No executives of EMC, including Goulden and CEO Joseph Tucci, own stock in VMware.
The IPO also reinforced the perception that VMware software would remain platform-neutral — vital because VMware works with many direct EMC competitors in servers and storage.
As EMC set things up, it still owns 86 percent of VMware and 98 percent of its voting stock, giving it control over the election of directors and approval of corporate transactions. EMC also has an agreement enabling it to use VMware's source code and IP, even if EMC wants to develop competing products. Not totally unlike eating your cake and having it too.
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