Spinoffs are increasingly used for creating shareholder value as companies more frequently examine their portfolios and sharpen the focus on their core businesses and assets.
These transactions, which involve separating an existing company’s businesses through the creation of one or more separate companies, remain a lesser-used tool for shedding assets than a straight sale. They are also one of the least-understood M&A transactions.
Still, company leadership is becoming more comfortable with the spinoff as a strategic tool, and with good reason. Companies that were separated through a spinoff generally outperformed the market from 2002-2017. That was true of both the spun-off entity (SpinCo) and what remained of the original company (RemainCo).
Additionally, a spinoff can often be accomplished at a reduced tax cost to the existing company and its shareholders when compared with a direct sale of the assets/business. The chart below shows the total combined shareholder return two years after spinoffs for SpinCos and RemainCos over the same 15-year period.
Spinoffs are not always successful, though. Poor planning ahead of the spinoff and a too-narrow focus on near-term results and market reaction can doom the long-term prospects for separated companies.
So, what are the characteristics of successful spins? What steps will help companies succeed in creating long-term value?
Start by creating the right strategic case. The first step is identifying the appropriate assets to spin off and the right time to do it. The rationale for the spinoff needs to be clearly articulated to the markets.
It could be enhancing focus as businesses reach different stages of maturity; creating a business-appropriate capital structure; or creating a distinct investment profile for both RemainCo and SpinCo. A well-defined strategic case can increase investor confidence when the spinoff is announced.
However, even the best business case only goes so far. An initial-announcement stock “pop” when investors react favorably to the planned spinoff is not correlated with sustainable total shareholder value return. That value comes from having a well-developed long-term plan and executing on it.
Creating Total Shareholder Value
Once management and the board are in agreement on the strategic case, six key steps companies should take to enhance the probability the spinoff will be successful are:
1. Identify the right leadership mix. In EY’s sample of 124 global spin-off transactions from 2002 to 2017, most SpinCos that did well — delivering a total shareholder return one year after the spin that is higher than the parent company’s TSR in the same period before the spin — named a candidate from the parent company as either CEO or CFO or both.
Those SpinCos that hired both from outside were less likely to be successful. It’s not unusual to bring in an outsider for one of the positions when looking for new ideas or an executive with a specific skill set, but our research suggests that at least one of the two executives should have internal familiarity with the company that is being spun off.
2. Get the operating model right. There is a big difference between being a separate public company and being part of a larger entity. SpinCo should be ready to operate as a stand-alone entity before the spin is effective.
But how should the operating model change to support the spin? Businesses in lower-growth industries can work on managing cash and streamlining operations to reduce costs. Businesses in higher-growth industries will need more management attention and an operating model to maximize their potential.
Management also needs to question whether the legacy assets are fit for the spinoff’s purpose. For example, ERP and other IT systems and applications used by the parent may not be appropriate for SpinCo; more streamlined systems and applications may be required.
Another question to ask: Is there a case to be made to redesign the supply chain to distribute the products or rethink the go-to-market model? It may not make economic sense to operate in certain countries once the spin becomes effective.
3. Devise a short- and long-term tax strategy. Any spinoff has potential tax implications. As companies develop their operating model, they should also think in terms of (a) the tax implications for the spinoff transaction itself (e.g., will it be taxable or tax-free); and (b) what will create a tax-efficient operating model for both SpinCo and RemainCo going forward.
For example, in order to make the spinoff tax free, the tax-structuring team might want to assign different operations to entities in one country. If the operations group decides separately to divest or move those operations to a different country, it could cause the spinoff transaction to be taxable in the initial country or to the shareholders.
Further, it could shift operations from a low-tax jurisdiction to a higher-tax jurisdiction, increasing the operating cash effective tax rate. Hence, a company needs to understand the tax implications of its operating model design and changes.
4. Prepare people for change. Make sure to have a stakeholder communication plan with clear messages about the rationale for the spinoff, the timeline, and the expected shareholder value creation for staff, management, customers, and suppliers, as well as investors and the market in general. Communicate objectives clearly, set targets, and delegate and monitor progress.
That means making sure the right people are cleared to make timely decisions for both SpinCo and RemainCo. Also, establish the proper incentives to retain and motivate the management and staff that management wants to keep. The needs of the new company may be different from those of the legacy company, so legacy incentives will likely need to be changed.
5. Focus on the new identity. While management tends to focus on shorter-term operational issues, the long-term success for any spinoff is predicated on the growth case for both SpinCo and RemainCo. This is an opportunity for SpinCo to set its market goals and identity, unfettered by the former parent’s go-to-market strategies.
Carefully plan out opportunities to grow the business, whether that means new products, increased R&D spending, new markets, new customers, or even acquisitions. The spinoff may also present an opportunity for RemainCo to deploy resources in its own search for growth. After all, part of the reason for the spinoff was to focus management on growing the core business.
6. Act with deliberate speed. EY also examined a subset of 54 larger global deals and found correlations between the spin timeline and shareholder returns. Successful spins that generated positive TSRs had a window of 7 to 16 months from announcement to spin. Spins that generated negative TSRs for SpinCo and RemainCo combined tended to take longer, up to 28 months.
Once the decision to spin is announced, companies should develop a timeline to accomplish the various pre-spin tasks, such as defining an operating model, planning the tax structure, preparing carve-out financials, and identifying market participation model. Then stick to that timeline.
The longer the wait, the more time for something internal or external to affect the performance and success of the company to be spun off. Furthermore, investors may run out of patience if companies take too long getting ready to spin.
A spinoff can be an optimal choice to increase shareholder value, giving investors a pure play in both the new and remaining company and letting each business focus on what it does best in its chosen markets. However, the process of completing a spinoff is complex and requires consideration of a myriad of legal, financial, tax, operating, people, capital markets and other issues.
Executives can efficiently navigate this process by understanding the operational challenges and through appropriate planning to allow the right amount of lead time and resources needed for the separation.
This planning and preparation will help companies execute the spinoff in a timely manner, achieving the short- and long-term objectives for both SpinCo and RemainCo.
Tze-Liang Chiam is principal, Americas operational transaction services, Ernst & Young LLP. Lasida Klinsukond is manager, operational transaction services, EY Americas.