Spin-Off vs. Split-Off vs. Carve-Out: An Overview
A spin-off, split-off, and carve-out are different methods a company can use to divest certain assets, a division, or a subsidiary. While the choice of a specific method by the parent company depends on a number of factors as explained below, the ultimate objective is to increase shareholder value. Here are the main reasons why companies choose to divest their holdings.
- A spin-off, split-off, and carve-out are three different methods of divestment with the same objective: to increase shareholder value.
- While there can be drawbacks to spin-offs, split-offs, and carve-outs, in most cases, where a separation is being considered, such synergies may have been minimal or non-existent.
- A spin-off distributes shares of the new subsidiary to existing shareholders.
- A split-off offers shares in the new subsidiary to shareholders but they have to choose between the subsidiary and the parent company.
- A carve-out is when a parent company sells shares in the new subsidiary through an initial public offering (IPO).
- Most spin-offs tend to perform better than the overall market and, in some cases, better than their parent companies.
In a spin-off, the parent company distributes shares of the subsidiary that is being spun-off to its existing shareholders on a pro rata basis, in the form of a special dividend. The parent company typically receives no cash consideration for the spin-off. Existing shareholders benefit by now holding shares of two separate companies after the spin-off instead of one. The spin-off is a distinct entity from the parent company and has its own management. The parent company may spin off 100% of the shares in its subsidiary, or it may spin off 80% to its shareholders and hold a minority interest of less than 20% in the subsidiary.
A spin-off in the U.S. is generally tax-free to the company and its shareholders if certain conditions defined in Internal Revenue Code 355 are met. One of the most important of these conditions is that the parent company must relinquish control of the subsidiary by distributing at least 80% of its voting and non-voting shares. Note that the term "spin-out" has the same connotation as a spin-off but is less frequently used.
In 2014, healthcare company Baxter International, Inc., spun-off its biopharmaceuticals business Baxalta Incorporated. The separation was announced in March and was completed on July 1. Baxter shareholders received one share of Baxalta for each share of Baxter common stock held. The spin-off was achieved through a special dividend of 80.5% of the outstanding shares of Baxalta, with Baxter retaining a 19.5% stake in Baxalta immediately after the distribution. Interestingly, Baxalta received a takeover offer from Shire Pharmaceuticals within weeks of its spin-off. Baxalta's management rebuffed the offer, saying it undervalued the company. The merger did eventually close in June 2016.
In a split-off, shareholders in the parent company are offered shares in a subsidiary, but the catch is that they have to choose between holding shares of the subsidiary or the parent company. A shareholder has two choices: (a) continue holding shares in the parent company or (b) exchange some or all of the shares held in the parent company for shares in the subsidiary. Because shareholders in the parent company can choose whether or not to participate in the split-off, distribution of the subsidiary shares is not pro rata as it is in the case of a spin-off.
A split-off is generally accomplished after shares of the subsidiary have earlier been sold in an initial public offering (IPO) through a carve-out. Since the subsidiary now has a certain market value, it can be used to determine the split-off's exchange ratio.
To induce parent company shareholders to exchange their shares, an investor will usually receive shares in the subsidiary that are worth a little more than the parent company shares being exchanged. For example, for $1.00 of a parent company share, the shareholder may receive $1.10 of a subsidiary share. The benefit of a split-off to the parent company is that it is akin to a stock buyback, except that stock in the subsidiary, rather than cash, is being used for the buyback. This offsets part of the share dilution that typically arises in a spin-off.
In November 2009, Bristol-Myers Squibb announced the split-off of its holdings in Mead Johnson in order to deliver additional value to its shareholders in a tax-advantaged manner. For each $1.00 of Bristol-Myers Squibb's common stock accepted in the exchange offer, the tendering shareholder would receive $1.11 of Mead Johnson stock, subject to an upper limit on the exchange ratio of 0.6027 Mead Johnson shares per share of Bristol-Myers Squibb. Bristol-Myers owned 170 million Mead Johnson shares and accepted just over 269 million of its shares in exchange, so the exchange ratio was 0.6313 (i.e., one share of Bristol-Myers Squibb was exchanged for 0.6313 shares of Mead Johnson).
In a carve-out, the parent company sells some or all of the shares in its subsidiary to the public through an initial public offering (IPO).
Unlike a spin-off, the parent company generally receives a cash inflow through a carve-out.
Since shares are sold to the public, a carve-out also establishes a net set of shareholders in the subsidiary. A carve-out often precedes the full spin-off of the subsidiary to the parent company's shareholders. For such a future spin-off to be tax-free, it has to satisfy the 80% control requirement, which means that no more than 20% of the subsidiary's stock can be offered in an IPO.
When two companies merge, or one is acquired by the other, the reasons cited for such mergers and acquisitions (M&A) activity are often the same, such as a strategic fit, synergies, or economies of scale. Extending that logic, when a company willingly splits off part of its operations into a separate entity, it should follow that the reverse would be true, that synergies and economies of scale should diminish or disappear. But that's not necessarily the case since there are several compelling reasons for a company to consider slimming down as opposed to bulking up through a merger or acquisition.
- Evolving into "pure play" businesses: Splitting up a company into two or more parts enables each to become a pure play (a publicly-traded company focused on only one industry or product) in a different sector. This will enable each distinct business to be valued more efficiently and typically at a premium valuation, compared with a hodgepodge of businesses that would generally be valued at a discount (known as the conglomerate discount), thereby unlocking shareholder value. The sum of the parts is usually greater than the whole in such cases.
- Efficient allocation of capital: Splitting up enables a more efficient allocation of capital to the component businesses within a company. This is especially useful when different business units within a company have varying capital needs. One size does not fit all when it comes to capital requirements.
- Greater focus: Separation of a company into two or more businesses will enable each one to focus on its own game plan, without the company's executives having to spread themselves thin in trying to grapple with the unique challenges posed by distinct business units. A greater focus may translate into better financial results and improved profitability.
- Strategic imperatives: A company may choose to divest its "crown jewels," a coveted division or asset base, in order to reduce its appeal to a buyer. This is likely to be the case if the company is not large enough to fend off motivated buyers on its own. Another reason for divestment may be to skirt potential antitrust issues, especially in the case of serial acquirers who have cobbled together a business unit with an unduly large share of the market for certain products or services.
Another drawback is that both the parent company and the spun-off subsidiary may be more vulnerable as takeover targets for friendly and hostile bidders because of their smaller size and pure-play status. But the generally positive reaction from Wall Street to announcements of spin-offs and carve-outs shows that the benefits typically outweigh the drawbacks.
How to Invest in Spin-Offs
Most spin-offs tend to perform better than the overall market and, in some cases, better than their parent companies.
So how does one invest in spin-offs? There are two choices: invest in a spin-off exchange traded fund (ETF) like the Invesco S&P Spin-Off ETF or invest in a stock once it announces a divestment through a spin-off or carve-out. In some cases, the stock may not react positively until after the spin-off is effective, which may be a buying opportunity for an investor.