Spin-Off vs. Split-Off vs. Carve-Out: An Overview
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.
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 percent of the shares in its subsidiary, or it may spin off 80 percent to its shareholders and hold a minority interest of less than 20 percent 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 percent 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 percent of the outstanding shares of Baxalta, with Baxter retaining a 19.5-percent 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.
In a split-off, shareholders in the parent company are offered shares in a subsidiary, but the catch is 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 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. In order 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 BMY common stock accepted in the exchange offer, the tendering shareholder would receive $1.11 of MJN stock, subject to an upper limit on the exchange ratio of 0.6027 MJN shares per share of BMY. 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 BMY was exchanged for 0.6313 shares of MJN).
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).
[Important: 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. In order for such a future spin-off to be tax free, it has to satisfy the 80 percent control requirement, which means that not more than 20 percent 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 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 a number of 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 component 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 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. 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.
There were a total of 19 spin-offs in 2017. Their initial market value was estimated to be $76 billion. A number of these deals involved the spin-off of a "YieldCo" (yield company) by utilities and solar energy companies. A typical YieldCo carries a portfolio of operational energy projects. Investors like such dividend-rich YieldCos because they have stable cash flows through long-term power purchase agreements, and are not exposed to other, riskier businesses of the parent company.
CNX Resources completed its spin-off of CONSOL Energy in November 2017 and began trading independently on the NYSE. The company returned 70.2 percent since spinning off from CNX as of June 2018.
On April 3, 2017, DXC Technology was spun off from Hewlett-Packard. DXC returned 39.7 percent to investors as of June 2018.
Spin-offs have generally outperformed the broad market. As of July 20, 2018, the Bloomberg U.S. Spin-Off Index gained more than 22 percent in the past year and outpaced the 13 percent gain seen by the S&P 500. The index returned 999.4 percent between its inception on December 2002 and December 31, 2017, while the S&P 500 Index returned 203.9 percent during that same period.
So how does one invest in spin-offs? There are two alternatives: invest in a spin-off exchange-traded fund (ETF) like the Invesco Spin-Off ETF—which has had average annual returns of 6.83 percent from its inception on December 15, 2006, up to December 19, 2018—or invest in a stock once it announces a divestment through a spin-off or carve-out. In a number of cases, the stock may not react positively until after the spin-off is effective, which may be a buying opportunity for an investor.
- 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 of spin-offs and carve-outs, in most cases, where a separation is being considered, such synergies may have been minimal or non-existent.
- Most spin-offs tend to perform better than the overall market and, in some cases, better than their parent companies.