Case Study International Management 2006 "Spin-Off"

Contents

1. Introduction
1.1 Introduction
1.2 Progress of Examination

2. Definition of Spin-off
2.1 Consideration of the different forms of relocation according to the German UmwG
2.1.1. Split-up (Aufspaltung)
2.1.2. Spin-off (Abspaltung)
2.1.3. Outsourcing (Ausgliederung)
2.2 Definition of the term “spin-off” for this paper
2.3 Segregation of other types of relocation
2.3.1. Equity Carve-out
2.3.2. Buy-out
2.3.3. Outsourcing

3. Reasons for Spin-offs
3.1 Incubator’s point of view
3.2 Spin-off’s point of view
3.3 Investor’s point of view
3.4 Regulatory reasons

4. Prerequisites for a spin-off
4.1 Structural and Operational Prerequisites
4.2 Consent of Shareholders
4.3 Communication
4.4 Capital Market Transaction

5. Increasing Value by spin-offs
5.1 Can Value be increased by Realization of a Spin-off
5.2 Explanations of Value Enhancement
5.2.1. Capital Market Improvements
5.2.1.1. Undervaluation of the Subsidiary inside the Conglomerate
5.2.1.2. Attracting new Investors
5.2.2. Improvements in Organization
5.2.2.1. Principal-Agent Theory
5.2.2.2. Transaction-Cost Theory
5.2.2.3. Property Rights Theory
5.2.2.4. Investment Allocation

6. Critical Examination
6.1 Potential Decrease in Bond Value
6.2 Inflow of Cash at the Parent Company
6.3 Insider Information
6.4 Allocation Efficiency at the Parent Company

7. Practical Example
7.1 Company History of Bayer
7.2 Reasons for Bayer to separate Lanxess
7.3 Reasons for Lanxess to be separated from Bayer
7.4 Spin-off Details
7.5 Current Situation of Bayer and Lanxess
7.5.1. Current Situation of Bayer
7.5.2. Current Situation of Lanxess
7.6 Market Reaction

8. Conclusion

References

Figures

Fig. 1: Company before and after a spin-off p

Fig. 2: Illustration of an equity carve-out p

Fig. 3: After the equity carve-out p

Fig. 4: Illustration of a Buy-Out p

Fig. 5: Categories of shareholders p

Fig. 6: Earnings Development Bayer p

Fig. 7: Groups and Countries of Investors p

Fig. 8: Earnings Development Lanxess p

Fig. 9: Chart of Lanxess vs. MDAX p

Fig. 10: Chart of Bayer vs. DAX p.

1. Introduction

1.1 Introduction

During upswing or boom phases, companies tend to diversify their products and services either by acquisitions or by the foundation of subsidiaries active in different businesses^[1]. As the market situation or the overall economic situations change, companies have to adapt their strategy and structure to the current market.

If there are changes in the general market situation, e.g. by the entry of new competitors, companies might need to restructure to be able to compete^[2]. In times of economic downturns, most companies need to restructure^[3] due to economic problems and high in-house costs, caused by high complexity and low transparency within the company.

Moreover, there seems to be a change in paradigms in the market. Whereas in the 60’s (in the US) conglomerates were a prominent way to increase the company value^[4], the current market pays no premium for being a large company^[5]. Since the 80’s in the US and the late 90’s in Western Europe, shareholder value rather is increased by a focused approach on core markets and selling or spinning-off the side-businesses^[6].

Major spin-offs were conducted in Western Europe during the recent years, e.g. the spin-off of Infineon from Siemens in 1999 which was followed by a listing of Infineon at the Frankfurt Stock Exchange in 2000, the spin-off of Hypo Real Estate from HypoVereinsbank in 2003, freeing the HypoVereinsbank from their difficult real estate financing business and, against the odds, lead to a successful performance of Hypo Real Estate at the Stock Market^[7] or the spin-off of Lanxess from Bayer in 2005.

Looking at the current development of the capital market, European conglomerates seem all to work on their restructuring and on their focus on a certain area^[8]. Recently announced or publicly evaluated transactions include e.g. MAN selling the majority of its printing machine division to Allianz Capital Partners, Linde evaluating the sale of their fork-lift division^[9], Electrolux envisaging the spin-off and listing of their outdoor division in the company „Husqvarna”^[10], to which shareholders consented in April 2006. In the course of this paper, we will evaluate the motives and value drivers of a spin-off with view on the parent company, the spin-off and the capital market including investors and bondholders.

1.2 Progress of Examination

We will start our examination with a definition of the term “spin-off” and point out the differences to similar transactions.

After that, we evaluate the motives for spin-offs from the point of view of the parent company, the subsidiary and the investors. We go on showing the prerequisites for a spin off. After that, we detail the potential reasons for the empirically evident value generation of spin-offs on the capital market and the improved performance of parent and subsidiary at the stock market after a spin-off. After that, we come to critical examination of the transaction “spin-off”. Following, we detail a practical example of a spin-off with a summary of the Lanxess spin-off from Bayer in 2005.

We finish our paper with a final conclusion.

2. Definition of Spin-off

2.1 Consideration of the different Forms of Relocation according to the German UmwG

2.1.1. Split-up (Aufspaltung)

If a^[11] company is split up, it does not exist any longer in the form of organisation as before.^[12] The whole assets of the split-up company will be divided and transferred to at least two new or already existing companies. By this transfer, the split-up company expires.^[13] As a general rule, the owners of the split-up company remain also the owners of the newby created or receiving companies. As compensation for losing the shares of the original company, the shareholders receive shares of the new companies.

2.1.2. Spin-off (Abspaltung)

In contrast to a split-up, a spin-off describes the transfer only of a part of the assets of a company to an already existing or newby created company.^[14]

Another difference between these two types of relocation is, that the original company will not expire after the transfer. In most cases, a capital decrease will occur in the origin company. This circumstance makes it essential, that the assets of the subsidiary are divided to the shareholders of the parent company, as in case of the split-up. However, not in any case the assets have to be distributed in the same ratio as the ones of the parent company. Thereby, the ownership structure can be reassigned.^[15]

2.1.3. Outsourcing (Ausgliederung)

Outsourcing is similar to a spin-off. The major difference is in the transfer of the assets of the subsidiary company. In case of outsourcing, the assets of the subsidiary are not distributed to the shareholders of the parent company, but to the parent company itself.^[16] In case of outsourcing, the ownership structure of the parent company remains unchanged, as it is merely a restructuring of the assets.

The real assets that have been sourced out are replaced by the shares of the new company. Therefore, a capital decrease will not occur in the parent company.

2.2 Usage of the term “spin-off“ in the economic literature

In the literature of economic science, a lot of definitions for the term “spin-off” can be found. Classical, mainly described in the Anglo-Saxon literature, a spin-off is the disentanglement of a part of a company and the pro-rata distribution of the shares of the spin-off to the shareholders of the parent company on the basis of a property dividend.

“A spin-off occurs when a firm distributes to its existing shareholders all of the common stock it owns in a controlled subsidiary, thereby creating a separate publicly-traded company.”^[17]

In part of the literature, remarkable differences in the definitions can be found. By some authors, the criteria of a spin-off are widened: Some sources define any demerger as a spin-off, as long as a new company is founded, which is judicially and commercially independent from its parent company. The distribution of the shares of the subsidiary to the shareholders of the parent company is not considered in these cases. However, there are also definitions, which define a spin-off in a much wider way. The authors in these cases name a spin-off the divestiture of a unit of a company however it is done.^[18]

On the other hand, there exists a dissension in using similar terms. The terms „Split-up“ „Equity Carve-out“ and MBO resp. LBO are often used synonymous, resp. the term „spin-off“ is used as topic for the different forms of demergers.

“A spin-off (or split-up) is a new, independent company created by detaching part of a parent company´s assets and operations. Shares in the new company are distributed to the parent company´s stockholders.”^[19]

This quotation for example uses two terms synonymously, that describe two very different procedures. As in case of a split-up, the parent company is splitted up to at least two subsidiary companies and will not continue after the transaction. This procedure describes as per §123 Abs. 1 UmwG a split-up of the company, but not a spin-off, in which the parent company still exists after the process.

2.3 Definition of the Term „Spin-off” for this Paper

In this elaboration we define a spin-off in the classical way, which is a pro-rata distribution of shares of a firm’s subsidiary to the shareholders of the firm on a basis of a property dividend.^[20]

illustration not visible in this excerpt

fig.1: Company before and after a spin-off
source: according to Charifzadeh, M. (2002), p. 97

2.4 Segregation of other Types of Relocation

2.4.1. Equity Carve-out

In case of an equity carve-out, exactly as in case of a spin-off, part of the equity of a parent company is divested.^[21] In difference to a spin-off, the shares are not pro-rata distributed to the shareholders of the parent-company, but are sold at the stock-market within an Initial Public Offering^[22], or sold to another company, for instance to a private equity firm. An equity carve-out can appear in two different ways. On the one hand as a primary carve-out. In this case, a recapitalisation will be carried out and the revenues fall to to the subsidiary company.

On the other hand the secondary carve-out. During the secondary carve-out no increase in capital will occur, but the shares that are sold, derive from the property of the parent firm. The equity carve-out is characterised by the fact, that the parent firm has, after the transaction, still a dominating influence within the divested unit. This means, that the stake of the parent company exceeds 50 percent after the carve-out.^[23] This is also the only difference between the equity carve-out and the subsidiary IPO. The two forms of separation are exactly the same, but in case of the subsidiary IPO, the majority participation is held by the shareholders, resp. the investor. The stake of the parent company falls below 50 percent. Asset sales like equity carve-outs are mostly motivated by liquidity constraints, since a seller receives cash in it.^[24] This is also one of the most important differences between spin-offs and equity carve-outs resp. subsidiary IPOs, as a spin-off does not involve exchange of any cash. Beside the fact, that a spin-off is not motivated by the company’s desire to generate immediate cash, there is one more important difference between these forms of divesting. While the initiative for a spin-off can be taken by the parent company, the spin-off or of both together, the initiative for a carve-out or a subsidiary IPO is in nearly all cases taken by the parent company alone. This is due to the financing aspect as named above. The parent company decides to sell a part of its real assets to get liquidity. Often there are no other reasons for selling, unlike in case of spin-offs, that can be driven by several motives, as we will see later on.

illustration not visible in this excerpt

fig.2: Illustration of an equity carve-out

source: according to Charifzadeh, M. (2002), p. 95

illustration not visible in this excerpt

fig.3: After the equity carve-out

source: according to Charifzadeh, M. (2002), p. 95

2.4.2. Buy-out

The term „Buy-Out“ is used for the acquisition of a part of a company or a whole company itself by new owners.^[25] It can be differentiated between the Management Buy Out (MBO) and Leveraged Buy Out (LBO). In practice, it is often critical to differentiate between these two forms of buy out. This is due to the fact, that the two forms are often combined with each other. The following consideration is going to clearify this. At first, the classical definitions of MBO and LBO are shown, followed by a short analysis, why the two forms are often combined in practice.

MBO describes a transaction, in which a company or a unit of it is overtaken by the management that worked so far in that firm. Through this, the management is not longer acting as an employee, but is free to act independently, gets self-employed. The classical definition of a Management Buy Out says that the purchase price has to be in a large part self-financed by the management.^[26]

In case of a Leveraged Buy Out, the company, or a part of it, is overtaken by a private equity investor or a holding company. Characteristical for a LBO is, that the financing is predominantly done by debt capital, to get a return on equity, that is as high as possible. (leverage-effect).^[27]

As mentioned above, in practice, it is often a problem to differentiate between these two forms of buy out. This is due to the fact, that the most MBOs are financed with the aid of private equity investors, because the management is not in the position to finance the transaction by itself. So in a wider way, a buy out can be defined as MBO, if the management holds an essential part of the voting capital.^[28] If this is not the case, the transaction can be defined as LBO. Because of this lack of clearness, some authors also use the terms “Leveraged MBO” and “Management LBO”.^[29]

Summing up: Characteristic for a Management Buy Out is, that the management is involved in the new company. In case of a Leveraged Buy Out, the involvement of the management is possible, but not stringently essential.

illustration not visible in this excerpt

fig.4: Illustration of a Buy-Out

source: Stahl, G., Wiehle, U., Diegelmann, M., Deter, H. (2005), p. 41

2.4.3. Outsourcing

The idea of outsourcing describes the removal of a division of an enterprise. Business activities are devolved from one company to another, mostly to an external service provider. The word „outsourcing“ is composed out of the words „outside“, „resource“ and „using“. The causes of an outsourcing are mostly mentioned as reduction of costs and the concentration on core competencies. These causes behave interactive to each other, as through the higher grade of concentration on core competencies the effectiveness and flexibility of the company shall be enhanced.^[30] Especially in times of an economic downturn, outsourcing is used to reduce capacities.^[31] In case of outsourcing, the company makes a “make-or-buy” decision. Two forms of outsourcing can be differentiated. The differentiation can be done in consideration of the grade of internal or external resources, which are used.^[32] As a general rule, the company, that is chosen to cover the business in the future, is specialised on that job and is assigned, to fulfil it long-lasting and independent.^[33] This form of outsourcing is named external outsourcing, because the service provision is dislocated to an external service provider. This also corresponds to the classical definition of outsourcing. In this classical case, the difference to a spin-off is evident, because no new company is founded nor is a part of the equity divested, but solely a part of the creation of value is dislocated to an external service provider.

Another alternative is the internal outsourcing. In this case, a new company structure is established. On the one hand, this can be a new founded structure, but it is also possible, that it has already existed as unit within the outsourcing company. The idea of internal outsourcing is, not only to transfer part of the creation of value, but also part of the assets of the parent company. If a judicial independent company is founded, this form of outsourcing can be named a divestion. Which form of demerger is used, depends on the respective situation. But it can absolutely be done by a spin-off.^[34]

Summing up: Internal outsourcing may lead to a spin-off, but also other forms of demegers may be considered to source out the business.

As external outsourcing is only a business relocation and internal outsourcing not a type of segregation by its own, but a dislocation of an operational device, that can be carried out by a spin-off or another form of dislocation, we resign to add an own figure.

3. Reasons for Spin-off’s

3.1 Incubator’s Point of View

Diversification in fields not connected to the core business leads to high complexity within the company regarding the structure as well as regarding the focus^[35].

Large conglomerates are often reacting slow to changes in the market, compared to smaller companies, due to high organisation levels and hierarchy structures, which slow down the in-house communication and the decision making process.

Furthermore, some units within in the company may not operate profitable or bear a comparatively high risk, which lessens the performance and valuation of the overall company.

By restructuring, the company plans to achieve an improvement of its performance, due to an improved focus and connected with that, increased transparency, improved operational figures and/ or risk-structure. The units to be spun-off are mostly chosen, according to statements of the management, due to their focus, which is not matching the overall strategy anymore, but this is mostly connected with an unsatisfactory performance of the subsidiary^[36].

In addition to the performance, the risk within a certain operating unit is another key motive for a spin-off. By spinning-off a volatile business part, e.g. the envisaged spin-off of Infineon’s DRAM-business^[37], the parent company may source out the risk (to its shareholders, which will directly hold a stake in the spin-off company) and will have a lower volatility concerning its revenue and profit projections. Through the reduced in-house risk and more reliable predictions for the future, the parent company estimates to increase its attractiveness to investors^[38].

A large part of the units which are to be spun-off were formerly acquired and not build by the company itself^[39]. High prices for the acquisition, lower synergies than expected and high costs in the integration process due to different company structures result in a negative impact on the parent company^[40]. By a spin-off, the parent company is able to correct potential acquisition mistakes in a comparatively easy way^[41].

Thus, restructuring the parent company to improve the structure, focus, operating performance and/ or risk structure are the main reasons for a spin-off^[42].

The former conglomerate might have been undervalued, due to operating and transparency reasons named above as well as the view of outside investors, that they would be able to do a more efficient risk allocation in their portfolio than the company^[43].

A comparatively low valuation to the market leads to problems in external growth strategies, e.g. M&A or capital increases as the company will not be able to pursue acquisitions or raise capital at a fair valuation. Moreover, it might more easily be acquired by another company, if its valuation is below the market.

By a separate valuation of parent company and subsidiary and taking into account the improvement in focus, structure and transparency, the parent company might be able to get a more “fair” valuation of its equity^[44]. This might lead to the easier execution at a fair valuation of a capital increase at the mother company after the spin-off^[45].

A spin-off may also be used a defending strategy – undervalued parts of the company which might have been acquired at a low price in the course of the acquisition of the whole company could be spun-off. This might reduce the interest of the buyer in the company; respectively direct the interest to the subsidiary^[46]. Through the release of hidden values in the spin-off and the independent listing on the Stock Market, the spin-off will is enabled to find its own, fair valuation^[47].

Moreover, by the reduction of side-businesses, the parent company reduces its structural complexity and is more transparent for the investor^[48].

After the separation, the respective share prices of each unit are linked closer to the respective activity than in a conglomerate. This may improve the effectiveness of incentive programs^[49].

A motive from a different angle for a spin-off might be the avoidance of influence by workers councils or currently implemented labour contracts – the creation of new units which are not bound to the labour contracts of the parent company enables the implementation of new contracts at different conditions^[50].

[...]

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^[1] Cf. Nadig, L. (1992); p. 30.

^[2] Cf. Nadig, L. (1992) p. 66.

^[3] Cf. Nadig, L. (1992), p. 66.

^[4] Cf. Hite/Owers (cited in Schultze, G. (1992) p. 108).

^[5] Cf. Cascorbi, A. (2003), p.1.

^[6] Cf. Anslinger, P/ Klepper, S/ Subramaniam, S. (1999) p. 17.

^[7] Cf. Knappmann, L. (Aufsteiger 2005) in MM, http://www.manager-magazin.de/geld/geldanlage/0,2828,391327,00.html, Status: 14.06.2006.

^[8] Cf. Berni, M. (Konzentration 2006) in HB, p.11.

^[9] Cf. N.N. Linde (2006) in FAZ.net, http://www.faz.net/s/RubC8BA5576CDEE4A05AF8DFEC92E288D64/Doc~ED0387551B8F5463C96C10B62C12B637F~ATpl~Ecommon~Scontent.html, Status: 07.06.2006.

^[10] Cf. Steuer, H. (Welten 2006) in HB, p. 12.

^[11] Umwandlungsgesetz

^[12] Cf. Hofmann, M. (1984), p.21 et seq.

^[13] Cf. §123 Abs.1 UmwG; Mailänder, P. (2000), p.177 et seq.

^[14] Cf. §123 Abs.2 UmwG.

^[15] Cf. Odenthal, S. (1999), p.52 et seq.

^[16] Cf. §123 Abs.3 UmwG; Mailänder, P. (2000), p.178

^[17] Cf. Blum,Norman , cited in Woo, C.Y./Willard, G.E./Daellenbach, U.S. (1992) 433 et seqq.

^[18] Cf. Nadig, L. (1992), p.11.

^[19] Brealey, R.A., Myers, S.C., Allen, F. (2006), p. 910.

^[20] Cf. Krishnaswarni, Sudha (1999), p. 74. ; Schultze, G. (1998), p.10.

^[21] Cf. Cascorbi, A. (2003), p.18.

^[22] subsequent IPO.

^[23] Cf. Cascorbi, A. (2003), p.18.

^[24] Cf. Desai, Hemang (1999), p. 76

^[25] Cf. Schneck, O. (2004).

^[26] Cf. Blum, N. (2006), p. 47.

^[27] Cf. Stahl, G., Wiehle U., Diegelmann, M., Deter, H., (2005), p.41.

^[28] Cf. Blum, N. (2006), p. 47.

^[29] Cf. Hoffmann, P., Ramke, R. (1992), p.24.

^[30] Cf. Gablers Wirtschaftslexikon, (2001).

^[31] Cf. Schneck, O. (2004).

^[32] Cf. Wullenkord, A. (2005), p. 38

^[33] Cf. Rundschreiben der Eidg. Bankenkommission 2002, p.1, http://www.ebk.admin.ch/d/archiv/2002/pdf/rs_outsourcing_d.pdf, 27.05.2006.

^[34] Cf. Blum, N. (2006), p. 51.

^[35] Cf. Schultze, G. (1998) p. 108.

^[36] Cf. Desai, H./ Jain, P. (1999), p. 100; Nadig, L. (1992), p. 45.

^[37] Cf. Fromm, T. (Infineon 2005) in FTD, http://www.ftd.de/technik/it_telekommunikation/30505.html, Status 09.06.2006.; Fromm, T./ Böschen, M/ Kramer T. (Infineon 2006) in FTD, http://www.ftd.de/technik/it_telekommunikation/72080.html, Status 09.06.2006.

^[38] Cf. ibid.

^[39] Cf. Kirchmaier, T. (2001), p. 17.

^[40] Cf. Cascorbi, A. (2003), p. 35-36.

^[41] Cf. Allen, J. (2001), p. 282; Kirchmaier, T. (2001), p.17.

^[42] Cf. Schultze, G. (1998), p. 107.

^[43] Cf. Meyer, R. (1999), p. 79.

^[44] Cf. Cascorbi, A. (2003), p.47.

^[45] Cf. Schultze, G. (1998) p. 105.

^[46] Cf. Achleitner, A. (1999), p. 216.

^[47] Cf. Cascorbi, A. (2003), p. 49; Krishnaswami, S./ Subramaniam, V. (1999), p. 75.

^[48] Cf. Schultze, G. (1998) p. 112.

^[49] Cf. Chemmanur, T./ Yan, A. (2004), p. 261.

^[50] Cf. Cascorbi, A. (2003), p. 50.