Alternative Restructuring Strategies

1. Alternative Restructuring Strategies

2. Experience is the name everyone gives to their mistakes. —Oscar Wilde

3. Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities Part I: M&A Environment Part II: M&A Process Part III: M&A Valuation and Modeling Part IV: Deal Structuring and Financing Part V: Alternative Business and Restructuring Strategies Ch. 1: Motivations for M&A Ch. 4: Business and Acquisition Plans Ch. 7: Discounted Cash Flow Valuation Ch. 11: Payment and Legal Considerations Ch. 15: Business Alliances Ch. 8: Relative Valuation Methodologies Ch. 2: Regulatory Considerations Ch. 5: Search through Closing Activities Ch. 12: Accounting & Tax Considerations Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs Ch. 3: Takeover Tactics, Defenses, and Corporate Governance Ch. 6: M&A Postclosing Integration Ch. 9: Financial Modeling Techniques Ch. 13: Financing the Deal Ch. 17: Bankruptcy and Liquidation Ch. 10: Private Company Valuation Ch. 14: Valuing Highly Leveraged Transactions Ch. 18: Cross-Border Transactions

4. Learning Objectives • Primary Learning Objective: To provide students with an understanding of alternative exit and restructuring strategies. • Secondary Learning Objectives: To provide students with an understanding of • Divestiture, spin-off, split-up, equity carve-out, split-off, and tracking stock strategies • Criteria for choosing strategy for viable firms • Options for failing firms

5. Divestitures • Sale of a portion of the firm to an outside party generally resulting in a cash infusion to the parent. Most common restructuring strategy. • Motives: • De-conglomeration / increasing corporate focus • Moving away from the core business • Assets are worth more to the buyer than to the seller • Satisfying government requirements • Correcting past mistakes • Assets have been interfering with profitable operation of other businesses

6. Deciding When to Sell: Financial Evaluation of Divestitures • Estimate unit’s after-tax cash flows viewed on a standalone basis, carefully considering dependencies with other operating divisions • Determine appropriate discount rate • Calculate the unit’s PV to estimate enterprise value • Calculate the equity value of the unit as part of the parent by deducting the market value of long-tem liabilities • Decide to sell or retain the division by comparing the market value of the division (step 3) minus its long-term liabilities (step 4) with the after-tax proceeds from the sale of the division Give examples of interdependencies that might exist among the operations of a parent firm? What is the appropriate discount rate for valuing a specific business unit within a parent firm? (i.e., the parent’s cost of capital or the cost of capital of the industry in which the business unit competes)

7. Divestiture Selling Process Proceed to Negotiated Settlement Reactive Sale Public Sale or Auction Pursue Alternative Bidders Private “One on One” or Controlled Auction Potential Seller Public Sale or Auction Proactive Sale Private “One on One” or Controlled Auction

8. Public or Controlled Auctions Sequence of events: 1. Qualified bidders sign nondisclosure / receive prospectus 2. Submission of non-binding bids expressed as range 3. Bids ranked by price, financing ability, form of payment, form of acquisition; and ease of deal 4. Best and final offers

9. Selling Process One on One Negotiation (single bidder) Public Auction (no limit on number of bidders) Controlled Auction (limited number of carefully selected bidders) Advantages/Disadvantages Enables seller to select buyer with greatest synergy Minimizes disruptive due diligence Limits potential for loss of proprietary information to competitors Most appropriate for small, private, or hard to value firms May discourage some bidders concerned about excessive bidding by uninformed bidders Potentially disruptive due to multiple due diligences Sparks competition without disruptive effects of public auctions May exclude potentially attractive bidders Choosing the Right Selling Process

10. Spin-Offs • Spin-Offs: New legal subsidiary created by parent with new subsidiary shares distributed to parent shareholders on pro-rata basis (e.g., Medco by Merck in 2004) • Shareholder base in new company is same as parent • Subsidiary becomes a publicly traded company • No cash infusion to parent • Tax-free to shareholders if properly structured

11. Stage 1: Parent board declares stock dividend of subsidiary shares Stage 2: Parent has no remaining interest in subsidiary Spin-Offs Parent Firm Parent Firm Shareholders Parent Firm Parent Firm Shareholders Subsidiary Stock Paid to Shareholders As Dividend Parent Shareholders Own Both Parent & Subsidiary Stock Subsidiary Independent of Former Parent Subsidiary How might a spin-off create value for parent company shareholders? How might a spin-off create value for spin-off shareholders?

12. Kraft Foods Breaks Up In 2010, Kraft acquired British confectionery company Cadbury for $19 billion. While the firm became the world’s largest snack company with the takeover, it was still entrenched in its traditional business, groceries, on the book’s at a low historical cost. The company now owned two very different product portfolios. Between January 2010 and mid-2011, Kraft’s share price grew faster than the S&P 500; however, it continued to trade at a lower price-to-earnings multiple than such competitors as Nestle and Groupe Danone. Expressing concern that Kraft was not realizing the promised synergies from the Cadbury deal, activist investors, Nelson Peltz’s and Bill Ackman, had discussions with Kraft’s management about splitting the firm. To avert a proxy fight, Kraft’s board announced on August 4, 2011, its intention to divide the firm into two distinct businesses. The proposal entailed separating its faster-growing global snack food business from its slower growing U.S. centered grocery business. The separation was completed through a spin-off to Kraft Food shareholders of the grocery business on October 1, 2012. The split up was justified as a means on increasing focus, providing greater opportunities, and of giving investors a choice between the faster growing snack business and the slower growing but more predictable grocery operation. Discussion Questions: 1. Speculate as to why Kraft chose not divest its grocery business and use the proceeds to either reinvest in its faster growing snack business, to buy back its stock, or a combination of the two? 2. How might a spin-off create shareholder value for Kraft Foods’ shareholders? 3. There is often a natural tension between so-called activist investors interested in short-term profits and a firm’s management interested in pursuing a longer-term vision. When is this tension helpful to shareholders and when does it destroy shareholder value?

13. Equity Carve-outs • Two forms: Initial public offering (IPO) and subsidiary equity carve-out • IPOs represent the first offering of stock to the public of all or a portion of the equity of a formerly privately held firm (e.g., UPS sells 9% of its shares in 1999) or a firm emerging from bankruptcy (e.g., GM in 2010) • The cash may be retained by the parent or returned to shareholders • Subsidiary equity carve-out is a transaction in which the parent sells a portion of the stock of a wholly-owned subsidiary to the public. (e.g., Phillip Morris’ 2001 sale of 15% of its Kraft subsidiary) • The cash may be invested in the subsidiary, retained by the parent, used to pay off parent or subsidiary debt, or returned to the parent’s shareholders • Although the parent generally sells less than 20% of the sub’s equity, the sub’s shareholder base may be different than that of the parent In addition to generating cash, what other motivations may a parent firm have in undertaking an equity carve-out?

14. Equity Carve-Outs Initial Public Offering Subsidiary Equity Carve-Out Private Firm Sells A Portion of Its Equity to the Public Parent Firm Sells A Portion of Its Subsidiary Stock to the Public Public/Private Equity Markets Cash Subsidiary Stock Cash Stock Public/Private Equity Markets Subsidiary of Parent Firm How does an equity carve-out differ from a spin-Off?

15. Tracking Stocks • Separate classes of common stock created by the parent for one or more of its operating units (e.g., USX creates Marathon Oil stock in 1991) • Each class of stock links the shareholder’s return to the performance of the individual operating unit • For the investor, such shares enable investment in a single operating unit (i.e., a pure play) rather than in the parent • For the parent and the operating unit, such shares • Give the parent another means of raising capital, • Enable parent to retain control • Represent an “acquisition currency” for the unit, and • Provide an equity-based incentive plan to attract and maintain key managers • May create conflict of interest

16. Tracking Stocks Value of the Tracking Stock Depends on the Performance of Subsidiary Tracking Stocks Issued by the Parent Firm

17. Split-Offs • A variation of a spin-off in which parent company shareholders are given the option to exchange their shares in the parent tax free for shares in a subsidiary of the parent firm. (e.g., AT&T spun-off its wireless operations in 2001 to its shareholders for their AT&T shares) • Frequently used when a parent owns a less than 100% investment stake1 in a subsidiary in order to: • Reduce pressure on the spun-off firm’s share price, because shareholders who exchange their stock are less likely to sell the new stock; • Increase the parent’s EPS by reducing the number of its shares outstanding; and • Eliminate minority shareholders in a subsidiary 1Minority shareholders add to financial reporting costs and can become contentious if they disagree with parent company policies. Parent firm efforts to sell its ownership stake may be difficult since potential buyers generally prefer to acquire 100% ownership of a business to avoid minority shareholders. Therefore, the parent firm may exit its ownership interest by transferring its stake to the parent firm’s shareholders through a split-off.

18. Stage 1: Exchange Offer Stage 2: Pro rata spin off of remaining subsidiary shares Split-Offs Parent Stock Parent Firm Parent Firm Shareholders Parent Firm Former Parent Firm Shareholders Subsidiary Stock • Subsidiary stock • now held by former • parent shareholders. • Parent has no relationship with former subsidiary Subsidiary Independent of Former Parent Subsidiary How is value created for shareholders of the split-off business? How is value created for parent firm shareholders? Note: If the parent cannot exchange all of its subsidiary shares, it will spin off any remaining shares to current shareholders on a pro rata basis.

19. Step 1: Kraft Implements Tax-Free Exchange Offer (a split-off) Step 2: Kraft Sub Merged with Ralcorp Sub in a Tax-Free Forward Triangular Merger Kraft Foods Splits-Off Post Cereals in Merger-Related (Morris Trust)Transaction Kraft Objective: Raise cash by selling Post Cereals in a tax free deal for Kraft and Kraft shareholders. Kraft Shares Kraft Foods Kraft Shareholders Ralcorp Kraft Sub (Post) Owned by Kraft Shareholders Kraft Sub (Post) Shares Post Assets & Liabilities Incl. $300 in Kraft Debt1 Kraft Sub Shares + $660 Million Note Payable to Kraft over 10 Years2 Ralcorp Stock Ralcorp Sub Stock Kraft Sub Assets & Liabilities Ralcorp Stock3,4 Ralcorp Sub Kraft Sub Shareholders Kraft Sub (Post) Kraft Sub (Post) Shares 1Kraft Foods retained the cash and Kraft Sub paid off the liability. 2Kraft Food receives 100% of the Post shares plus the present value of the ten-year note, which it converted to cash by selling it to a banking consortium. 3Ralcorp stock received by Kraft shareholders was valued at $1.6 billion at that time. Total purchase price for Post equaled $2.56 billion, consisting of $1.6 billion in Ralcorp stock, $300 million in Kraft debt and a $660 million note payable to Kraft. The transaction had to satisfy Morris Trust regulations requiring the selling firm’s shareholders to become the majority shareholder in the merged firms. This normally requires the selling firm to have a larger market value than the buyer. 4Cash received by Kraft was tax free (since it is viewed as an internal reorganization) as were the share exchange of Kraft Sub (Post) shares with Kraft shareholders and the subsequent exchange for Ralcorp stock.

20. Voluntary Liquidations or Bust-Ups • Involves the sale of all of a firm’s individual operating units • After paying off any remaining outstanding liabilities, after-tax proceeds are returned to the parent’s shareholders and the corporate shell is dissolved • This option may be pursued if management views the growth prospects of the consolidated firm as limited

21. Choosing Appropriate Restructuring Strategy: Viable Firms • Choice heavily influenced by the following: • Parent’s need for cash • Degree of operating unit’s synergy with parent • Potential selling price of operating entity • Implications: • Parent firms needing cash more likely to divest or engage in equity carve-out for operations exhibiting high selling prices relative to their synergy value • Parent firms not needing cash more likely to spin-off units exhibiting low selling prices and synergy with parent • Parent firms with moderate cash needs likely to engage in equity carve-out when unit’s selling price is low relative to synergy

22. Choosing Appropriate Restructuring Strategy: Failing Firms • Choice heavily influenced by the following: • Going concern value of debtor firm • Sale value of debtor firm • Liquidation value of debtor firm • Implications: • If sale value > going concern or liquidation value, sell firm • If going concern value > sale or liquidation value, reach out of court settlement with creditors or seek bankruptcy protection under Chapter 11 • If liquidation value > sale or going concern value, reach out of court settlement with creditors and liquidate or liquidate under Chapter 7

23. Discussion Questions • Divestitures, equity carve-outs, and spin-offs represent alternative restructuring strategies? Explain the primary advantages and disadvantages of each. • Under what circumstances might senior management prefer to divest a business unit rather than to spin-off the business? • Under what circumstances might senior management prefer an equity carve-out to a spin-off?

24. Things to Remember… • Divestitures, spin-offs, equity carve-outs, split-ups, split-offs, and tracking stock are common restructuring strategies to enhance shareholder value • Divestitures and equity carve-outs are more likely for operating units whose selling price is much higher than its perceived synergy with parent and whose parents need cash • Spin-offs are more likely for operating units whose selling price and synergy are low and whose parent firm does not need cash