Sponsored Spin-Off

  • The sponsored spin-off has drawn increasing attention from the private equity community as a tax-efficient technique to acquire a substantial interest in a division or subsidiary of a public company
  • For Sellers, the structure can deliver tax-free cash proceeds in excess of those available in a traditional spin-off or reverse Morris Trust transaction, while providing a "smart money" valuation benchmark for the newly public subsidiary
  • Sponsors can utilize the structure to acquire a large stake in a business at an attractive valuation and with full transaction leverage (constrained only by the limitiations of having a significant public investor base)
  • The end result of the structure is for the Sponsor to own up to 49.9% of the divested company with the remaining greater than 50% of the shares owned by the public shareholders of Seller
  • There are three principal variations on the structure insofar as it would be relevant to a non-core asset spin: (i) Sponsor invests pre-spin; (ii) Sponsor invests post-spin; and (iii) Sponsor invests as part of the spin, through debt/equity and/or equity/equity swaps
  • All three variations allow for the Seller to receive tax-free proceeds (through de-leveraging) up to the full leverage capacity of the spun entity and avoid any corporate tax on the sponsor equity proceeds
  • The sponsor equity proceeds will be either utilized to repay debt, pay dividends to shareholders, or repurchase Seller shares, depending on the particular facts and the structure chosen
  • All three structures should receive an IRS ruling confirming tax-free treatment
  • Transaction could also be structured as a Sponsored Split-Off, where the 51% to be received by Seller shareholders is distributed via an exchange ofefr where shareholders tender their ParentCo stock for SplitCo stock
  • In a "going private" version of the structure, the split-off could be done on a targeted basis to a discrete subset of ParentCo shareholders who seek to enter into a private JV with the financial sponsor
  • Precedent transactions: Marshall & Ilsley/Metavante, Alberto-Culver/Sally Beauty

Exhibit A – Benefits to Parties

Structural Benefits to Parent and Shareholders   Benefits to Target
  • Captures 100% of enterprise value at a premium valuation
  • No tax leakage
  • Substantial up-front proceeds - enhanced beyond typical upstream dividend
  • Retains significant upside in Target for Parent shareholders
  • Removes risk associated with one-step spin-offs
    • Provides value benchmark without need for an IPO
    • Mitigates significant downside from shareholder churn post-spin
  • Creates strategically and financially independent public entity
    • Optimal access to capital
    • Direct access to capital markets
    • New acquisition currency
    • "Dry powder" provided by Sponsor
  • Benefits of Sponsor as investor
    • Sets premium valuation as a floor
    • Investors will react positively to Sponsor participation
    • Stable, long-term shareholder under lockup
    • Active and experienced board presence

Exhibit B – Other Considerations

Size of
  • Can be up to 49.9%
Form of
  • Can be structured as common, potentially convertible preferred, or combination
  • Convert offers Sponsor downside protection and potential coupon, but raises incremental tax complexity
  • Sponsor will enter into governance arrangements with SplitCo
  • As a large stockholder, Sponsor can have significant governance rights and influence, though tax requirements will provide some limitations
  • Potential rights could include initial Board seats (up to 49.9% of inital Board should be permissible)
  • Agreement as to inital management
  • Subsequent management changes subject to approval of Board
  • Sellers will want to require Sponsor to sign initial standstill
    • Protect tax treatment
    • Need to discuss ability of Sponsor to acquire additional shares without offer for entire company (relates to value paid)
  • Sponsor may request poison pill or excess share provision to protect it during stanstill period
Ability to Increase Ownership
  • Ability for Sponsor to increase ownership will be related to standstill negotiation
  • Sponsor cannot have a plan or intention to increase ownership to 50% or above
  • Any increase could result in trigger of corporate level taxes under Section 355(e)
  • Safe harbors would permit purchases by Sponsor to 50% or above after 1-2 years so long as there was no plan or intention

Exhibit C – Possible Transaction Structures

  Key Facts Seller Proceeds Sponsor Investment Execution Complexity
  • Sponsor invests in SpinCo representing up to 49% value, <= 20% vote
  • Leverage placed in SpinCo through debt/debt swap or cash "boot" in reorganization
  • Debt and equity funded proceeds can be utilized to de-lever Seller, pay dividend, or repurchase shares
  • Convertible preferred representing up to 49% value, <= 20% vote
    • SpinCo tax deconsolidated
    • Potential to recap into "full vote" security post-spin, subject to IRS ruling
  • Simple to execute, although breaks some new ground from IRS perspective
  • Sponsor invests in SpinCo immediately post-spin, up to 49% vote and value
  • Leverage placed on SpinCo through debt/debt swap or post-spin leveraged dividend
  • Debt-funded proceeds can be used to de-lever Seller or pay dividend to shareholders
  • Equity-funded proceeds distributed to shareholders
  • Common or convertible preferred
  • Simple to execute and consistent with prior IRS rulings
Invests as
Part of Spin
  • Sponsor invests through exchanging Seller debt and/or equity securities for up to 49% SpinCo vote and value
  • Leverage placed on SpinCo through debt/debt swap
  • Debt-funded proceeds used to de-lever Seller
  • Equity-funded proceeds used to buy-back Seller debt and/or equity
  • Common or convertible preferred
  • Meaningful execution complexity within likely IRS requirements, although doable

Transaction Structure - Sponsor Invests Pre-Spin

Step 1 Transaction Steps
sponsored spin-off step 1
  • Seller contributes Sub to NewCo in exchange for 100% NewCo common stock and cash funded by leverage and sponsor equity
  • Sponsor invests in NewCo convertible preferred representing less that or equal to 20% NewCo vote and greater than or equal to 20% NewCo value
    • Can convert into >20% of NewCo vote, subject to IRS ruling
    • Accomplishes tax deconsolidation
Step 2 Transaction Steps
sponsored spin-off step 2
  • Seller distributes shares of NewCo to its shareholders
  • Seller uses (i) cash up to NewCo basis to retire debt or pay dividend/repurchase shares and (ii) cash in excess of basis to pay dividend/repurchase shares

Transaction Structure - Sponsor Invests Post-Spin

Step 1 Transaction Steps
sponsored spin-off step 1
  • Seller contributes Sub to NewCo and spins NewCo to its shareholders
Step 2 Transaction Steps
sponsored spin-off step 2
  • Immediately post-spin, Sponsor invests for up to 49.9% of NewCo equity concurrent with NewCo being levered up to capacity
  • Proceeds of debt and equity immediately distributed to Seller shareholders

Transaction Structure - Sponsor Invests Concurrent with Spin

Step 1 Transaction Steps
sponsored spin-off step 1
  • Seller annouces plans to spin off Sub
Step 2 Transaction Steps
sponsored spin-off step 2
  • Sub borrows money and distributes the proceeds tax-free to the Seller (up to the amount of the Seller's tax basis in the stock of Sub)
Step 3 Transaction Steps
sponsored spin-off step 3
  • Seller contributes Sub to NewCo in exchange for (i) 100% of NewCo equity, and (ii) a NewCo Note with at least a 7-year maturity
Step 4 Transaction Steps
sponsored spin-off step 4
  • Sponsor buys Seller debt and/or equity for cash
    • Sponsor "debt-equity swap" limited to 20% SpinCo vote; top up through equity-equity swap
  • Investment bank buys debt of Seller equal to the value of the NewCo Note
Step 5 Transaction Steps
sponsored spin-off step 5
  • Seller spins off NewCo
    • 49.9% NewCo equity to sponsor in retirement of the Seller debt and/or equity
    • 50.1% to the public as a dividend
    • NewCo Note to investment bank to retire the Seller debt
Step 6 Transaction Steps
sponsored spin-off step 6
  • Investment bank sells NewCo Note to bond investors