Lecture 7:

Corporate Divestiture and

Bankruptcy
Corporate Finance
Professor Joseph McCahery
Road Map
• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Tracking stock
• Bankruptcy and reorganization
Leveraged Recaps
What are leverged recaps: significant cash payouts to
common shareholders financed by new borrowings
• Usually a one-time dividend payment
• Sometimes an exchange offers—cash, debt, new common
stock are exchanged for old common stock
• Often managers do not participate in the cash portion of
the distribution
• Often triggered by a hostile takeover bid
Goals:
• Increase managerial incentives (signaling)
• Eliminate over-investment (often in response to HF activists)
• Take advantage of tax shields (more leverage reduces costs of capital)
• Debt financing allows firms to return capital without having to access
large cash balances offshore (Apple)
Leverage recaps: 1985-2007
Empirical evidence--Recaps

• In first year post-recap

• 20% increase in ratio of operating income to assets
• 30% reduction in undistributed cash flow
• 35% reduction in capital expenditures
• Other evidence:
• Prior to recap, stock price to major corporate
investments was negative
• After recap, stock price reaction to investments was
zero.
Leveraged Recaps: Positive Market Response since 2011
Road Map
• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Tracking stock
• Bankruptcy and reorganization
Divestitures
• A firm sells an asset or division to the highest
bidder. The cash is reinvested in new assets or
returned to shareholders.
• Why do it?
• The divested asset may have higher value to the buyer.
Buyers may be better managers or face a lower cost of
capital
• To pay down debt (e.g., after leveraged acquisition)
• Focus on core business and get rid of peripheral
• Evidence:
• Stock price increase +1.45% (Linn and Rozef, 1985)
• The operating performance of the parent company improves
afer divestiture takes place (consistent with value focus)
Philips sees the light at the end of the tunnel
Philips sees the light at the end of the tunnel
Behavorial views
• A parent firm may delay divestiture due to
• Inertial until crisis triggers change
• Sell-off interpreted as form of corporate failure
• Businesses seen as making return
• Evidence of cognitive biases:
• Confirmation bias (avoiding evidence of weaknesses)
• Sunk cost fallacy (bias hanging on to irrecovable costs)
• Escalation of commitment (more investment will lead to
turnaround)
• False optimism (poor performance due to other factors)
• Anchoring and adjustment (adjusting estimates
inadequately)
Benefits of Focused Divestors
What is the Evidence
Types of divestitures
Road Map
• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Tracking stock
• Bankruptcy and reorganization
Spinoffs
• In a spinoff, a firm separates out assets or a division and
creates new shares with claims on this portion of the
business
• Existing shareholders in the firm retain these shares in
proportion to their original holdings (they can keep them or sell
them)
• No capital is raised.

• A spin-off occurs when the parent firm gives remaining

shares in the subsidiary to the parent’s shareholders.
• Examples:
• American Express & Lehmann Brothers
• GM & EDS
Reasons for Spin-offs: 1992-2005
Spin-offs 1990-2007: (b) UK; (c)
Europe
Corporate spin-offs to increase focus
Spin-offs 1990-2007: Europe (ex UK)
Spinoffs—sources of gains
• Example #1: Cyprus Minerals
• Mining subsidiary of Amoco. Had never been
profitable. Lost $95m in the year before being
spun off.
• Old management stayed in place.
• Cyprus cut overhead by 30% and became
profitable within 6 months of being independent.
• What may be going on here?
Spinoffs—sources of gains
• What may be going on here?
• ‘With carve outs, companies have once in a
lifetime opportunity to develop a new executive
and board compensation program. They can
clearly indicate to investors, executives, and other
employees that performance, ownership, risk and
reward are bound together’ (John England, Towers
Perrin)
• Carve outs may make it possible to link managerial
performance and compensation and facilitate
outside monitoring of management.
Spinoffs—sources of gains
• Example #2 AT&T/Lucent
• After 1996 spin-off from AT&T, Lucent picked up coverage
from 24 telecom analysts; previously only two of them
covered AT&T.
• Spinoffs may create value when investors are unable to
value disparate businesses under one single corporate
umbrella.
• Example #3 Philip Morris and RJR Nabisco.
• PM spun off Nabisco because of fears that tobacco
lawsuits were weighing down on the value of food assets.
• Spinoffs may create value when problems in one line of
business negatively affect the other parts of the business.
Spinoffs—sources of gains
• Example #4 AT&T
• As a regulated telecommunications firm, AT&T
found itself constrained in its decision making in
its R&D divisions.
• In 1995, AT&T spun off its research division (Bell
Labs, renamed Lucent Technologies) and its
computer division (renamed NCR).
• Spinoffs may create value when parent companies
are unable to manage divisions optimally because
of regulatory constraints.
Tax Treatment of Spinoffs
• Spinoffs are generally taks free if the parent company
had control of the subsidiary before the spinoff and
gives this control after the spinoff
• The distribution must represent at least 80% of the
outstanding shares;
• The subsidiary has to become independent of the parent
company (i.e., the parent company must not retain
‘practical control’)
• The transaction must have a business reason (e.g., giving
managers a stake in the ownership of the unit).

• Otherwise, distributions of another firm’s stock are

generally considered dividends, and hence taxable.
Summary of US studies: shareholders
gains
Sponsor to Strategic Deals: 2019
Road Map
• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Tracking stock
• Bankruptcy and reorganization
Carve-Outs
• Also known as partial public offerings, an equity carve-out is an IPO
for shares (typically a minority stake) in a subsidiary company.
• In contrast to a spinoff, some or all of the subsidiary’s equity is
offered directly to the public via an IPO:
• Taxable;
• Raise capital (proceeds can go either to the parent or to the
subsidiary)
• Often the parent company retains control of the subsidiary
• Otherwise similar to a spinoff
• The stock market reaction of spin-offs and carve-outs is similar (i.e.,
favorable initial response followed by long-run out performance).
Also, experience faster growth.
• Because the parent company typically retains control of the subsidiary,
some of the improvements that result from the separation between
the parent and the company may not occur in carve-outs.
Why pursue a carve-out?
• Why do a carve-out than a spin-off?
• Control by the parent may be valuable;
• Issue new equity; to find growth or to take advantage of over-
valuation
• Can a carve-out present an opportunity for the firm to make
money?
• According to the law of one price, identical assets should have
identical prices. In a well-functioning capital market, arbitrage
prevents the law of one price from being broken, and in fact, violations
of the law are rarely seen.
• But, equity carve-outs in technology stock in which the parent
company has stated its intention to spin-off its remaining shares
represents cases of mispriced stocks.
• Three things are necessary for mispricing: trading costs, irrational
investors, and opportunistic firms that time the market.
Sample equity carve-outs
Carve-outs: the case of Palm and 3Com
• Palm, which makes held held computers, was owned by 3Com, a profitable
company selling computer network systems and computers.
• On March 2, 2000, 3Com sold 5% of Palm to the public through an IPO
• Pending IRS approval, 3Com planned to spin-off the remaining shares of Palm to
3Com’s shareholders before the end of the year.
• 3Com shareholders would receive 1.5 shares of Palm for every share of 3Com the owned—so the
price of 3Com should have been 1.5 times that of Palm.
• Given 3Com’s other profitable business assets, it was expected tht 3Com’s price would also be above
1.5 times that of Palm.
• Investors could therefore buy shares of Palm directly or by buying shares embedded within shares of
3Com
• The day before the Palm’s IPO, the price of 3Com closed at $104.13 per share.
• After the first day of trading, Palm closed at $95.06 per share, implying that the
price of 3Com should have jumped at least to $145. Instead, 3Com fell to $58.81
per share.
• The day after the IPO, the mispricing of Palm was noted by the WSJ and NYT. The
amount of the mispricing was easy to see, yet it persisted for months.
Siemens loosens its grip on its carved-out
offspring
Subsequent Performance of Carve-Outs
Summary of US studies on shareholder gains
Road Map
• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Tracking stock
• Bankruptcy and reorganization
Tracking Stock
• Shares of stock that track the performance of divisions or
subsidiaries.
• The parent may or may not receive cash from the tracking stock.
• The parent usually retains complete control over the subsidiary.
• Most tracking stockholders get not voting rights.
• Upshot: Very similar to carve-out, but with more control for parent
company.
• Example: GM has issued tracking stock for two of its divisions:
Electronics Data Systems divisions (GME) and Hughes Aircraft
(GMH).
• Issues:
• Does it generate the same benefits?
• Legal problems:
• Claims in the event of bankruptcy?
• Fiduciary duty of the board; how to deal with potential transfer pricing issues.
Examples of Tracking Stock: US
Dell Buys Back VMare Tracking Stock
Tracking Stock—Empirical Evidence
• Mixed evidence of Tracking Stock:
• Short term performance:
• D’Souza and Jacob (2000) average abnormal two-day announcement
return of 3.7% for 37 tracking stocks issued by 14 U.S. companies
between 1984 and 1999.
• Harper and Madura (2002) show positive tracking stock
announcement ACARs of 2 to 3%.
• What about long-run performance?
• Chemmanur and Paeglis (2001) show that the stock of parent firms
underperform industry indexes over a subsequent three-year period,
while the average subsidiary outperforms its industry index.
• Billett and Vijh (2004) show negative buy-and-hold returns for
subsidiaries, but insignificant long- term excess returns for parents.
Tracking stock an executive pay
boondoggle?
 Points to Remember

Divestitures Carve-out Tracking Stock Spin-off

Raise Cash? Yes Some Maybe No

Loose Control? Yes No No Yes

Taxable? Yes Yes No No

Impact on Very negative Negative Unaffected Pretty Negative

bondholders
Road Map

• Mechanisms for exercising or changing control:

• Leveraged recapitalizations
• Divestitures
• Spin-offs
• Equity carve-out
• Bankruptcy and reorganization
Bankruptcy: Overview
• Corporations are in bankruptcy when they cannot pay the
financial claims of creditors.
• Bankruptcy may arise because of insolvency or illequidity.
Bankruptcy may be initiated by either the creditors or the
debtors.
• Insolvency: The sum of the claims of the creditors exceeds the
value of the assets.
Assets Liabilities
A Creditor Claims: C>A
Equity Holders: E<0
Bankruptcy: Overview (2)
• Illiquidity: The value of the assets exceeds the
value of creditors claims, but there is a
temporary shortage of cash required to pay
them.
Assets Liabilities
A Creditor Claims: C<A
Equity Holders: E>0 But no Cash!
Component of Bankruptcy Costs
• Direct costs (legal fees, accounting fees,
administrative costs, etc)
• Indirect costs (cost of financial distress)
• Bondholder – shareholder conflicts
• Asset substitutions problem (excessive risk)
• Debt overhang problem (underinvestment)
• Shortsighted investment problem
• Reluctance to liquidate problem (prolong proceedings)
• Claims dilution and dividend payments
Incentives of Debtor and Creditors
• All bankruptcy procedures must determine
• Who gets liquidated and who gets reorganized
• Which creditors get what
• Whether management is allowed to stay
• Bankruptcy procedures must avoid dangerous
incentives:
• When there are many creditors, they may rush to liquidate
collateral inefficiency
• When bankruptcy procedure is too lenient on
management, they are not penalized enough (en ante) for
wasting resources and bringing the firm to its knees.
Incentives of Debtors and Creditors
• Example: When there are many creditors, they may rush to
liquidate collateral inefficiently.
• Consider a firm who produces computer screens. It needs
money to build a factory, at cost $4millions. The factory
would only be worth $2million to anybody else. In each of
the next 5 years, it will produce 5,000 monitors at a profit
of $ u per monitor. In good years, u=$400, in bad years, u=
$100. Good and bad years are equally likely and
idiosyncratic (they do not depend on market risk).
• The discount rate is 10%.
• The firm borrows $5million at a fixed rate of 10% from each
of two banks. The factory is offered as collateral. The
repayment schedule is given below (next slide).
Incentives of Debtors and Creditors

End of 4,000,000 3,400,000 2,740,000 2,014,000 1,215,400 -

period
principal

Interest 400,000 340,000 274,000 201,400 121,540

Payment 1,000,000 1,000,000 1,000,000 1,000,000 1,336,940
Bank 1 (2,000,000) 500,000 500,000 500,000 500,000 668,470
Bank 2 (2,000,000) 500,000 500,000 500,000 500,000 668,470
Inefficient Liquidation: Project has
positive present value
Period 0 1 2 3 4 5
End period 4,000,000 3,4000,000 2,740,000 2,014,000 1,215,400 -
principal
Interest 4,000,000 340,000 274,000 201,400 121,540

Payment 1,000,000 1,000,000 1,000,000 1,000,000 1,336,940

Bank 1 (2,000,000) 500,000 500,000 500,000 500,000 668,470

Bank 2 (2,000,000) 500,000 500,000 500,000 500,000 668,470

Expected 1250000 1250000 1250000 1250000 1250000

Revenue
CF after 250,000 250,000 250,000 250,000 250,000
Interest
Discount 1.1 1.21 1.331 1.4641 1.61051
Factor
Present 227,273 206,612 187,829 170,753 (54,9830
Value
Total 738,483
 Inefficient Liquidation
Suppose bad realization in period 1, and insufficient funds to
pay both banks—what should be done?
Period 0 1
End of period principal 4,000,000 3,400,000
Interest 400,000
Payment 1,000,000
Bank 1 (2,000,000) 500,000
Bank 2 (2,000,000) 500,000

Actual Revenue 500,000

Total payment demand 1,000,000
Cash shortfall (500,000)
Inefficient Liquidation: Continuation

Period 0 1 2 3 4 5
Expected NA NA 1250000 1250000 1250000 1250000
revenue
Discount NA NA 1.21 1.331 1.4641 1.61051
factor
PV $1,033,058 $939,144 $853,767 $776,152
NPV $3,602,120
Inefficient Liquidation
• Scenario: Liquidation

• Nevertheless, one of the banks, fearing

preemption from the other bank, may rush to
seize collateral, selling the factory for its
scalpe value of $2M
• Good bankruptcy procedure protects firms
from scenarios like this.
 Incentives of Debtors and Creditors
• Optimal Bankruptcy procedure:
• Achieves an ex post efficient outcome (an outcome that
maximizes the total value of the proceeds-measured in
money terms-received by existing claimants).

• Preserves the bonding role of debt by penalizing managers

adequately in bankruptcy sales. However, bankruptcy
should not be so harsh that managers try to avoid it at any
cost, for example by gambling with the company’s assets.

• Should preserve the absolute priority claims-the most

senior creditors should be paid off before anything is given
to the next senior creditors, and so down the ladder.
 Incentives of Debtors and Creditors
• Why should governments worry about standardizing
the bankruptcy procedure?
• As long as contracts are enforceable, private parties can
agree on what happens in states of bankruptcy.
• In a world of costless contracting, debtors and creditors
anticipate the possibility of default and consequent
collective action problems and specify as part of their
initial contract what should happen in the case of default.
• In practice, transaction costs may be too large for debtors
and creditors to design their own bankruptcy procedure,
especially in cases where the debtor gets new creditors
and new assets as time passes.
What’s wrong with the current
Bankruptcy Procedures?
• Example:
• Assume discount rate is zero.
• Senior creditors are owed $100
• Liquidation value of company is $90

There are two states of the world with 50% probability each:
• Prosperity: firm is worth $180.
• Depression: firm is worth $40.

• Then if the company is kept as a going concern for one year it will be
worth:
• V=180*0.5=40*0.5=$110

• So, should we keep the firm running?

What’s wrong with the current
Bankruptcy Procedures?
• Apparently, claimants could bargain around this
inefficiencies and get around them by buy each other
out (Coase Theorem).
• But, the existence of numerous and heterogenous
claimants can make the negotiations difficult and lengthy,
if practically impossible.

• Chapter 11 reduces the severity of some of these

problems because it implements the majority’s will,
• But asymmetries in information among claimants about
the firm’s value still can prevent an efficient outcome from
being reached.
Possibilities of Bankruptcy Reform: (1)
Court-run Procedures
• Modify the currently existing court-run procedures.
• Example: Indonesia
• Bankruptcy Reform made a condition for loans
• The locals decided to “go Dutch.”
• Statistics show that the reform has been a failure:
• Since 1998, only 50 reorganization filings
• Judges throw out petitions on the grounds that creditors should give
more time to the borrowers
• In countries with law efficiency of judicial system, court-intensive
procedures may impose substantial deadweight costs.
• The deadweight loss may prevent solvent firms from undertaking
positive NPV projects.
Possibilities of Bankruptcy Reform: (2)
Creditor-run Procedures
• Creditors appoint an administrative receiver in charge of:
• Running the firm in default;
• Disposing of its assets piecemeal or as an ongoing operation;
• Distribute the proceeds in accordance with absolute priority.
• Advantages:
• Quick, therefore minimizing the firm’s loss of value, and
• Minimizes the intervention from the court
• Disadvantages:
• Might not be interested in maximizing the firm’s value
• May favor some creditors over others
• Feasibility problems when banks are also bankrupt