There’s been a recent surge in company spin-offs and demergers in the Australian market – spurred on by the success of high profile break ups like Brambles, Amcor and Foster's. What does it take to make a demerger successful? Our five key lessons will help you navigate the path to a successful break up.
Behind most demerger decisions is the Board’s view that a tighter business focus will benefit both the demerging company and its shareholders. Demergers can open up better growth prospects for companies as well as giving investors greater choice.
The evidence indicates that the vast majority of company break ups are well-justified. Demergers generally result in a lift in corporate performance and higher returns for shareholders. Australian demerged entities also tend to outperform the broader market, although this typically only happens 12 months after they split from their parent entity.
The pickup in Australian demerger activity is consistent with a global trend, particularly in the United States where shareholder activist campaigns commonly involve spin-off or demerger proposals.
PepsiCo is a recent example. Listed on NYSE with a market capitalisation of US$130 billion, it has been targeted by activist fund Trian Fund Management, led by Nelson Peltz. Trian has been pushing for PepsiCo’s global snacks and beverages businesses to be separated into two independent public companies, which it believes would create significant additional shareholder value.
Despite PepsiCo publicly rejecting Trian’s separation proposal earlier this year, Trian has met with more than 100 of PepsiCo’s largest shareholders and continues to lobby for a break-up.
Based on our experience advising on a number of demergers, we have identified five lessons for successful demerger transactions.
1. Choose the right entity to demerge
To determine which entity should be demerged, consider the balance sheet needs for each business, the relative size of each entity and certain tax considerations. Dividend policies for each company will be relevant - the demerged entity will generally not have any franking credits because these usually remain with the parent company. The need for third party approvals or consents will also depend on which entity is demerged.
2. Give your child a good start to life
Decisions about which businesses and assets should be allocated to the entity to be demerged are sometimes obvious and sometimes require judgement calls. Don't use the transaction as just a way to remove low-growth assets from the parent company’s business portfolio. At some point in the process the entity to be demerged should usually obtain its own independent advice.
3. Stay friends after the break-up
Demergers are complex transactions because they involve “unscrambling the egg”. Even where the business being separated has been run as an independent division, it’s still usually reliant on head office functions such as IT systems and other back-office functions.
In many cases it will also be part of group arrangements when it comes to tax, financing and purchasing and procurement. For some issues it can be difficult or costly to cut ties immediately, so transitional services arrangements and post-demerger committees with representatives from both companies can help smooth the transition to the new world for both parties.
4. Avoid tax traps
Critical to any demerger is determining whether the transaction would qualify for income tax relief, including no CGT for the parent company, no CGT for shareholders of the parent company and no tax on dividends that shareholders may receive as a result of the demerger.
A demerger that does not qualify for relief will deliver far less value. Section 45B of Income Tax Assessment Act 1936 is an integrity measure to ensure that only “genuine” demergers receive tax relief. The focus is on purpose – the tax benefit of demerger must be merely incidental to the commercial objectives, rather than an end in itself.
Examples of reasons the ATO has not accepted as genuine grounds for a demerger include “reducing administrative costs” and other situations relating to simplifying corporate structures. The ATO will be interested in any arrangements where it considers that “too much” of the distribution is being funded from profits (realised or unrealised) or where there is a real prospect of a disposal of ownership interests post-demerger.
It is usually considered imperative to obtain certainty for the company and its shareholders regarding the tax outcomes of a proposed demerger by way of a combination of private rulings and class rulings.
5. Be prepared for a takeover
Parent companies and demerged entities are both particularly susceptible to takeover bids, given a narrower business focus and smaller size may appeal to a bidder. Bidders will also benefit from significant disclosure (including an independent expert’s report) in the explanatory booklet for the demerger, thereby allowing them to conduct detailed public due diligence ahead of any approach. There is a long list of companies which have been takeover targets following demergers, some almost immediately following the split.