A Q&A Discussion with Partner Mark Mandel About the Sponsored Spin-off Structure
An unconventional and creative adaptation of the "tax-free spin-off" — whereby a parent company divests a business and new, publicly traded shares are distributed to its stockholders — is generating interest because of the tax and other advantages it can provide over the traditional spin-off. It's called the "sponsored spin-off" and involves a sponsor taking a minority albeit significant stake in the spun-off company. The strategy can enable a seller to divest businesses "tax-free," potentially saving billions of dollars, enhance the profile of the spun-off business and offer many benefits to stockholders. Alberto-Culver used this technique when it spun off Sally Beauty not long ago, and Marshall & Ilsley is utilizing it to divest Metavante in a deal involving investment by a private equity firm.
In the following Q&A, New York-based mergers and acquisitions/private equity partner Mark Mandel of White & Case explains the benefits of this novel deal structure and provides insight derived via the Firm's experience in this area.
Q: What is a "sponsored" spin-off and the benefits of its structure over a straight sale of a business?
Mark: In a sponsored spin-off, the parent company sells a minority stake in a unit to a private equity buyer — the sponsor — and distributes the remaining interest to its stockholders. Under the Internal Revenue Code, the sale by a company of newly issued stock is not taxable, and a spin-off is not taxable if complicated tax requirements can be met. A straight sale, however, is subject to hefty taxes.
Q: What are the tax advantages of the "sponsored" spin-off structure over a "leveraged" spin-off?
Mark: Although the leveraged spin-off (whereby a parent company leverages the subsidiary, removes funds and distributes the stock in it to shareholders) provides cash, it can leave the subsidiary burdened by debt. In contrast, a sponsored spin-off avoids both the tax burden of a cash sale and the debt burden of a leveraged spin-off.
Q: What are key benefits of including a large investor as a sponsor in a spin-off?
Mark: For stockholders who have received shares in this now publicly traded company after the shares are spun off, the participation of a sophisticated investor, such as a private equity firm, can also make the business more appealing. Investment by a committed financial "partner" so to speak, such as a private equity firm, may be viewed as a vote of confidence in the business and can also help the company get the direction it needs to make the transition to a stand-alone company.
Q: What are some of the criteria that must be met in order for a spin-off to qualify as a "tax-free" transaction?
Mark: In order to qualify under Section 355, the parent must distribute "control" — meaning at least 80 percent of the voting stock — of the unit. Section 355(e) of the Code stipulates that if one or more persons acting pursuant to a "plan" acquires, directly or indirectly, 50 percent or more of the stock of the controlled subsidiary or the distributing corporation, the spin-off will be taxable at the corporate level. Generally, any stock acquisition of the subsidiary or parent within two years of the spin off is presumed to be part of a plan for purposes of section 355(e). Because of these tax constraints, the sponsor may want to limit its ownership to a minority stake in the company for at least two years.
Q: What is considered a minority stake?
Mark: A minority stake in the spun-off company may constitute up to 19.9 percent of the spun-off company's voting rights and up to 50 percent of an economic interest in the company.
Q: How can a private equity sponsor in particular benefit from the structure of a sponsored spin-off ?
Mark: In a sponsored spin-off, the sponsor only acquires a minority stake, allowing it to invest in a public company with less initial investment risk than if it had a majority interest. A sponsored spin-off offers multiple exit options for the private equity firm. If the stock appreciates, the sponsor can sell shares of a liquid investment in the public market. If the spun-off company's stock trades at a weak level, and the private equity firm believes that the company is strong, it can, after at least two years, offer to buy the remaining shares at a low cost per share. That would allow it to gain control of the company, making it a more traditional private equity investment.
Q: When did US companies start implementing the sponsored spin-off structure?
Mark: The first US-sponsored spin-off was Lucent Technologies' sale of its Enterprise Networks Group, renamed Avaya, in 2000. However, the very small stake, which was about five percent, acquired by the sponsor resulted in the spin-off generating little cash for the parent and did not raise the sort of tax issues that a larger stake would have under the Internal Revenue Code. The conventional tax wisdom had always been that 20 percent was the maximum amount of stock that could be acquired by a sponsor in connection with a spin-off.
Q: Can you share any insight from past transactions that White & Case's M&A practice has handled for clients?
Mark: Pitney Bowes Inc., advised by White & Case, gained IRS approval for a proposed sponsored spin-off of its Capital Services business to an affiliate of Cerberus Capital Management. The deal involved an investment by Cerberus for common and preferred stock of a Pitney Bowes unit representing up to 19.9 percent of the voting interest and up to 48 percent of the economic interest in the spun-off entity. Pitney Bowes ultimately did not complete the deal as a sponsored spin-off but rather as a taxable stock sale of the business last year, explaining that the Securities and Exchange Commission would have required submission of additional financial statements that would have prolonged the time frame of the spin-off. However, because the Internal Revenue Service issued a ruling that approved the structure of the proposed Pitney Bowes sponsored spin-off, it's likely to remain a model for future sponsored spin-offs. The structure approved by the IRS involved a carefully crafted, two-stage investment by the sponsor.
Q: Have any major deals been sponsored during the past year?
Mark: One major transaction was completed in the last year and another is in progress. Alberto-Culver sold a 47.5 percent stake in its Sally Beauty business to buyout firm Clayton, Dubilier & Rice for approximately $575 million. Alberto-Culver shareholders own the remaining stock. The deal marked only the third sponsored spin-off ever to be undertaken in the US. Marshall & Ilsley is utilizing this technique to divest Metavante. Terms of the deal call for private equity firm Warburg Pincus to pay for a 25 percent interest in the company, with the remainder going to shareholders. News of these deals is drawing more attention to this novel deal structure, and I think more are likely to follow as the benefits become better understood. Considering the potential benefits of the sponsored spin-off structure to companies, sponsors and public stockholders alike, more US companies should consider this structure when divesting businesses.