Corporate spin-offs represent a compelling set of opportunities for investors. These companies have many attractive fundamental characteristics and have historically performed better than market averages. As a result, active investors need to familiarize themselves with these unique investment situations. This article explores the different spin-off types, key drivers, categories, and (most importantly) fundamental characteristics investors need to consider.
Simply put, a spin-off is a transaction that separates a segment or subsidiary (“SpinCo”) from the parent company (“RemainCo”). While there are a handful of different ways to ultimately complete a spin-off, this underlying principle holds true. There are three main ways companies execute spin-offs and distribute ownership in the new SpinCo:
- Traditional spin-off
You can learn much more about each of these types of transactions here.
Why a company would ever want to execute a spin-off is a little counterintuitive. Spinning off a business means that the remaining company is smaller and after all, executives that run larger companies get paid more.
“It turns out that the link between the size of the company and the pay of the CEO is one that is nearly impossible to make go away. We can isolate the impact of all kinds of other characteristics (e.g., industry, return on assets, profitability, research and development expense, etc.) and even use complicated statistical techniques to remove the influence of “unmeasurable” characteristics, and the size-to-pay link remains intact.”
Kevin Hallock, Cornell University
Given these circumstances, why would an executive team and board of directors at a public company ever consider, let alone go through with a spin-off?
While there are numerous incentives and factors at play, it really boils down to a few key drivers:
- The legacy management team is interested in creating value, or
- A new management team comes in with a fresh set of eyes and without the historical institutional imperative mindset
- Activist investor pushes management publicly or behind the scenes
- The businesses can’t stay together any longer due to regulatory reasons
This topic is dissected in much greater detail here.
By looking through years and years’ worth of spin-offs, a handful of common, overlying features emerge at these companies. Investors can use these different features to categorize and better understand each new investment opportunity. Spin-offs generally fit into one or more categories based on the company’s size, growth characteristics, business quality, key driver, and transaction structure.
- Clean Separation
- Spin and Merge
- Merge and Spin
- Big Company Small Company
- Higher Quality Lower Quality
- High Growth Low Growth
- Carve-Out Distribution
Each of these categories is explained in this detailed article.
Spin-offs are executed by companies in a wide range of industries and come in many different forms. Despite this, there are numerous common characteristics that make spin-offs very compelling and are critical for investors to understand. The characteristics fall into three broader groups: Market Factors, Opportunities for Fundamental Analysis by Active Investors, and Opportunities for Improved Performance at the SpinCo.
- Potentially forced selling of SpinCo by parent company shareholders
- Limited or new analyst coverage
- Valuation re-rating
Opportunities for Fundamental Analysis by Active Investors: It Takes Effort to Find and Analyze
- Can’t find these opportunities through analytical screens
- Limited financial history as a standalone company
- Cumbersome to piece together historical SpinCo financials
- Filing documents are not written for investors to easily understand
- “Orphan business” or other type of unique asset can lead to a limited or new peer group for market valuation and business comparison purposes
- Potential management incentives for a low initial valuation
- Spin-offs are effectively a new public offering, but without the fanfare
Opportunities for Improved Fundamental Performance at the SpinCo
- New management incentives
- Better alignment of incentives
- Reduces business complexity and improves focus
- Optimizes capital structure and capital allocation
- Improves corporate functions, decision making, and accountability
- Investors can see if management prefers one business over another
- The fact that management is pursuing a spin-off, in and of itself, says something
You can learn more about each of these characteristics here.
Just because a company is a spin-off or the parent of a spin-off does not mean it is going to be a successful investment. However, investors that understand the current spin-off opportunity set can tilt the odds in their favor by studying these types of investment situations.
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