BASIC CONCEPTS OF CORPORATE RESTRUCTURING

What is Corporate Restructuring?

Any change in a company’s:1. Capital structure,2. Operations, or3. Ownershipthat is outside its ordinary course of

business.

Why Engage in Corporate Restructuring?

• Sales enhancement and operating economies• Improved management• Information effect• Wealth transfers• Tax reasons• Leverage gains• Hubris hypothesis• Management’s personal agenda

Corporate restructuring

Operational restructuring

Workforce reduction

Takeover

Merger/ Consolidation

Acquisition of stock

Acquisition of assets

Joint venture / Strategic alliance

Divestiture/ spin off/ Carve out

Financial restructuring

Recapitalization

Leveraged Recapitalization

Dual Class Recapitalization

Exchange OfferShare repurchase

Reorganization /Liquidation

Inside Bankruptcy

Outside BankruptcyGoing Private /

Leveraged Buyout

Varieties of Takeovers

Takeovers

Acquisition

Proxy Contest

Going Private(LBO)

Merger

Acquisition of Stock

Acquisition of Assets

Takeover: transfer of control over a firm from one group of shareholders to another

Forms of Acquisitions

• Merger or consolidation– Merger: absorption of one firm by another; the

acquiring firm retains its name and identity– Consolidation: creation of an entirely new firm

• Acquisition of stock – Purchase of the firm’s voting stock in exchange for

cash or shares (e.g. by means of a tender offer)• Acquisition of assets

– Buying all of the target’s assets, which requires a formal vote of the shareholders of the selling firm

Classifications Mergers and Acquisitions

1. Horizontal• A merger in which two firms in the same industry combine.• Often in an attempt to achieve economies of scale and/or scope.

2. Vertical• A merger in which one firm acquires a supplier or another firm that

is closer to its existing customers.• Often in an attempt to control supply or distribution channels.

3. Conglomerate• A merger in which two firms in unrelated businesses combine.• Purpose is often to ‘diversify’ the company by combining

uncorrelated assets and income streams4. Cross-border (International) M&As

• A merger or acquisition involving a local and a foreign firm - either the acquiring or target company.

15 - 7

Divestiture/ Spin off/ Carve out

• Divestiture: the sale of a segment of a company to a third party• Spin-offs—a pro-rata distribution by a company of all its shares

in a subsidiary to all its own shareholders• Equity carve-outs—some of a subsidiary' shares are offered for

sale to the general public• Split-offs—some, but not all, parent-company shareholders

receive the subsidiary's shares in return for which they must relinquish their shares in the parent company

• Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist

• Tracking Stock—special stock issued as dividend: pays a dividend based on the performance of a wholly-owned division

Strategic Alliance

• Strategic Alliance -- An agreement between two or more independent firms to cooperate in order to achieve some specific commercial objective.

• Strategic alliances usually occur between (1) suppliers and their customers, (2) competitors in the same business, (3) non-competitors with complementary strengths.

Strategic Alliance

• Strategic alliance (or teaming agreement): parties work together on a single project for a finite period of time– Do not exchange equity– Do not create permanent entity to mark

relationship– Written memorandum of understanding (MOU):

memorializes strategic alliance and sets forth how parties plan to work together

Joint Venture

• A joint venture is a business jointly owned and controlled by two or more independent firms. Each venture partner continues to exist as a separate firm, and the joint venture represents a new business enterprise.

Joint Venture

• Joint venture: parties work together for lengthy or indeterminate period of time– Form new, third entity– Divide ownership and control of new entity,

determine who will contribute what resources– Advantage: two entities can remain focused on their

core businesses while letting joint venture pursue the new opportunity

– Downside: governance issues and economic fairness issues create friction and eventual disbandment

Going Private

• A public corporation is transformed into a privately held firm

• The entire equity in the corporation is purchased by management, or management plus a small group of investors

• Can be done in several ways:– "Squeeze-out"—controlling shareholders of the firm buy up the

stockholding of the minority public shareholders– Management Buy-Out—management buys out a division or subsidiary,

or even the entire company, from the public shareholders– Leveraged Buy-Out (LBO)

Going Private

• Going Private -- Making a public company private through the repurchase of stock by current management and/or outside private investors.

• The most common transaction is paying shareholders cash and merging the company into a shell corporation owned by a private investor management group.

• Treated as an asset sale rather than a merger.

Motivation for Going Private

• Elimination of costs associated with being a publicly held firm (e.g., registration, servicing of shareholders, and legal and administrative costs related to SEC regulations and reports).

• Reduces the focus of management on short-term numbers to long-term wealth building.

• Allows the realignment and improvement of management incentives to enhance wealth building by directly linking compensation to performance without having to answer to the public.

Motivations:

Motivation for Going Private

• Large transaction costs to investment bankers.• Little liquidity to its owners.• A large portion of management wealth is tied up in

a single investment.

Motivations (Offsetting Arguments):

Leverage Buyout (LBO)

LBO is a transaction in which an investor group acquires a company by taking on an extraordinary amount of debt, with plans to repay the debt with funds generated from the company or with revenue earned by selling off the newly acquired company's assets

• Leveraged buy-out seeks to force realization of the firm’ potential value by taking control (also done by proxy fights)

• Leveraging-up the purchase of the company is a "temporary" structure pending realization of the value

• Leveraging method of financing the purchase permits "democracy" in purchase of ownership and control--you don't have to be a billionaire to do it; management can buy their company.

Leverage Buyout (LBO)

• Leverage Buyout (LBO) -- A primarily debt financed purchase of all the stock or assets of a company, subsidiary, or division by an investor group.

• The debt is secured by the assets of the enterprise involved. Thus, this method is generally used with capital-intensive businesses.

• A management buyout is an LBO in which the pre-buyout management ends up with a substantial equity position.

Corporate Financial RestructuringWhy Restructure?

Proactive DistressDefensive

Management acts to preserve or enhance shareholder value

Management acts to protect company, stakeholders and management from change in control

Lenders and shareholders lose, but try to work out best way to minimize loss

A Simple Framework

• A company is a “nexus of contracts” with shareholders, creditors, managers, employees, suppliers, etc.

• Restructuring is the process by which these contracts are changed – to increase the value of all claims.

• Applications: – restructuring creditor claims;– restructuring shareholder claims ;– restructuring employee claims

Valuation is a Key to Unlock Value

• Value with and without restructuring• Consider means and obstacles• Who gets what?• Minimum is liquidation value

Valuation

Going Concern LiquidationAfter Restructuring

Getting the Financing RightStep 1: The Proportion of Equity & Debt

Debt

Equity

Achieve lowest weighted average cost of capital

May also affect the business side

Getting the Financing RightStep 2: The Kind of Equity & Debt

Debt

Equity

Short term? Long term?Baht? Dollar? Yen?

Short term? Long term?Baht? Dollar? Yen?

Bonds? Asset-backed?Convertibles? Hybrids?

Bonds? Asset-backed?Convertibles? Hybrids?

Debt/Equity Swaps?Private? Public?Strategic partner?Domestic? ADRs?

Debt/Equity Swaps?Private? Public?Strategic partner?Domestic? ADRs?

Ownership & control?Ownership & control?

Capital Structure: Optimal Range?

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?

Leveraged Recapitalization

• Strategy where a company takes on significant additional debt with the purpose of paying a large dividend (or repurchasing shares)

• Result is a far more leveraged company -- usually in excess of the "optimal" debt capacity

• After the large dividend has been paid, the market value of the shares will drop.

Exchange Offers

• Give one or more classes of claimholders the option to trade their holdings for a different class of securities of the firm.

• Typical examples are allowing common shareholders to exchange their shares for bonds or preferred stock,

• Or vice-versa• Motivations?

Reorganization Processes• Out-of-court negotiated settlement

– Firm continues• Exchange: equity for debt• Extension: pay later• Composition: creditors agree to take less

– Firm ceases to exist: assignee liquidates assets and distibutes proceeds on a pro-rate basis

• Merger into another firm (which assumes or pays off debt)– Continues as subsidiary– Absorbed into other operations

• Formal legal proceedings– Firm continues: Ch 11, court supervises composition or modification of

claims– Firm ceases to exist

• Statutory assignment: assignee liquidates assets under formal legal procedures• Ch 7 liquidation: bankruptcy court supervises liquidation

When Default Threatens, Value the Company

S a le to S tra te g ic B u yer A u c tion

M e rg ed V a lue

E x is t in g M an a g em e nt N e w M a n a ge m e nt

V o lu n ta ry R eo rg a n iza tion C h 1 1 R e org a n iza tion

G o in g C o nce rn V a lue

V o lu n ta ry L iq u id a tion C h 7

L iq u id a tio n V a lue

H ig h e s t V a lu a tion o f C om p a n y?

SHARE REPURCHASES

• Share repurchases are cash offers for outstanding shares of common stock

• Share repurchases change the book capital structure of the firm by reducing the amount of common stock

• Leverage ratio increases because the amount of common stock is reduced

SHARE REPURCHASES

• Management incentives– Share repurchases increase the percentage ownership of the

firm for nonparticipants such as officers and directors– Incentives of officers and directors to think as owners will be

strengthened– Reduce agency problems

• Management responsibility– Returning excess cash to shareholders may demonstrate that

officers and directors acted in the best interest of shareholders– Shareholders' trust in their officers and directors is

strengthened because excess funds were not used for negative NPV investments

SHARE REPURCHASES

– Undervaluation signal• Non-participation of officers and directors in buyback programs

may signal that stock price is undervalued • Cash flows are likely to increase in the future

– Greater flexibility• Market rewards a history of consistent increases in dividends and

punishes company that fails to do so– Patterns of dividend behavior by individual firms are established over time– Earnings rise with fluctuations while dividends increase in a stair step

fashion with a lag behind growth in cash flows

• In share repurchases, the expectation is that cash will be returned to shareholders when funds are available in excess of needs to finance sound investment programs

SHARE REPURCHASES

• Takeover defenses– Share repurchase price may be viewed more favorably than

takeover price– Share repurchase may cause takeover bidders to offer a higher

premium • When a firm tenders for 10% or 20% of its shares, shareholders who

offer their shares are those with the lowest reservation prices• Shareholders who did not tender have the highest reservation prices• In order for takeover bidder to succeed, he must offer a higher

premium to the remaining higher reservation price shareholders• Required higher premium may deter potential bidders

Fixed Price Tender Offers

• Tender offer– Company sets number of shares it is offering to

purchase– Company sets price at which it will repurchase

shares– Company sets period of time offer will be open– Officers and directors of repurchasing firm do

not participate in tender offer

• Tender price– Average 20% over prevailing market price– Tendering shareholders receive full tender offer

price• Tendering shareholders pay no brokerage fees• Company pays any transfer taxes levied

• Number of shares– Offer specifies maximum number of shares the

firm will buy

– If oversubscription• Company may buy pro rata basis from all tendering

shareholders up to a maximum• Company may buy all tendered shares

– If undersubscription • Company buys all shares tendered• Company may cancel offer if it includes a minimum

acceptance clause• Company may extend offer period• Company purchases shares offered during extension

period either pro rata or on basis of order in which shares are offered

Dutch Auction Repurchases (DARs)

• Implementation– Firm specifies number of shares and range of

prices for share repurchase– Shareholders can tender shares at any price

within stated range– Firm puts together shareholder responses into

supply schedule curve for the stock

– Firm repurchases shares at lowest price (purchase price) that allows it to buy number of shares it sought in offer

– Purchase price is paid to all shareholders who tendered at or below purchase price

– If oversubscribed — firm purchases shares tendered on pro rata basis

Transferable Put Rights (TPRs)

• Implementation– Firm issues put options to shareholders in

proportion to number of shares owned– If firm wishes to repurchase 10% of outstanding

shares, it gives shareholders 1 TPR per 10 shares owned

– Each TPR gives shareholder right to sell one share back to firm at fixed price within specified period

– All shares put back to firm are repurchased — no prorationing occurs

– Shareholders that do not wish to sell shares back to firm can sell their TPRs in open market

– If significant premium of put price over prevailing market price

• TPRs have value• Trading in TPRs will take place

• TPR trading can discover market clearing price of shares company seeks to repurchase

BUSINESS COMBINATIONS

BUSINESS COMBINATIONS

• Mergers and Consolidations:– Two firms join and integrate operations

• Acquisitions:– One firm buys a controlling interest in

another firm with the intent to make the other firm a subsidiary of the acquiring firm.

• Hostile Takeovers:– Acquisition bid is unsolicited.– Generally results in incumbent management

being removed.

AA Company

BB Company

AA Company

(a) Statutory Merger

AA Company

BB Company

CC Company

AA Company

BB Company

AA Company

BB Company

(b) Statutory Consolidation

(c) Stock Acquisition

Forms of Business Combinations

Forms of Business CombinationsStatutory Merger

• A statutory merger is a combination of two or more firms in which all but one cease to exist legally; the combined organization continues under the original name of the surviving firm.

• The operations of the previously separate companies are carried on in a single legal entity

Forms of Business CombinationsStatutory Merger

• In a typical merger, shareholders of the target firm—after voting to approve the merger—exchange their shares for those of the acquiring firm.

• Those not voting in favor (minority shareholders) are required to accept the merger and exchange their shares for those of the acquirer.

Forms of Business CombinationsStatutory Consolidation

• In a statutory consolidation, all entities that are consolidated are dissolved during the formation of the new company, which usually has a new name.– In a merger, either the acquirer or the target survives.

• The assets and liabilities of the combining companies are transferred to a newly created corporation

• Combination of Daimler Benz and Chrysler to form DaimlerChrysler in 1999

Forms of Business CombinationsStock Acquisition

• One company acquires the voting shares of another company and the two companies continue to operate as separate, but related, legal entities.

• The acquiring company accounts for its ownership interest in the other company as an investment.

• Parent–subsidiary relationship

• For general-purpose financial reporting, a parent company and its subsidiaries present consolidated financial statements that appear largely as if the companies had actually merged into one.

Determining the Type of Business Combination

AA Company invests in BB Company

Acquires net assets Acquires stock

Record as statutorymerger or statutory

consolidation

Acquired companyliquidated?

Record as stockacquisition and

operate as subsidiary

Yes

No

AA Company invests in BB Company

Acquires net assets

Record as statutorymerger or statutory

consolidation

Acquired companyliquidated?

Record as stockacquisition and

operate as subsidiary

Forms of Business Combinations

• Statutory mergers and acquisitions may be effected through acquisition of stock as well as through acquisition of net assets.

• To complete a statutory merger or consolidation following an acquisition of stock, the acquired company is liquidated and only the acquiring company or a newly created company remains in existence.

Methods of Effecting Business Combinations

• Friendly- managements of companies involved come to agreement on the terms of the combination and recommend approval by the stockholders.– A single transaction involving exchange of assets or voting

shares• Hostile takeover- managements of the companies involved

are unable to agree on the terms of a combination and the management of one of the companies makes a tender offer directly to the shareholders of the other company to “tender” their shares for securities or the assets of the acquiring company.

Obtaining Control

A business combination can be effected by one company acquiring either the assets or the voting stock of another company:

• Purchase assets of an existing company– May assume liabilities as well

• Purchase > 50% of outstanding voting stock of another company– Parent/subsidiary relationship

Accounting for Control• Purchase of “net assets”

– Acquiring company records assets/liabilities purchased in its own ledger.

– Selling company distributes to its shareholders the assets or securities received in combination from the acquiring company and liquidates, leaving only the acquiring company as the surviving legal entity.

• Acquisition of stock– Acquiring company (parent) records a single

“investment” account– Parent and subsidiary remain separate legal entities– Parent/subsidiary financial statements are combined

(consolidated).

Basic Issues in Combinations(continued)

• Purchase versus pooling– Purchase is group asset acquisition at

market values– Pooling was merging of accounts at

book value

Purchase Method - Valuation

• All assets and liabilities are recorded at Fair Market Value.– First identify and value tangible assets– Next identify and value intangible assets

• Goodwill - Price paid in excess of Fair Market value of the net assets.

Basic Purchase: Example with Goodwill

Acquisitions Company purchases net assets of Johnson Company:

• Net assets (per books) = Rs.148,000• Purchase price = Rs.350,000 cash• Direct acquisition costs = Rs.10,000• Fair value (current appraisal) of net assets =

Rs.297,000• Goodwill = Rs.63,000

– Cost Rs.360,000 less Rs.297,000 fair value

Example: Johnson Company Net Asset Values

Assets Book Value Fair ValueAccounts receivable 28,000 28,000Inventory 40,000 45,000Land 10,000 50,000Buildings (net) 40,000 80,000Equipment (net) 20,000 50,000Patent 15,000 30,000Copyright - 40,000Goodwill 20,000 0Total Assets 173,000 323,000

Liabilities & EquityCurrent liabilities 5,000 5,000Bonds payable 20,000 21,000Total liabilities 25,000 26,000

Net assets 148,000 297,000

Entry to Record Purchase

Accounts Receivable 28,000Inventory (fair value) 45,000Land (fair value) 50,000Building (fair value) 80,000Equipment 50,000Patent 30,000Copyright 40,000Goodwill (based on current price) 63,000

Current liabilities 5,000Bonds payable 20,000Bonds payable premium (to fair value) 1,000Cash 360,000

Basic Purchase: Example with GoodwillPurchased with Stock

• Assume same facts as in prior example.• Acquisitions Company issues Rs.1 par value

common stock for the Rs.350,000 purchase price.

Calculation of shares required:Fair value of shares = Rs.50Shares required = 7,000 (Rs.350,000 / Rs.50)

Entry to Record PurchaseAccounts Receivable 28,000Inventory (fair value) 45,000Land (fair value) 50,000Building (fair value) 80,000Equipment 50,000Patent 30,000Copyright 40,000Goodwill (based on current price) 63,000

Current liabilities 5,000Bonds payable 20,000Bonds payable premium (to fair value) 1,000Cash 10,000Common Stock (7,000 x Rs.1) 7,000Paid-in Capital in Excess of Par 343,000

Entry for Johnson, Inc. (Seller)Investment in Acquisitions Company Stock 350,000Current liabilities 5,000Bonds payable 20,000

Accounts receivable 28,000Inventory 40,000Land 10,000Buildings 40,000Equipment 20,000Patent 15,000Goodwill 20,000Gain on Sale of Business 202,000

COMMON MOTIVATIONS FOR MERGERS AND ACQUISITIONS

1) Synergy

• Synergy is the notion that the combination of two businesses creates greater shareholder value than if they are operated separately.– Operating Synergy

• Economies of Scale• Economies of Scope

– Financial Synergy – lowering the cost of capital

Operating Synergy

• Economies of scale refer to the spreading of fixed costs over increasing production levels.

• Economies of scope refer to using a specific set of skills or an asset currently employed in producing a specific product or service to produce related products or services,– cheaper to combine multiple product lines in one

firm than to produce them in separate firms.

Financial Synergy

• Reduction in the cost of capital of the acquiring firm, or the newly formed firm, resulting from the merger or acquisition.

• The cost of capital could be reduced if the merged firms have cash flows that do not move up and down in tandem (i.e., so-called coinsurance), realize financial economies of scale from lower securities issuance and transactions costs, or result in a better matching of investment opportunities with internally generated funds.

2) Diversification

• Buying firms outside of a company’s current primary lines of business is called diversification– Diversification may create financial synergy that

reduces the cost of capital, or – it may allow a firm to shift its core product lines or

markets into ones that have higher growth prospects, even ones that are unrelated to the firm’s current products or markets.

2) DiversificationProducts\ Markets

Current New

Current Lower Growth / Lower Risk

Higher Growth/ Higher Risk (RelatedDiversification)

New Higher Growth/Higher Risk (RelatedDiversification)

Highest Growth/ Highest Risk (UnrelatedDiversification)

3) Strategic Realignment

• Firms use M&As to make rapid adjustments to changes in their external environments.

• Regulatory Change: Those industries that have been subject to significant deregulation in recent years-financial services, healthcare, utilities, media, telecommunications, -have been at the center of M&A activity, because deregulation breaks down artificial barriers and stimulates competition.

• Technological Change: Technological advances create new products and industries. – Large companies view M&A as a fast and sometimes less

expensive way to acquire new technology

4) Hubris and the “Winner’s Curse”

• Acquirers may tend to overpay for targets, having been overoptimistic when evaluating synergies.

• Competition among bidders also is likely to result in the winner overpaying because of hubris, even if significant synergies are present.

5) Buying Undervalued Assets: The q-Ratio

• The q-ratio is the ratio of the market value of the acquiring firm’s stock to the replacement cost of its assets.

• Firms interested in expansion can choose to invest in new plant and equipment or obtain the assets by acquiring a company with a market value less than what it would cost to replace the assets (i.e., a market-to-book or q-ratio that is less than 1).

6) Mismanagement• Agency problems arise when there is a difference between

the interests of current managers and the firm’s shareholders. – These managers, who serve as agents of the shareholder, may be

more inclined to focus on their own job security and lavish lifestyles than on maximizing shareholder value.

– Mergers often take place to correct situations where there is a separation between what managers and owners (shareholders) want. Low stock prices put pressure on managers to take actions to raise the share price or become the target of acquirers, who perceive the stock to be undervalued and who are usually intent on removing the underperforming management of the target firm.

• Agency problems also contribute to management-initiated buyouts, particularly when managers and shareholders disagree over how excess cash flow should be used.

7) Managerialism

• The managerialism motive for acquisitions asserts that managers make acquisitions for selfish reasons, be it to add to their prestige, to build their spheres of influence, to augment their compensation, or for self-preservation.

8) Tax Considerations

• Tax benefits, such as loss carry forwards and investment tax credits, can be used to offset the taxable income of firms that combine through M&As.

• Acquirers of firms with accumulated losses may use them to offset future profits generated by the combined firms. Unused tax credits held by target firms may also be used to lower future tax liabilities.

8) Tax Considerations

• Additional tax shelters (i.e., tax savings) are created due to the purchase method of accounting, which requires the book value of the acquired assets to be revalued to their current market value for purposes of recording the acquisition on the books of the acquiring firm. – The resulting depreciation of these generally higher

asset values reduces the amount of future taxable income generated by the combined companies, as depreciation expense is deducted from revenue in calculating a firm’s taxable income.

9) Market Power

• The market power theory suggests that firms merge to improve their monopoly power to set product prices at levels not sustainable in a more competitive market

10) Misvaluation

• In the absence of full information, investors may periodically over- or undervalue a firm. Acquirers may profit by buying undervalued targets for cash at a price below their actual value or by using equity (even if the target is overvalued), as long as the target is less overvalued than the bidding firm’s stock.

• Overvalued shares enable the acquirer to purchase a target firm in a share-for-share exchange by issuing fewer shares, which reduces the probability of diluting the ownership position of current acquirer shareholders in the newly combined company.