The Ins and Outs of Spins

For strategic buyers and private equity funds in search of quality targets, acquiring only a portion of a company through a spin-off can end up being a good proposition. Spin-offs are independent businesses created through a sale or a distribution of new shares of a parent company’s existing division.

These deals are on the rise. Equity research firm The Edge expects $1.5 trillion worth of global parent companies to 
execute spin-offs in 2015, over double 2014’s figure. Furthermore, the firm projects the value of these global transactions to reach $3 trillion by 2016.

Domestically, The Edge expects an 18% increase in spin-off transactions, with around 40 to 42 US parent companies spinning off this year. This is compared to 34 transactions by U.S. parents last year.

What’s behind this upward momentum? Many companies and investors have realized that businesses can garner higher valuations if they are independently owned. Shareholder activists have also been exerting pressure on parent companies to maximize their worth through these transactions.

Going It Alone and Flourishing

Recent successful spin-offs have also boosted their appeal. Consider retail bank holding company Citizens Financial Group, which spun off from parent company the Royal Bank of Scotland (RBS). Before its separation, the regulatory pressures and subprime fallout that RBS was undergoing reportedly hindered Citizen’s growth. But after Citizens’ September 2014 initial public offering, the bank has been expanding its commercial lending and other businesses.

Taking Shareholders for a Spin

Spin-offs have also become a popular way for companies to increase shareholder value. The current low interest rate environment has motivated many firms to spin off income-producing assets. “This is particularly evident in the energy sector, where companies have routinely spun off assets into master limited partnerships (MLPs), and for companies with substantial real estate holdings as they have spun off assets into real estate investment trusts (REITs),” said Shaival Patel, a director in event driven equities at The Spin-Off Report, a publication authored by Horizon Kinetics and PCS Research Services.

A recent example from the energy sector is California-based Sempra Energy’s plan to separate its liquefied natural gas business into an MLP called Sempra Partners. In healthcare, Ventas has spun off most of its skilled nursing and rehabilitation facilities into a new REIT named Care Capital Properties.

It’s All About the Margins

On top of increasing shareholder value, buyers can also look forward to rising profits when they acquire a spin-off.

According to Patel, margin growth usually becomes part of the new company’s overall strategy, and there are often opportunities for shareholders to purchase a low-margin business, with margin expansion being a key part of the growth story.

For instance, when military shipbuilder Huntington Ingalls Industries was spun off from security firm Northrop Grumman, it had 6% operating margins; it was able to grow those margins to upwards of 8% in a relatively short time.

Running a Tight Ship

Aside from the promise of higher margins, a spin-off’s independence is a key advantage for investors seeking to acquire a well-run target. As a streamlined firm with established leadership, a spin-off allows management to have a laser focus on a single business area.

“In buying a spin-off, there is a greater probability that the company has been ‘polished up’ and gained credibility since an enhanced and ‘public company ready’ leadership team will have been put in place and things like contracts and key processes tidied up,“ said George Budden, a partner at Deloitte.

Not All Hunky-Dory

However, the process of buying spin-offs is not always easy, specifically for smaller-cap firms.

Challenges include retaining employees used to working in a larger organization that offers brand prestige and more career mobility. Adapting information technology to a smaller firm that has basic systems might also present problems. Additionally, the new company’s back office infrastructure might not be ready for independence from the previous owner.

Getting in Early

Despite these setbacks, there are things investors can do to make the acquisition process more seamless. For instance, when buying a spin-off, get in early.

“A good time to buy a business is just before it is spun off as the buyer can get involved in the cleanup process and avoid the added cost of having a new, heavyweight board; unwinding the stock exchange listing; and experiencing shareholder issues that might come up post spin,” Deloitte’s Budden said.

Taking initiative is also is key. Smaller buyers in particular have a better chance of landing a desired acquisition if they proactively engage companies that own assets they are interested in. “Small-cap firms can use a spin-off idea as a way to open a discussion about a division they want to acquire,” Budden said.