A Study of Different Modes of Corporate Restructuring


By

Rakesh Kumar Sharma
Senior Lecturer of Management
Ansal Institute of Technology
Sector-55, Gurgaon
 


The 1980's bore witness to a decade of aggressive mergers, acquisitions and takeovers. The mergers and acquisitions scenario is hotting up in India. According to PricewaterhouseCoopers, the value of M&A deals announced in the first six months of 2005 was $6.9 billion, compared to $2.9 billion in the first half of 2004, and more than the $5.2 billion in the whole of 2004. The corporate are being concerned at cocktail parties by people who are eager to explain their system for making creamy profits by investing in common stock. Fortunately, these bores go into temporary hibernation whenever the market goes down.

There are a number of factors depicting the significance of this study. All innovations and inventions in terms of corporate and principles happen abroad, and then are being carried to Indian environment. Corporate restructuring, out of all emerging concepts of findings ways to serve shareholders better, has been a very successful concept abroad and its been followed all the more in high context cultures like India. The rapidity with corporate finance due to external factors like increased price volatility, a general globalisation of the markets, tax asymmetric, development in technology, regulatory change, liberalisation, increased competition and reduction in information and transaction costs and also intrafirm factors like liquidity needs of business, capital costs and growth perspective have lead to practice of corporate restructuring as a strategic move to maximise the shareholder's value.

The "Corporate restructuring" is an umbrella term that includes mergers and consolidations, divestitures and liquidations and various types of battles for corporate control. The essence of corporate restructuring lies in achieving the long run goal of wealth maximisation. This study is an attempt to highlight the impact of corporate restructuring on the shareholders value in the Indian context. Thus, it helps us to know, if restructuring generates value gains for shareholders (both those who own the firm before the restructuring and those who own the firm after the restructuring), how these value gains have be created and achieved or failed.

Further, it will also focus on issues involving ownership and controls. This leads logically to the subject of leveraged buyouts. It was during 1980s that many of the new tools which made leveraged buyouts possible, including high yield or junk bonds, found favour.

Last year, M&A activities were largely restricted to IT and telecom sectors. They have now spread across the economy. As Businessworld recently reported, this is the fourth wave of corporate deal-making in India.

The first happened in the 1980s, led by corporate raiders such as Swaraj Paul, Manu Chhabria and R P Goenka, in the very early days of reforms. In view of the license raj prevailing then, buying a company was one of the best ways to generate growth, for ambitious corporates.

In the early 1990s, in the liberalised economy, Indian business houses began to feel the heat of competition. Conglomerates that had lost focus were forced to sell non-core businesses that could not withstand competitive pressures. The Tatas, for instance, sold TOMCO to Hindustan Lever. Corporate restructuring, largely drove this second wave of M&As.

The third wave started about five years ago, driven by consolidation in key sectors like cement and telecommunications. Companies like Bharti Tele-Ventures and Hutch bought smaller competitors to establish a national presence.

What makes the most recent wave of M&As different from the three previous ones is the involvement of global players. Foreign private equity is coming into Indian companies, like Newbridge's recent investment in Shriram Holdings.

Multinational corporations are also entering India. Swiss cement major Holcim's investment in ACC and Oracle's purchase of a 41 per cent stake in i-flex solutions (for $593 million) are good examples.

Meanwhile, Indian companies, sensing attractive opportunities outside the country are also venturing abroad. Tata Steel has bought Singapore-based NatSteel for $486 million. Videocon has bought the colour picture tubes business of Thomson for $290 million.

Such global forays have become a possibility because foreign exchange is no longer a scarce commodity. They have also become a necessity because in globalising industries, only players with global scale and reach can survive.

At the same time, the difficulties involved in making M&As click must not be underestimated. A paradigm shift is likely in the coming years. Friendly deals could give way to aggressive ones. In future, we may see hostile bids and leveraged buyouts. Most M&As so far have been cash deals. With the Sensex crossing 9000, stock deals may become more common. As the appetite for deal making increases, the valuation is also bound to go up. In short, exciting times are ahead.

The term corporate restructuring encompasses three distinct, but related, groups of activities; expansions including mergers and consolidations, tender offers, joint ventures, and acquisitions; contraction including sell offs, spin offs, equity carve outs, abandonment of assets, and liquidation; and ownership and control including the market for corporate control, stock repurchases program, exchange offers and going private (whether by leveraged buyout or other means). Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world. One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A.

This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.

We will briefly look at each of the three major categories of restructuring in the section which follow as:

* Expansions:

Expansions include mergers, consolidations, acquisitions and various other activities which result in an enlargement of a firm or its scope of operations. There is a lot of ambiquity in the usage of the terms associated with corporate expansions.

A Merger involves a combination of two firms such that only one firm survuves. Mergers tend top occur when one firm is significantly larger than the other and the survivor is usally the larger of the two.A Merger can take the form of :

* Horizontal merger involves two firms in similar businesses. The combination of two oil companies or two solid waste disposal companies, for example would represent horizontal mergers.

* Vertical mergers involves two firms involve in different stages of production of the same end product or related end product.

* Conglomerate mergers involves two firms in unrelated business activities.

A consolidations involves the creation of an altogether new firm owning the assets of both of the first two firms and neither of the first two survive. This form of combination is most common when the two firms are of approximately equal size.

The joint ventures, in which two separate firms pool some of their resources, is another such form that does not ordinarily lead to the dissolution of either firm. Such ventures typically involve only a small portion of the cooperating firms overall businesses and usually have limited lives.

The term acquisitions is another ambiguous term. At the most general, it means an attempts by one firm, called the acquiring firm to gain a majority interest in another firm called the target firm. The effort to gain control may be a prelude to a subsequent merger to establish a parent subsidiary relationship, to break up the target firm and dispose of its assets or to take the target firm private by a small gropu of investots. There are a number of strategies that can be employed in corporate acuisitions like friendly takkeovers, hostile takeovers etc.The specialist have engineered a number of strategies which often have bizarre nicknames such as shark repellents and poison pills terms which accurately convey the genuine hostility involved. In the same vain, the acquiring firm itself is often described as a raider. One such strtegy is to emply a target block repurchase with an accompaying stanstill agreement. This combination sometimes describes as greenmail.

* Contractions:

Contraction, as the term implies, results in a maller firm rather than a larger one. If we ignoe the abondanment of assets, occasionally alogical course of action, coporate contraction occurs as the result of disposition of assets. The disposition of assets, sometimes called sell-offs, can take either of three board form:

* Spin-offs
* Divestitures
* Carve outs.

Spin-offs and carve outs create new legal entities while divestitres do not.

* Ownership and Control

The third mahor area encompassed vy the term corpoate restructuring is that of ownership and control. It has been wrested from the current board, the new managemt willl often embark on a full or partial liquidatin strategy involving the sale of assets. The leveraged buyout preserves the integrity of the firm as legal entity but consolidates ownership in the hands of a small groups. In the 1980s, many large publicly tradedd firms went private and employes a similar strategy called a leveraged buyout or LBO.

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders.

Synergy

Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:

Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.

Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.

Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.

Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes  a merger  does just the opposite.

Mergers and Acquisitions : Valuation matters

Investors in a company that is aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth.

Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.

There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company . Here are just a few of them:

Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:

Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.

Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.

Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.

Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill capital expenditures cash taxes - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

Mergers and Acquisitions : Break Ups

As mergers capture the imagination of many investors and companies, the idea of getting smaller might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders.


Advantages

The rationale behind a spinoff, tracking stock or carve-out is that "the parts are greater than the whole." These corporate restructuring techniques, which involve the separation of a business unit or subsidiary from the parent, can help a company raise additional equity funds. A break-up can also boost a company's valuation by providing powerful incentives to the people who work in the separating unit, and help the parent's management to focus on core operations. Most importantly, shareholders get better information about the business unit because it issues separate financial statements. This is particularly useful when a company's traditional line of business differs from the separated business unit. With separate financial disclosure, investors are better equipped to gauge the value of the parent corporation. The parent company might attract more investors and, ultimately, more capital. Also, separating a subsidiary from its parent can reduce internal competition for corporate funds. For investors, that's great news: it curbs the kind of negative internal wrangling that can compromise the unity and productivity of a company. For employees of the new separate entity, there is a publicly traded stock to motivate and reward them. Stock options in the parent often provide little incentive to subsidiary managers, especially because their efforts are buried in the firm's overall performance.

Disadvantages

That said, de-merged firms are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies. And the smaller size of the firm may mean it has less representation on major indexes, making it more difficult to attract interest from institutional investors. Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm divides itself into smaller units, it may be losing the synergy that it had as a larger entity. For instance, the division of expenses such as marketing, administration and research and development (R&D) into different business units may cause redundant costs without increasing overall revenues.

Restructuring Methods

There are several restructuring methods: doing an outright sell-off, doing an equity carve-out, spinning off a unit to existing shareholders or issuing tracking stock. Each has advantages and disadvantages for companies and investors. All of these deals are quite complex.

Sell-Offs

A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn't fit into the parent company's core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.
Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders' method certainly makes sense if the sum of the parts is greater than the whole. When it isn't, deals are unsuccessful.

Equity Carve-outs

More and more companies are using equity carve-outs to boost shareholder value. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent's shareholder value.

The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm's board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.

That said, sometimes companies carve-out a subsidiary not because it's doing well, but because it is a burden. Such an intention won't lead to a successful result, especially if a carved-out subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits.

Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.

Spinoffs

A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of the subsidiary to its shareholders through a stock dividend. Since this transaction is a dividend distribution, no cash is generated. Thus, spinoffs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out, the subsidiary becomes a separate legal entity with a distinct management and board.
Like carve-outs, spinoffs are usually about separating a healthy operation. In most cases, spinoffs unlock hidden shareholder value. For the parent company, it sharpens management focus. For the spinoff company, management doesn't have to compete for the parent's attention and capital. Once they are set free, managers can explore new opportunities.

Investors, however, should beware of throw-away subsidiaries the parent created to separate legal liability or to off-load debt. Once spinoff shares are issued to parent company shareholders, some shareholders may be tempted to quickly dump these shares on the market, depressing the share valuation.

Tracking Stock

A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. The stock allows the different segments of the company to be valued differently by investors. Let's say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to have a fast growing business unit. The company might issue a tracking stock so the market can value the new business separately from the old one and at a significantly higher P/E rating. Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth business for shareholders? The company retains control over the subsidiary; the two businesses can continue to enjoy synergies and share marketing, administrative support functions, a headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company can use the tracking stock it owns to make acquisitions.

Still, shareholders need to remember that tracking stocks are class B , meaning they don't grant shareholders the same voting rights as those of the main stock. Each share of tracking stock may have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all.

Review of Existing Literature

Review of existing literature has a great relevance in the research of any project as it acts as a backbone for new studies. Review of existing literature includes the history of the study, previous studies that had already being done on the subject. It lets the researcher explore on all these dimensions which have remain untouched in previous studies on the said topic. Therefore, it provides a necessary base and acts as a broader frame work and guideline to give researcher a clear cut focus for the fresh attempt.

Here are some of the views and studies by some of the researchers about the impact of corporate restructuring on shareholders value:

Guru of corporate restructuring: Bruce Wasserstein

In the mid-1980s, there was an avalanche of takeovers of underperforming companies, the targets of institutions and arbitrageurs who suspected that, with the help of plentiful leverage, they could increase corporate values by 'mobilizing assets'. Often that term meant disposal of non-performing assets. In his 1998 book Big Deal, Wasserstein surveys the 'the battle for control of America's leading corporations'. He describes five waves of mergers beginning in the mid-1800s: the first involved the building of the railroad empires; the second, in the 1920s, saw merger mania fueled by a frothy stock market and rapid industrial growth; the third happened in1960s featured the rise of the conglomerate; the fourth occurred with the hostile takeovers of the 1980s, driven by names such as Icahn, Boesky and Milken; and finally, a fifth wave happening today. Wasserstein attributes the explosion of M&A activity at the turn of the century to the need for companies to reposition themselves in today's ever changing competitive environment.

Porter (1987) attempted to study this relationship in a slightly different way. He took rate of divestment of new acquisitions by companies within a few years as an indicator of success or failure. He found that about 75 percent of all unrelated acquisition in the sample was divested after few years and 60 percent of acquisitions in entirely new industry.

In 1992, Aggarwal, Jaffe and Mandelkar studied post merger performance of the companies with a different perspective. They adjusted data for size effect and beta weighted market return and found that shareholders of the acquiring firms experienced a wealth loss of about 10% over the period of five years following the merger completion.

A study done by J. Fred Weston and Samual C. Weaver shows that around 50% mergers are successful in terms of creation of values for shareholders.

Anslinger and Copeland (1996) studied returns to shareholders in unrelated acquisition covering the 1985 to 1995 and they found that in two third cases companies were failed to earn their cost of acquisition.

Robert W. Holthausen "The Nomura Securities Company Professor, Professor of Accounting and Finance and Management": Various studies have shown that mergers have failure rates of more than 50 percent. One recent study found that 83 percent of all mergers fail to create value and half actually destroy value. This is an abysmal record. What is particularly amazing is that in polling the boards of the companies involved in those same mergers, over 80% of the board members thought their acquisitions had created value.

Corporate India - Still counting costs of restructuring : S. Vaidya Nathan : Not one company has restructured itself in a way that could rekindle investor interest and improve valuations substantively.

Wockhardt has come the closest : Restructuring, painful and protracted: Numerous companies -- big and small -- have traversed the restructuring route and shown some improvement in stock prices. But this aspect is only from the point of view of shareholders who had entered the stocks at lows, post-1996. No domestic company pursuing restructuring has shown conclusive and sustainable improvement in valuation in the long-term interest of the shareholders. As far as companies with a presence in a range of businesses go, though most have shed a few businesses, they still retain the profile of unfocussed business entities with limited competitive edge. And they are still in the process of restructuring despite having had a few rounds of mergers, de-mergers, asset sell-offs, one-time special dividend payments, stock buybacks and capital reduction.

Prashant Kale of University of Michigan, and Harbir Singh of Wharton, a study on M&As between 1992 and 2002, concluded that in the initial years of economic liberalisation, Indian companies failed to create sufficient value from acquisitions, as compared to MNCs. However, with the passage of time, Indian companies have begun developing the necessary capabilities to create more value from deals. But returns on acquisitions fell after 1998.

Stressing on the importance on changes required in the restructuring environment in the country, Ashwani Puri, Head, Corporate Finance and Recovery Services-PricewaterhouseCoopers India said, "Business Restructuring in India has been slow and expensive. Lack of conducive regulatory environment, a complex tax framework, court processes and an endless list of compliance issues impede the process and impair efficient and effective realignment of resources through restructuring. 

Evidences and several studies suggests that "Intense competition, rapid technological change, major corporate accounting scandals, and rising stock market volatility have increased the burden on managers to deliver superior performance and value for their shareholders. In the modern "winner takes all" economy, companies that fail to meet this challenge will face the certain loss of their independence, if not extinction. Corporate restructuring has enabled thousands of organizations around the world to respond more quickly and effectively to new opportunities and unexpected pressures, there by reestablishing their competitive advantage".

Thus recombinant techniques' of corporate finance often have an impact on the financial markets far beyond the individual companies and sectors they involve and, in theory, all return real control of companies to shareholders. Virtually without exception, stock prices of participating companies rise in response to announcements of corporate restructuring. But are such events good for investors beyond the very short term?

References

* Dalal Street
* Finance India
* ICAI Capital Market
* Money outlook
* Indian Economy

Websites:

www.bseindia.com
www.domainb.com
www.sebi.gov.in
www.nseindia.com
www.statsindia.com
www.investopedia.com
www.envestindia.com
www.moneycontrol.com

Books:

* Kothari, C.R., Research Methodology Methods and Techniques, Washwa Prakashan, 2003
Mergers & acquisitions; Centre for monitoring Indian Economy
 


Rakesh Kumar Sharma
Senior Lecturer of Management
Ansal Institute of Technology
Sector-55, Gurgaon
 

Source: E-mail December 27, 2007

          

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