Tuesday, February 8, 2011

The Risky and Profitable Business of Investing in Spin-Off Companies

Investments in spin-off companies are often profitable (depending on their timing, of course). These transactions can take many different forms (spin-off IPO, carve-out, split-off, etc.). Marathon Oil Corporation’s decision to spin off its refinery business, Marathon Petroleum Corporation, for example, is one of many spin-offs in 2011’s transaction pipeline. Other recent and pending spin-offs include ConocoPhillips’ divestiture of its 20% ownership interest in Lukoil, Lundin Petroleum and Petrofrac’s spin-off of EnQuest PLC, and Norse Energy’s spin-off of Panoro Energy, to name a few.

What is a “spin-off” really? Provided certain rules under the Internal Revenue Code are met, spin-offs are a tax-free way for a company to divest a business (compared to an outright sale). And while a company’s specific circumstances may alter the outcome, the basic requirements to qualify for spin-off treatment include:

1. The parent company must control the “spun-off” company through either 80% or more of the total combined voting power of the company and 80% of all of the classes of shares entitled to vote.

2. The spun-off company cannot be used to distribute earnings and profits of the parent company.

3. The spin-off must have a legitimate business purpose.

4. The parent company and the spun-off company must have been involved in an “active trade or business” for the 5 year period leading up to the transaction closing date (and must continue to do so immediately after the spin-off).

5. There must be a “continuity of interest” (ownership) among the parent company and the spun-off company after the closing.

6. The parent company must distribute all of the stock it owned in the spun-off company.

Once a company chooses to spin off part of its business, there is a lag time between announcement and when the transaction becomes effective. This is because certain tax, legal and regulatory steps are required. Company lawyers must draft documents to legally divide the business and file the necessary paperwork (e.g., an SEC Form 10 registration).

Historically, in a spin-off transaction, the parent company’s stock does well, outperforming industry averages, in these months leading up to the announced transaction, but often not nearly as well in the months following the closing. Making a short term gain on parent stock in a prospective spin-off, therefore, means investors should understand how likely the company is to meet the legal requirements for completing the transaction because this can impact the speed and possibly the “steam” behind a pre-closing run-up.

Spun-off companies, by contrast, often tend to have negative share price returns in the months following a transaction. For example, take Pride International’s (PDE) 2009 spin-off of Seahawk Drilling (HAWK). According to some industry analysts, Seahawk experienced a -60% share price return in 2010. Spun-off companies can make attractive acquisition targets and are valued as longer term investments, however, because spun-off companies (especially smaller cap companies) have relatively high and absolute share price returns over the long term. A word of caution, however: analysts say that energy industry spin-offs have historically underperformed when compared to similar size transaction in other industries.

Have you been involved in a spin-off transaction? Please share your thoughts on spin-offs with us.

1 comment:

  1. Thanks for boiling all those pages of IRS rules and explanations down into a handful of bullet points.

    When following stock spin-offs of all kinds it is hard not to think "what are they doing?" in that space between the announcement of the intention and the next steps.

    Your post filled a gap in my understanding of the process.