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Sponsored spin offs: the private equity fund as anchor investor

One way for large corporates to find private equity buyers for non-core operations may be to spin them off. Paul S Bird and Peter F G Schuur of Debevoise discuss the legal and tax issues involved in structuring such an investment opportunity.

In these times of tight financing, finding a buyer for a non-core line of business presents real challenges for a corporate parent. A spin-off may be an attractive structure to facilitate a private equity fund's interest in such an investment. Unlike a cash sale of a subsidiary or a division, if the spin-off qualifies as a tax-free investment, the parent will not incur any tax cost in disposing of the target business. As a result, the spin-off may create an investment opportunity that would otherwise not be available to the private equity fund. This section discusses the structural, legal and tax issues that must be carefully analyzed in structuring a spin-off for a private equity investment, including the new guidelines on structuring constraints contained in the so-called “Anti-Morris Trust” rules issued by the IRS in 2002.  

Structure of Transaction
In order to effect a tax-free spin-off in anticipation of an investment by a private equity fund, parent typically would first distribute all of the stock of an existing or newly created subsidiary to its shareholders on a pro rata basis in the form of a special dividend. If the target business is held in a separate subsidiary or constitutes a relatively small portion of parent's value, parent generally would spin off the target business. The distribution would be followed by a pre-arranged investment by the private equity fund in the spin-off company. As described below, however, in some situations, parent and the fund may prefer that parent spin off all of the non-target businesses so that the fund can acquire shares in the parent (containing only the target business) after the spin-off.  As used in this section, “Spinco Target” refers to the business in which the private equity fund will make its investment, and “Parent” refers to the spinning or spin-off company, as the case may be.

For a spin-off to qualify as a tax-free transaction, generally the private equity fund's investment must be structured as a primary investment (that is, a purchase of newly issued shares) and the fund must acquire less than 50% by vote and value of the shares of Spinco Target. If the spin-off fails to qualify as tax-free, both Parent and its shareholders may be subject to significant taxes in connection with the distribution.

Advantages/Disadvantages
There are a number of reasons why a spin-off to facilitate a private equity fund's investment may be advantageous to both the fund and Parent. From the fund's perspective, the target business may be an attractive investment opportunity because it is not correctly valued by the market (for example, because Parent trades at a lower P/E ratio than the appropriate ratio for the target business). From Parent's perspective, the spin-off may free Parent to focus on its core business while preserving for Parent's shareholders a share of any future increase in value that the private equity fund brings to Spinco Target.  The investment by the private equity fund may also enhance the ability of Spinco Target to operate as a stand-alone business, thereby allowing Parent to effect the spin-off earlier than it would have otherwise been able to do.  In addition, the spin-off may facilitate a more direct incentive structure for management compensation. Further, the participation of a private equity fund as an “anchor” investor in Spinco Target may serve to validate Parent management's decision to spin off the business and the choice of the management team selected to lead Spinco Target.

There are also disadvantages attendant to a post-spin-off investment by a private equity fund. Under the Anti-Morris Trust rules, if the investment is agreed to or is the subject of an understanding, arrangement or substantial negotiations at some time within the two-year period ending on the date of the spin-off, the private equity investor generally will not be permitted to acquire 50% or more by vote or value of the shares of Spinco Target. As a result, the private equity investor will not be able to exercise outright control over Spinco Target or its board of directors. As discussed in greater detail below, a subsequent change of control of either Parent or Spinco Target within the two-year period following the spin-off could result in burdensome taxes being imposed on Parent. Spin-offs can also involve significant transaction costs, and Parent and its shareholders receive no proceeds from the distribution of shares. Moreover, unlike a privately held portfolio company, Spinco Target will continue to be subject to SEC reporting requirements, and the value of the shares will continue to fluctuate in the market.

Structuring Considerations
Separation Issues. Unless the spin-off business currently operates autonomously on both an operating and financing basis, a spin-off will raise a series of separation issues, similar to those faced in connection with an asset purchase of a division. Generally, a distribution agreement will allocate assets and liabilities, including contingent liabilities and debt between Parent and Spinco Target. Parent and Spinco Target may also need to enter into transitional service arrangements and intercompany licensing arrangements for shared technology. In connection with a spin-off, Parent and Spinco Target will also enter into a tax sharing arrangement for allocating pre-spin-off tax liabilities and tax benefits, as well as responsibility for any taxes that are imposed on Parent if the spin-off fails to qualify as a tax-free transaction. Although Spinco Target will establish its own management incentive plans, there typically will also be a need for a separate agreement allocating pre-spin-off assets and liabilities relating to employee benefits between Parent and Spinco Target. The private equity firm will want to be actively involved in negotiating the terms of these separate arrangements and any indemnities that accompany them.

Control issues. As mentioned above, if the private equity fund's investment is agreed to or is the subject of an understanding, arrangement or substantial negotiation regarding the investment on a similar investment at some time during the two-year period ending on the date of the spin-off, under the tax rules the private equity fund generally will not be permitted to acquire 50% or more by vote or value of the shares of Spinco Target. Since, for tax purposes, voting power is generally measured by a shareholder's power to appoint directors, the fund also will not be able to control Spinco Target's board of directors. The fund may nevertheless be able to obtain practical control if the remaining ownership of Spinco Target is highly dispersed. In addition, the private equity firm may be able to negotiate veto rights, both at the shareholder and board of directors level, although these must be carefully tailored to avoid giving the fund “deemed control” over Spinco Target for tax purposes. Control arrangements, as well as representations relating to the target business and other arrangements relating to the private equity fund's investment, would be set forth in a separate investment agreement.

Debtholder issues. In connection with the spin-off, the existing debt of the group must be allocated between Parent and Spinco Target. A significant due diligence issue is whether the spin-off will violate the terms of the indentures or credit agreements governing the debt of either company. As many indentures and credit agreements restrict the amount of dividends or distributions to shareholders or the disposition of “all or substantially all” or significant portions of a company's assets, a spin-off may be subject to the debtholders' consent. In order to inject an appropriate amount of leverage into Spinco Target, it may be desirable to allocate a disproportionate amount of debt to the target company in connection with the spin-off. One practical limit on pushing debt into a subsidiary that is to be spun off, however, is the Parent's tax basis in the subsidiary; any excess amount of debt will give rise to corporate tax in connection with the spin-off.

In order to increase flexibility in allocating debt between Parent and Spinco Target, it may be preferable for Parent to transfer all of its non-target business to a new subsidiary, leaving behind the target business together with an appropriate amount of debt. Parent would then spin off the new subsidiary and the private equity investor would acquire shares in Parent containing only the target business. Of course, if the non-target businesses are significantly larger than the target business, this reverse structure may significantly increase transaction costs. Also, since any company-level taxes resulting from the spin-off's failure to qualify as a tax-free transaction will be imposed on Parent, the private equity fund's investment will be subject to a significant contingent liability. In this situation, a good tax indemnity is critical.

Tax issues. A spin-off must satisfy a number of technical requirements to qualify as a tax free transaction. If a spin-off does not satisfy these requirements, Parent will be subject to tax on the excess of the value of Spinco Target over Parent's tax basis in the shares of Spinco Target. In addition, Parent's shareholders will be treated as having received a taxable distribution from Parent equal to the value of Spinco Target.

The principal requirements for a tax-free spin-off are:

• Parent and Spinco Target each must have been engaged in an active trade or business during the entire five-year period prior to the spin-off;
  
  
• Parent must distribute stock that constitutes at least 80% of the Spinco Target's voting stock and 80% of each other class of stock, and generally can-not retain any shares of Spinco Target;
  
  
• the spin-off must be undertaken for an IRS-approved “corporate business purpose” (including facilitating an investment in Spinco Target or Parent);
  
  
• the spin-off cannot be principally a “device” for distributing earnings to the shareholders of Parent; and
  
  
• the shareholders of Parent must retain a continuing interest in both Parent and Spinco Target.

As discussed above, a spin-off that is followed by an investment must also satisfy the Anti-Morris Trust rules that generally provide that, if an otherwise tax-free spin-off is part of a plan pursuant to which one or more persons acquires shares constituting 50% or more by vote or value of either the Parent or the spin-off company, the spin-off will be treated as taxable to the Parent company, but not necessarily to the shareholders. A plan will be presumed to exist if a change of control of Parent or the spin-off corporation occurs at any time during the two years prior to, or the two years following, the spin-off.

Temporary Treasury regulations issued in April 2002 provide additional guidance on when a spin-off and a subsequent acquisition are considered to be part of a plan for purposes of the Anti-Morris Trust rules. The regulations list a number of facts and circumstances that must be weighed in determining whether the acquisition is part of the plan, and also provide for several safe harbors that, if satisfied, prevent a spin-off and an acquisition from being considered as part of a plan.  The temporary regulations focus more on objective factors and less on subjective intent and are generally considered more favorable to taxpayers.  Unfortunately, a spin-off that is followed by a pre-arranged investment of 50% or more in Parent or the spin-off company will not qualify for any of the safe harbors. As a result, such an investment must be limited to less than 50% of the shares of the target company by vote or value.  For this purpose, an option granted in connection with the investment will be treated as exercised, unless Parent can establish that, upon the date that the option is written, there was a 50% or smaller possibility that the option would be exercised.  In the event the private equity investor first approaches a spun off corporation after the spin-off has been effected and a six-month “cooling off” period has occurred, however, if the spin-off was motivated by a corporate business purpose other than to facilitate an acquisition, pursuant to a safe harbor, the private equity investor would be permitted to acquire 50% or more of the spin-off company or the Parent.

Shareholder Approval
Shareholder approval is not required for most spin-offs. Section 271 of the Delaware General Corporation Law requires shareholder approval only for a sale, lease or exchange of all or substantially all of a company's assets. The relevant cases suggest that a spin-off is not a sale, lease or exchange. Furthermore, in the majority of spin-offs, the assets being spun off will not represent “all or substantially all” of the company's assets. A transaction involving a major reshuffling of the company's subsidiaries or assets, followed by the spin-off of substantially all of the company's assets, may require shareholder approval under Delaware law and other states' law such as New York, which require shareholder approval for a sale, lease, exchange or other disposition of all or substantially all assets.

Securities Law Issues
The federal securities law issues relating to spin-offs are fairly well settled.

In September 1997, the SEC's Division of Corporate Finance (the “Division”) released a staff legal bulletin setting forth the factors the Division would consider to determine whether a subsidiary being spun off by its parent company would be required to register the spin-off under the Securities Act of 1933, as amended (the “33 Act”). The Division stated that it would not require registration in cases where:

• Parent's shareholders do not provide consideration for the spun-off shares;
  
  
• the spin-off is pro rata to Parent shareholders;
  
  
• Parent provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets;
  
  
• Parent has a valid business purpose for the spin-off; and
  
  
• if Parent spins off “restricted securities,” it has held those securities for at least two years.

The Division explained that the first two factors help satisfy the requirement that the spin-off not involve a “sale” of the securities by Parent by ensuring that shareholders not give up value for the spun off shares. To satisfy the third factor, the subsidiary, if not already a reporting company under the Securities Exchange Act of 1934, as amended (the “34 Act”), is required to file with the SEC on a Form 10 and provide to the shareholders an information statement, which contains essentially the same disclosure as required for a registration statement on Form S-1 under the 33 Act. The fourth factor - the need for a valid business purpose - also addresses the issue of whether the parent company receives value for the spun-off shares. Examples of a valid business purpose are allowing management of each business to focus solely on that business, providing employees of each business stock-based incentives linked solely to his or her employer or business' performance, enhancing access to financing by allowing the financial community to focus separately on each business and enabling the companies to do business with each other's competitors.

For the Division, the fifth factor ensures that Parent will not be deemed an underwriter engaged in a public distribution of “restricted securities.” The two-year holding period does not apply where Parent formed the subsidiary being spun off.

Staff Bulletin No. 4 also confirms that the Division will not require 33 Act registration simply because the parent company asks its shareholders to vote on the proposed spin-off. So long as there is a valid business purpose for the spin-off, the Division declared that a vote on the asset transfer that may be involved in the spin-off does not change the overall nature of the transaction.

Form 10 is used to register the spun-off securities under the 34 Act. Much like an S-1 prospectus, the information statement included in the Form 10 describes the spun-off company's business, properties and management, and includes information on executive compensation, employee benefit plans, financial data, management's discussion and analysis of results of operations and financial condition and historical and pro forma financial statements. SEC review of a Form 10 registration statement is substantially similar to that for an S-1.

Structuring the sale of a non-core business as a spin-off clearly involves significant and challenging hurdles and will require close coordination with counsel and other advisors; yet it can often be the only good way for a corporate parent and a prospective private equity investor to tap the pent up value in an underutilized line of business.

* Reprinted from The Debevoise & Plimpton Private Equity Report (Spring 2002), by Paul S Bird and Peter F G  Schuur, partners at Debevoise & Plimpton.

Copyright © 2002 Debevoise & Plimpton

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Hong Kong and Moscow.

Paul S Bird (psbird@debevoise.com) is co-chair of Debevoise & Plimpton's Mergers and Acquisitions Group and is based in the firm's New York office. Peter F G Schuur is a partner in Debevoise & Plimpton's Tax Group, and is based in the firm's London office. Copyright 2002 by Paul S. Bird and Peter F.G. Schuur. All rights reserved. Portions of this article have appeared, or may appear, in other materials published by the authors or their colleagues. No portion of this article may be reproduced without the express consent of the authors.