Gabelli Funds – Financial Engineering Playbook by Christopher J. Marangi
Introduction
Financial engineering – including spin-offs, exchange offers, Reverse Morris Trust transactions, tracking stocks, share repurchases and REIT conversions – is increasingly being used by public corporations to create and surface value. Our Private Market Value with a Catalyst TM methodology, supported by deep, bottom-up research pre-disposes us toward companies with underappreciated assets and managements focused on gaining recognition for those assets. Financial engineering has been and will remain a natural focus for investment. In this white paper, we survey a variety of techniques utilized by the likes of Dr. John Malone’s Liberty Media, among others.
Avenues For Value Creation/Surfacing
We believe three primary levers lead to value creation/surfacing via financial engineering:
- Tax-efficiently re-arrange assets for sale. The operations of diversified companies may appeal to different buyers. Rather than selling assets and incurring corporate level taxation, a number of companies have separated “wanted” from “unwanted” businesses via spin-off or exchange offer.
- Brink’s Company: With different potential buyers for Brink’s home security (Broadview) and armored car businesses, Brink’s spun-off Broadview in October 2008. In January 2010, security market-leader Tyco/ADT purchased Broadview at a significant premium.
- Ralcorp: In March 2011, Conagra launched a series of unsolicited offers for Ralcorp, culminating at $94/share. Ralcorp rebuffed those offers and in January 2012, spun-off Post Holdings, a business not highly valued by Conagra. In November 2012, Ralcorp finally accepted a $90/share offer from Conagra, but not before surfacing an incremental $21/share (based on Ralcorp holders receiving one-half share of Post, which as of December 2013 trades at $49/share).
- Highlight misunderstood dynamics. Corporations often possess segments that differ from their primary business line and thus are less well-followed. Separating those assets can force market participants to assign an appropriate value to those assets.
- Cablevision, a cable operator in the New York market, also owned the Madison Square Garden (MSG) sports assets and the AMC group of cable networks. These units were not ascribed full value in the public market or in the controlling Dolan family’s October 2007 $36.26 LBO offer. CVC spun-off MSG and AMC in February 2010 and June 2011, respectively, potentially facilitating the future acquisition of each piece. The three stocks today would aggregate to $50/share, more than doubling the return of the S&P 500.
- Liberty Ventures: Having been spun-off from Liberty Media in 2011, Liberty Interactive (owner of multichannel commerce company QVC) issued a security known as Liberty Ventures (LVNTA) that tracks the value of an overlooked package of publicly-traded securities, cash and tax-advantaged liabilities. Since LVNTA began trading in August 2012, it has risen from $45/share to nearly $120/share as of this writing.
- Arrive at more favorable capital structure. Modern finance theory would suggest returns to equity can be enhanced by reducing cash flow shared with the government via taxes through the use of leverage or corporate structures such as REITs or MLPs.
- DIRECTV: Although now common, rarely have buybacks been as large or effective as DTV’s. Since 2006, DTV (at one time controlled by John Malone’s Liberty Media) has used its cash flow and debt capacity to purchase over $30 billion of its own stock, reducing its share count from 1.4bn to 530m and driving a compounded return of 10% through 2013.
- Gaylord Hotels owned and operated four large convention and lodging properties until selling its brands to Marriott Intl. and converting to a REIT (now known as Ryman Hospitality) in January 2013. In the process, it triggered a 100%+ rise in its adjusted share price from $19 in December 2011 to over $40 in December 2013.
Financial Engineering Techniques
In this section we review in more depth the techniques and requirements of some of the most popular financial tools:
Reorganizations
A. Spin-offs. Under §355 of the US tax code, corporations may distribute assets to shareholders tax-free if they meet the following criteria:
- Control requirement: Parent must “control” at least 80% of the vote of SpinCo prior to distribution.
- Active Business requirement: Parent and SpinCo must each actively conduct at least one trade or business after the distribution and have been conducting such trade or business for at least five years prior to the distribution.
- Device Test: The distribution must not be used principally to distribute the earnings and profits of a corporation.
- Distribution requirement: Parent must distribute at a minimum “control” of SpinCo.
- Business Purpose requirement: The distribution must be motivated by one or more business purposes.
Corporations and investors pay most attention to not running afoul of the Device Test. The acquisition of Parent or SpinCo subsequent to a distribution will generally not fail the device test as long as there were no “substantive negotiations” – understood to mean the discussion of price – regarding a deal for two years prior to the distribution. Several safe harbors exist, including a waiting period of two years following a distribution. We note several recent deals – including the acquisition of Ralcorp ten months after its spin-off of Post Holdings – have been announced relatively shortly post spin, evidently because of an absence of substantive negotiations prior to the spin-off.
Split-offs (a/k/a Exchange Offers).
Distributions that are not made pro-rata to all shareholders are known as “split-offs” and are more popularly employed as “exchange offers.” In an exchange offer, shareholders can vary their ultimate holdings of Parent and SplitCo. As shown in Exhibit 2, a Parent company can choose to dispose of its stake in a subsidiary by offering shareowners the opportunity to volunteer to exchange their holdings of Parent for holdings of SplitCo at varying levels. The company selects a ratio of Parent to SplitCo (usually a discount to SplitCo’s ultimate trading price) that would clear the market and the Parent shares turned in by volunteering shareholders are retired.
Corporations can benefit from exchange offers (versus spin-offs) because they enable the shrinking of their shares outstanding. However, exchanges typically require a value for the SplitCo determined via a preceding IPO or by a “buyer” in a Reverse Morris Trust transaction. Shareholders more clearly benefit from exchanges because they allow the re-arrangement of holdings without having to incur the taxes and trading costs of buying one entity and selling the other.
See full PDF below.
