Equitycarve-outs: A new spin on thecorporate structurePatricia Anslinger,he purpose of a corporate center is to do for theDennis Carey, subsidiaries what they cannot do eƒfectively forKristin Fink, and Tthemselves. Many structures serve this purpose:Chris Gagnonoperating companies, multibusiness companies, holdingcompanies, conglomerates, and even investment firms such as Berkshire Hathaway – all are diƒferent ways for a single, central parent to deliver value to its business units. The newcomer to the list is the equity carve-out. Like its predecessors, the carve-out enables a subsidiary to draw on the wisdom, experience, and practical assistance Pat Anslinger and Kristin Finkof the executive center. But it also oƒfers something new: are consultants in McKinsey’sa degree of independence that appears to foster innovationNew York office. Dennis Careyand co-founder of the DirectorsInstitute of Wharton andAn equity carve-out is the sale by a public company of managing director of Spencera portion of one of its subsidiaries’ common stock Stuart Executive Searchthrough an initial public oƒfering (IPO). Each carved-out Consultants. Chris Gagnon,subsidiary has its own board, operating CEO, and financialformerly a principal in the Newstatements, while the parent provides strategic direction Jersey office, is principal of Blueand central resources. As in any other corporate structure,Capital Investment. Copyright the parent can provide executive management skills,© 1997 McKinsey & and government relationships, and employee All rights , and perform time-consuming administrativeABOUT THE RESEARCHe used the Securities Data Corporationstrategies (see Appendix on page 172Wdatabase to examine all US domesticfor a detailed description of the companies equity carve-outs from 1985 to July 1996 inin this subset and how they performed). which the parent retained at least 50 percent We interviewed executives from four out of the subsidiary shares and had annualof five of these of at least $200 million. We thenHow the sample was compiledrefinedthesampleusingCompustat,Bloomberg,and news reports to eliminate certain 350 Securities Data Corporation database
subsidiaries such as financial institutions, –17 Financial buyers
foreign companies listed via ADRs, companies –44 Financial institutions
that were too young to evaluate, or those for –29 ADRs, foreign parents
–24 Spin-offs
which data were unavailable. –2 Reverse carve-outs
A subset of the sample was then created, –52 No record in Compustat
–13 Price discrepancies
comprising companies that had completed –50 Too small; inactive companies
multiple equity carve-outs and could be said toview 119 SamplethemasanintegralpartoftheiroperatingCURRENT RESEARCH∫ ∫∫∫THE McKINSEY QUARTERLY 1997 NUMBER 1165
∫∫∫∫CURRENT RESEARCHfunctions, freeing the subsidiary’s CEO to concentrate on products and markets. What is diƒferent is the way inwhich the role of the corporate center is clearly spelt out in contractual number of companies have chosen to spin oƒf a singlesubsidiary in this manner. A smaller group, includingThermo Electron, Enron, Genzyme, Safeguard Scientificsand, more recently, The Limited, have chosen the carve-outas their basic organizing structure, repeatedly selling stakesin their business units. The results are examined the performance of US equity carve-outsubsidiaries from 1985 to 1995, in cases where 50 percent or more of each subsidiary’s shares were retained by theparent. (We were interested only in those companies wherethe parent remained an operating center, not a looselyaƒfiliated holding company.) Over a three-year period, the subsidiaries in this sample showed average compoundannual returns of percent – percent better than the Russell 2000 Index (Exhibit 1). Those companies thatExhibit 1Overall performance of subsidiary carve-outsSubsidiary carve-out sampleRussell 2000 IndexAverage shareholder return1 Year2 Year3 YearCompound annual return
median return
size11910576Exhibit 2Performance of companies that repeatedly carve outParentCarved-out subsidiariesRussell 2000 IndexAverage shareholder return1 Year2 Year3 YearCompound annual sold stakes in subsidiaries fared even years aƒter the carve-out, their subsidiaries showedannual returns of percent. The parent companiesthemselves experienced average annual shareholder returnsof percent (Exhibit 2).** Parent company returns in the larger sample were notThe results suggest that equity carve-outs are an eƒfectiveevaluated as many only spun way for companies to exploit growth opportunities andout a single, small business,increase shareholder value. Safeguard Scientifics, forwhose performance wasinstance, has spawned six new companies since 1985, unlikely to have a significantwith revenue growing from $66 million then to $ billion effect on the McKINSEY QUARTERLY 1997 NUMBER 1
So what is it about a carve-out that promotes such growth?The answer appears to lie in the changed relationshipbetween the corporate center and the business unit, and the eƒfect this has in three important areas: corporategovernance, human resources, and governanceMore value from the corporate center. Many corporatecenters oƒten do little more than shadow-manage businessunits; and frequently they suboptimize the plans ofindividual business units in the search for intra-companysynergies. Carve-outs prevent these abuses. The agreementsbetween parent and subsidiary are communicated to thesubsidiary’s shareholders through the oƒfering prospectus. If the cost of the services the parent provides (typically 1 to 2 percent of revenue) is not deemed worth the benefits,then the subsidiary’s board has a responsibility to minorityshareholders to renegotiate the agreement or bring theservices in corporate center is therefore forced explicitly to add value by answering to an outside constituency ofshareholders. No transaction will be tolerated, eitherbetween the subsidiary and its parent or the subsidiary and another business unit, that is not in the economicinterests of all market scrutiny. Business units that are 100 percent-owned are the sole responsibility of their parents, and arethus the subject of countless corporate reviews, meetings,and reports. Carve-outs, however, are under the directscrutiny of investors and analysts who constantly measurethem against other companies. Far from fearing suchattention, CEOs of companies that conduct carve-outswelcome it as a means of monitoring (and improving)performance. ‘’We outsource that stuƒf to the market,’’ saysJohn Hatsopolous, CFO of Thermo Electron. “They’rebetter at it than we are and we get them to do the work.”Human resources High motivation. Linking pay and business unitperformance is one of the most diƒficult issues corporateboards face, and they seldom provide the kind of incentivesthat encourage outstanding performance. In carve-outs,however, corporate boards can use the market to align payclosely to performance, awarding managers stock in theirown carved-out units rather than cash bonuses and/orparent company payback is clear: increased entrepreneurialism, which benefits the parent company, the subsidiary, and CURRENT RESEARCH∫ ∫∫∫THE McKINSEY QUARTERLY 1997 NUMBER 1167
∫∫∫∫CURRENT RESEARCHtop managers alike. As Victor Poirier, CEO of ThermoCardiosystems (a carve-out from Thermo Electron), points out: “What you do is represented in the stock price.”In fact, many of the subsidiary CEOs we interviewed sawtheir compensation more than double during the first yearof independent England, a principal at compensation firm TowersPerrins, believes the prospect of higher compensation is akey motivation for executives in carved-out subsidiaries.‘’With carve-outs, companies have a once-in-a-lifetimeopportunity to develop a new executive and boardcompensation program. They can clearly indicate toinvestors, executives, and other employees that performance,ownership, risk, and reward are bound together. It’s excitingto work with these new-born companies.’’Money is not the only incentive. The carve-out structurealso responds to the psychological need of high-performingexecutives to be autonomous. Business unit presidents are no longer bit players in a billion-dollar company, they are that CEOs’ ownership of subsidiary stock will drive them to be too independent, at the expense of the group, can be dealt with by compensating them with a balance of subsidiary and parent stock. ThermoElectron rewards its subsidiary CEOs with a 40/40/20package: 40 percent subsidiary stock, 40 percent parentstock, and 20 percent stock in a diƒferent, though related, business retention. Companies sometimes lose their mosttalented people because they cannot oƒfer them enoughindependence.* Before Thermo Electron embarked on itscarve-out strategy, several key executives were lured awayby venture capitalists who promised them the chance toexercise their entrepreneurial talent by running their ownoperation with their own board of directors. Since then, nota single key executive has been lost. Safeguard Scientificshas had a similar experience: the company has not lost a topexecutive in the past five carve-out structures actually oƒfer executives a nicetradeoƒf between risk and reward. The CEO who is luredaway by a venture capital firm to start a new company* Spencer Stuart discovered probably faces a tougher initiation than the CEO of athat out of 41 CEO assignmentssubsidiary carve-out who has strong support from theover an eight-month period, parent percent were filled byexecutives who were numberSuccession planning. Subsidiary carve-outs serve astwo in their previous companies,breeding grounds for candidates who might succeed seniorand who were motivated by theexecutives in the parent company. Here, subsidiary CEOsdesire to run an independentget the chance to prove their business acumen and ability with their own board of directors. In discussions with168THE McKINSEY QUARTERLY 1997 NUMBER 1
GTE and SmithKline Beecham we learned that theyconsider board experience important in identifying internal candidates for for new ventures. The stock market’s closescrutiny of margins and earnings can inhibit investment in growth, which means new ventures within corporationsare sometimes underfunded. Equity carve-outs give parentcompanies in this position the chance to fund projects thatmight otherwise drain earnings. While the parent companyincludes the subsidiary’s equity on its balance sheet, theincome statement contains only a proportion of thesubsidiary’s expenses (51 percent ownership by the parentcompany would record 51 percent of the subsidiary’sexpenses).‘’Subsidiary carve-outs allow us to develop new businesseswe would not otherwise have developed,’’ states John Wood,CEO of Thermedics, a quality assurance and inspectionproduct company. Wood spun out Thermo Cardiosystems,which makes implantable heart-assistance devices, in has since achieved compound annual returnsfor shareholders of 66 investors. Because carve-outs enable investors to buy shares in distinct businesses, they can attract a newconstituency of shareholders. Investors can own shares infood company Nabisco, a carve-out of RJR, without owningshares in the parent tobacco company, for example. BoiseCascade, an integrated paper and forest products company,attracted 26 major new institutional investors when itoƒfered a minority interest in Boise Cascade OƒficeProducts, a direct supplier of branded and private-labeloƒfice furniture and -outs can also increase analysts’ coverage of theparent company and its various subsidiaries, which in turncan increase demand for stocks. Safeguard Scientifics sayscarve-outs have prompted new interest in the company from top-tier, international market analysts, and that it nowreceives more requests for company literature in a monththan it previously did in a capital at attractive prices. Traditional financialtheory suggests the market will value a project or business the same, irrespective of whether the parent or the subsidiary is raising funds. Many CEOs weinterviewed, however, felt the subsidiary could oƒfer stock at more attractive prices. Although we cannot test this opinion empirically, it is possible that when aCURRENT RESEARCH∫ ∫∫∫THE McKINSEY QUARTERLY 1997 NUMBER 1169
∫∫∫∫CURRENT RESEARCHTAX AND ACCOUNTING CONSIDERATIONSThe parent or subsidiary can receive thehe decision on how much to carve out willproceeds of the IPO. If the parent sells shares inTdepend on accounting and tax advantages. the subsidiary, it is considered a taxable gain orIf the parent retains 80 percent it can beloss. If the subsidiary sells primary shares, it isconsolidated for tax purposes and subsidiarygenerally treated as a non-taxable event, even dividends are fully deductible. A stake greaterif the proceeds of the shares are used to repaythan 50 percent allows a consolidation forloans to the subsidiary from the reasons .What to take into accountStake retained by parent<20%20% to <50%50% to <80%80%+Parent consolidates subsidiary for NoNoYesYesaccounting purposes
Parent consolidates subsidiary for tax NoNoNoYespurposes*
Parent can distribute/alter remaining shares NoNoNoYesin a tax-free distribution (section 355)
Dividend received deduction on subsidiary 708080100dividends to parent
Parent reports its equity investment in the Cost
Equity
Full
Full
subsidiary for accounting purposesmethodmethodconsolidationconsolidation* Tax consolidation is based on controlling 80% of the subsidiary voting shares based on vote and valuesubsidiary does an IPO, analysts take the time to evaluate its growth and profitability fully; whereas when the parentgoes to the market, its performance overshadows the smaller unit’s potential. Why doesn’t everyone do equity carve-outs?Any company undertaking an equity carve-out shouldrealize that the act itself is no guarantee of success. The median compound annual return of our sample groupwas only percent, compared with percent for theRussell 2000 over a three-year period. In other words, while some companies do extremely well from carve-outs,others do analyzing the also-rans, we discovered that not all thecarve-outs were done to spur performance: some parentcompanies wanted to distance themselves from slower-growing businesses. Others carved out units but failed togive them the strong management teams they needed; stillothers simply failed to take advantage of the new structure,applying the same old compensation and managementpractices as must also realize that an equity carve-out will not suit everyone. It makes sense only under certaincircumstances, when subsidiaries can be separated easily170THE McKINSEY QUARTERLY 1997 NUMBER 1
from the parent and other business units without creatinghuge transfer-pricing issues, and when the subsidiary hasgood prospects. Companies also have to be prepared to deal with extracomplexity and costs. Contractual agreements mean thattransfer pricing, co-marketing, and technology sharingbetween the subsidiary and the parent or other subsidiarieshave to be scrutinized by each board, which can be diƒficultand time-consuming. In addition, a carve-out duplicatesadministrative costs, and the cost of a subsidiary’s debt islikely to rise once its assets and liabilities are separated from the more secure equity carve-outs also require subsidiarymanagement teams to work cooperatively with thecorporate center. ‘’The best, most secure management teams will always take advantage of all the help they canget,” says Dave MacLachan, CFO of Genzyme. “Weaker,more insecure managers will always push for moreindependence than they are ready for.’’ Some of the carve-out companies we examined seemed to have stumbled and failed on this very , it has to be remembered that an equity carve-out is not a substitute for selling a business unit that should be discarded. It is instead a way of keeping businessestogether that can create value together, but under a new,more vital properly, and under the right conditions, carve-outs oƒfer an exciting opportunity to increase returns to shareholders. In the 1990s, innovation and growth areincreasingly tied to specific employees who are mobile, and who demand a considerable share of the value they help create. To perform well in an environment ofspecialization, increased competition, and diminishingproduct life cycles, those individuals need the power to act quickly and independently. At the same time,globalization and shared resources such as reputationdemand a degree of -outs can help address all these issues. They fostermany of the performance advantages found in independent,agile businesses, but they do not forfeit the opportunity toprofit from synergies among business units, or from thewisdom and experience of the executive RESEARCH∫ ∫∫∫THE McKINSEY QUARTERLY 1997 NUMBER 1171
∫∫∫∫APPENDIXPerformance of subsidiaries of companies that repeatedly carve outParent
Subsidiary carve-out*PO dateParent
March 97,
March 97,
Average compound
– Iownership
subsidiary
subsidiary
annual returnThermo Electron
percentage†market
value as
Measuring and controlling devices
value
a percent
Mar$ millionket value, March 97 – $5, million
oYear3 Yearf paren1 Year2 t†Thermedics Inc. – 08/83
51
7
Biomedical products
Thermo Instrument Systems – 08/86
86
3,
50
Monitoring and process control instruments
Thermo TerraTech Inc. – 08/86
81
3
–
–
Environmental services
Thermo Power Corporation – 06/87
63
1
–
–
–
Refrigeration systems, engines, cogeneration
Thermo Cardiosystems – 01/89
55
1
Heart-assist devices
Thermo Voltaic Corporation – 03/90
59
1
Electromagnetic testing instruments
ThermoTrex Corporation – 07/91
51
5
X-ray systems
Thermo Fibertek – 11/92
81
11
Paper recycling, papermaking systems
Thermo Remediation – 12/93
69
1
NA
Soil and waste fluids recycling services
ThermoLase – 07/94
65
7
NA
Personal care products
Thermo Ecotek Corporation – 01/95
83
6
NA
NA
Combustion technologies, clean fuels
ThermoSpectra Corporation – 08/95
72
2
NA
NA
NA
Imaging and measurement instruments
Trex Medical Corporation – 06/96
91
6
NA
NA
NA
X-ray and related apparatus
ThermoQuest Corporation – 03/96
94
13
NA
NA
NAAnalytical instrumentsEnron – Petroleum
Market value, March 97 – $9, million
Enron Oil & Gas – 10/89
86
3,
29
Crude petroleum
Enron Global Power & Pipelines – 11/94
58
4
NA
NA
Engineering services
Genzyme Corporation – Biotech
Market value, March 97 – $1, millionGenzyme Transgenics – 07/93
72
7
–
–
–
Therapeutic/diagnostic products and services
Genzyme Tissue Repair – 12/94
67
6
NA
NA
NA
Tissue repair products
Limited – Retail
Market value, March 97 – $5, millionIntimate Brands – 10/95
84
5,
79
NA
NA
Intimate apparel and personal care products
Abercrombie & Fitch – 9/96
85
2
NA
NA
NA
Casual apparel
Safeguard Scientifics – Information technology
Market value, March 97 – $ millionTangram Enterprise Solutions – 02/88
72
9
–
–
Prepackaged software
Cambridge Technology Partners – 04/93
21
1,
35
Systems integration, consulting services
Coherent Communications – 06/94
37
15
NA
Telecommunications technology
USDATA – 06/95
21
2
NA
NA
Software, hardware, design consulting
Integrated Systems Consulting Group – 04/96
11
1
NA
NA
NASystems integration, application development* Parents have had at least one subsidiary carve-out which they either bought back or spun-off
† Market values are approximate since share ownership may change over time
NA Not available
Source: Annual reports; Bloomberg; Compustat172THE McKINSEY QUARTERLY 1997 NUMBER 1
