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When carve-outs make sense. (Current Research).

Carve-outs (1) seem too good to be true: a financial instrument that increases a company's stock price without sacrificing control over a valuable business unit.

It turns out that they are too good to be true. An analysis of more than 200 major carve-outs in Europe and the United States during the past 12 years shows that around the time of the announcement only 10 percent of them raised the parents' share price by more than 12 percent. During the 2 years after the transaction, most carve-outs actually destroyed shareholder value. (2) There is one important exception, however: carve-outs that followed a clear trajectory to full independence (through a spin-off, for example) significantly outperformed typical S&P 500 companies (Exhibit 1, on the next page).

In general, few carve-outs remain under the parent's control. Even a minority IPO in a high-growth business brings transaction currency for acquisitions, equity funding for internal growth, and responsibilities to the shareholders, and over time these forces tend to reduce still further the parent's control. After about five years, only 8 percent of carve-outs continue to exist as public companies clearly controlled by the parent (that is, in which the parent holds more than 50 percent of the shares).

An additional 31 percent of the parents hold minority stakes of less than 25 percent. Third parties have acquired or merged with 39 percent of the carve-outs (Exhibit 2).

A parent company that goes on trying to exercise control runs the risk of losing the benefits of the carve-out and precipitating conflict with the subsidiary as it attempts to pursue its own best interests. Consider Vastar Resources, a US oil exploration and production company carved out by ARCO in 1993. At one point, Vastar found itself bidding against ARCO for exploration and production projects. ARCO resolved this conflict by shifting its focus to international projects and leaving any bidding in the US market to its subsidiary.

Executives who plan to separate subsidiaries form their parent companies through carve-outs will gain the strategic and funding benefits only by giving the subsidiaries a high degree of autonomy early on. As part of the parent company, they may have faced restricitions in seeking customers, suppliers, funding, and transaction opprotunities. Before one telecom-equipment provider was carved out and subsequently spun off (2) for example, it had virtually no access to customers for its telecom hardware products that competed with those of its parent. Similarly, Palm was in a better position to close strategic alliances with AOL, Motoral, and Nokia after its carve-out from 3Com.

Initially, there may be reasons to float a minority stake in a subsidiary through a carve-out instead of floating a majority or full stake. In the United States, for example, a carve-out of a stake of less than 20 percent that is followed by a spin-off often makes it possible for a parent company to divest a subsidiary without incurring the capital gains taxes the parent could face in a trade sale or a full IPO for cash. Guidant and Palm, for instance, were carve-outs later spun off by their respective parents, Eli Lilly and 3Com, in tax-free distributions to the shareholders of the parents.

Of course, a similar tax-free divestiture could also be realized through a straight spin-off, but maintaining short-term control over a carved-out subsidiary lets its parent raise cash while preventing it from being taken over by a direct competitor. Giving the subsidiary a chance to establish itself with suppliers, competitors, customers, and investors before exposing it to the full brunt of market forces may also serve the interests of the shareholders of the parent, which benefits from a stronger spin-off or sale of the carved-out subsidiary further down the road.

As a financial tool, carve-outs can provide some benefit. But a corporate executive must avoid illusions about what they can deliver. Carving out even small stakes in subsidiaries will likely lead to complete and irreversible separation. Companies that don't plan for this eventuality may destroy shareholder value.

Independence pays

Index: Median total returns to shareholders at time of initial public
offering (1) = 100

                                   Median excess return
                                   over S&P 500, percent

Independent (2)                             +26
Acquired or merged                          -17
Repurchased by parent or delisted           -17
Controlled by parent (2)                    -32

(1)Includes 204 carve-outs, with a value exceeding $50 million,
announced prior to January 1, 1998.

(2)Independent carve-outs >75% of shares for public trading; parent-
controlled carve-out offer <75% of shares for public trading.

Source: Thomson Financial; McKinsey analysis
EXHIBIT 2 Hard to hold

Percent of carve-outs (1)

Public companies under clear parental control

Total carve-outs            100
Acquired or merged           39
Repurchased by parent        11
Delisted                      3
Independent (2)              31
Parent controlled (2)        16
Shares offered to public
 percent                    <50

(1)Includes 204 carve-outs, with a value exceeding $50 million,
announced prior to January 1, 1998.

(2)Independent carve-outs offer > 75% of shares for public trading;
parent controlled carve-outs offcer < 75% of shares for public trading.

Source: Thomson Financial: McKinsey analysis

Note: Table made from bar graph

(1.) The flotation by a parent company of a minority holding in a subsidiary, in the United States usually of less than 20 percent of its shares, through an initial public offering for cash.

(2.) See Patricia Anslinger, Sheila Bonini, and Michael Patsalos-Fox, "Doing the spin-out," The McKinsey Quarterly 2000 Number 1, pp. 98-105. We refined these findings by looking at all transactions, between January 1990 and May 2001, that exceeded $50 million as recorded in the Thomson Financial Securities Data global database. To control for the recent bull market, the performance of these companies was measured relative to median market returns. In addition, all of the carve-outs in our sample were categorized according to their ultimate degree of independence from their corporate parents.

(2.) A spin-off is the full flotation of a subsidiary through the distribution of share in it to the shareholders of the parent.

Andre Annema is a consultant and Marc Goedhart is an associate principal in the Amsterdam office, and Bill Fallon is a principal in the New York office.
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Author:Annema, Andre; Fallon, William C.; Goedhart, Marc H.
Publication:The McKinsey Quarterly
Geographic Code:1USA
Date:Mar 22, 2002
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