Types of Corporate Restructuring

Every company follows a lifecycle composed of four stages: start-up, growth, maturity, and decline. The table below summarizes each lifecycle stage’s corresponding profitability, revenue growth, and risk profile.

$$ \begin{array}{c|c|c|c|c} \textbf{Stage in} & \textbf{Start-up} & \textbf{Growth} & \textbf{Maturity} & \textbf{Decline} \\ \textbf{Life Cycle} & & & & \\ \hline \text{Revenue} & \text{Beginning} & \text{Rising} & \text{Slowing} & \text{Negative} \\ \text{growth} & & & & \\ \hline \text{Free cash flow} & \text{Negative} & \text{Improving} & \text{Peak} & \text{Declining} \\ \hline \text{Business risk} & \text{High} & \text{Medium} & \text{Low} & \text{Medium-} \\ & & & & \text{High} \\ \hline \text{Debt in capital} & \text{Close to 0%} & {0-20\%} & {20+\%} & 20+\% \\ \text{structure} & & & & \end{array} $$

Most managers are willing to change the fate of their company at the maturity and decline stages. These types of changes are grouped into 3 main categories:

• Investments: These are actions that increase a company’s scope or size, leading to revenue growth.
• Divestments: These actions will reduce the size or scope of a company by removing higher-risk and lower-profitability operations to improve financial performance.
• Restructuring: These changes improve cost and financing structures without altering the scope or size of a company. This will lead to an increase in growth and profitability while reducing risks.

Motivations for Corporate Structural Change

An issuer’s motivation for structural change can either be top-down or issuer-specific.

$$ \begin{array}{c|c|c|c} & \textbf{Divestment} & \textbf{Investment} & \textbf{Restructuring} \\ & \textbf{Actions} & \textbf{Action} & \textbf{Actions} \\ \hline \text{Top-down} & \text{High-security} & & \\ & \text{price.} & & \\ & \text{Industry shocks.} & & \\ \hline \text{Issuer} & \text{Increase growth.} & \text{Valuation.} & \text{Bankruptcy and} \\ \text{-specific} & \text{Synergy} & \text{Liquidity.} & \text{liquidation.} \\ & \text{realization.} & \text{Regulation.} & \text{Improve ROC.} \\ & \text{Secure resources.} & \text{Focus on business} & \\ & \text{Opportunity to} & \text{lines.} & \\ & \text{acquire an} & & \\ & \text{undervalued target.} & & \end{array} $$

Top-down drivers cover all three types of restructuring. All changes have been pro-cyclical, coinciding with price falls during recessions. Some explanations for the correlation between corporate transaction activity and asset price are:

• Greater CEO confidence: When CEOs are confident about the future, they are likely to take significant actions, leading to increased asset prices.
• Lower financing cost: Higher equity prices and lower interest rates will lead to lower interest expenses for equity and debt-financed transactions.
• The board and management know their stock is overvalued: Overvalued stocks can be exchanged in restructuring transactions to realize value.

In rare circumstances, corporate transactions in weak economic growth periods create more value than those in strong economic growth periods. During regulatory changes, there are more industry-specific waves of corporate transactions.

Types of Corporate Restructuring

Investment Actions

Access to resources, creating synergies, increasing growth, and improving capabilities are common motivations for investment actions. Cost synergies are generally created through economies of scale, while revenue synergies are created through economies of scope.

1. Equity investment: This involves a company purchasing a large stake in another company’s equity that is less than 50% of its shares. Both companies operate independently. However, if the investment is large, the investor can have representation on the investee’s board. An equity investment is made as the first step before an actual acquisition to establish a strategic partnership with the investee or as an investment in an undervalued company.
2. Joint venture: This is when two companies come together and jointly run a separate company to achieve a certain business objective. Each company will contribute employees, know-how, and assets to the joint venture company and will share the profits from the joint venture. They are commonly used when conducting business in a new market.
3. Acquisition: An acquisition occurs when an acquirer purchases a target and gains control of either a specific group of assets or an entire company in exchange for some consideration, such as cash or shares, or a combination of both. Upon completion of the acquisition process, the target ceases its existence as an independent company. The target becomes a subsidiary of the acquirer, who then prepares consolidated financial statements. Unlike joint ventures and equity investments, the acquirer in an acquisition assumes full control over the target.

Divestment Actions

Since divestment represents a consolidation of a company’s business, the motivations for divestment actions are similar to investment actions. The two main types of divestment actions are:

1. Spin-off: A spin-off occurs when an independent company is formed by separating a distinct part of the parent company’s business. A spin-off aims to increase employee and management focus by separating distinct businesses.
2. Sale/Divestiture: A divesture occurs when a target is sold to an acquirer. Once the sale is complete, the seller no longer has exposure to the divested business, and a transfer of control to the acquirer occurs in exchange for cash.

Valuation is the most important variable when choosing between selling or spinning off. A moderately sized business with many interested acquirers will likely have a higher valuation. Spin-offs don’t face strict regulatory scrutiny since they reduce market power concentration.

Restructuring Actions

Forced and opportunistic improvements are the two types of issuer-specific motivations for restructuring actions. Opportunistic improvements are actions that trim the cost structure, modify the balance sheet composition, or change the business model (franchising). Forced improvements are used to improve the return on capital when profitability decreases below investors’ required rate of return. Types of forced improvements can be in the form of:

1. Cost restructuring: These actions reduce costs by improving profitability and operational efficiency and increasing margins to those of industry peers or historical levels. Cost restructuring can come after periods of underperformance or in response to an unwelcome acquisition or a hostile takeover. The common ways of reducing costs are outsourcing and offshoring.

   • Companies often outsource some functions of their business, such as legal and IT, to specialized third-party companies that can offer these services at a lower cost due to economies of scale. Outsourcing can free up a company’s assets, such as office and warehouse space.

   • Offshoring is relocating operations to a different country to reduce costs, mainly through economies of scale or lower labor costs. Offshoring can take the form of opening a subsidiary in a foreign country.

   Outsourcing and offshoring are often combined.

2. Balance sheet restructuring: A balance sheet restructuring changes the balance sheet composition by changing the capital structure, asset composition, or both. The two common ways of balance sheet restructuring are:

   • Sale-leaseback: A company sells an asset and immediately leases it back for its remaining useful life. In this instance, the implication is that the company will forgo ownership of the asset but retain the right to use it. Sale leasebacks are used to secure cash in a relatively short time.

   • Dividend capitalization: Dividend capitalization occurs when an issuer restructures equity to debt through share repurchases or debt-financed dividends. The aim is to reduce the WACC of the issuer by replacing expensive equity with cheaper debt. The transaction increases shareholder value since the company’s value remains the same after the number of shares outstanding reduces. An issuer can only use this method with stable operating cash flow and revenue.

3. Reorganization: A court-supervised restructuring for companies facing insolvency. A bankruptcy court takes control of a company to supervise the negotiation between the company and its creditors while the company continues its normal business operations. Reorganizations can be a strategy to renegotiate contracts with unfavorable terms. The liquidation process typically occurs after the reorganization process has failed to achieve its objective and the company cannot pay its debts.

4. Leveraged buyouts (LBO): An LBO occurs when a parent acquires a target largely through debt financing and begins restructuring activities to publicly list or sell the target.

Question

Which of the following is the most likely motivation for divestment actions?

1. Increase return on invested capital.
2. Increase revenue.
3. Increase company size.

Solution

The correct answer is A.

The motivation for divestment is to increase the return on invested capital.

B and C are incorrect. Sales and spin-offs reduce the company’s revenue and size.

Reading 21: Corporate Restructuring

LOS 21 (a) Explain types of corporate restructurings and issuers’ motivations for pursuing them.