“Partial” Success

In the current IPO market, carve-outs are poised for a revival.

When Leland took the finance reins in 2005, El Paso was under pressure from its enormous debt load. Its IPO of 30 percent of El Paso Pipeline Partners late last year, however, created a master limited partnership (MLP) — a form that combines the tax benefits of a limited partnership with the liquidity of a public company. Because MLPs don’t pay corporate taxes, and pipeline businesses typically get higher multiples on their cash flows than do energy exploration and production businesses (El Paso Corp.’s other service lines), El Paso Pipeline Partners was able to pay down $500 million of its corporate debt. And it did so more cheaply than had it raised the funds itself. El Paso Pipeline Partners’s shares rose 20 percent from their offering price in 2007, establishing for the carved-out entity a price-earnings ratio of 23.8, compared with its parent’s 17.0.

“The MLP is a unique financial structure. It gives us a great currency to fund growth projects,” Leland says. “It’s also a source of capital; we can sell additional pipeline assets to the MLP and use the proceeds for general corporate purposes.” El Paso Corp., he adds, got a positive reaction from analysts when it announced last February that carving out an MLP and taking part of it public was an objective for 2007. After the S-1 documents for the new company were completed, the IPO was done in November.

After the IPO, a carve-out can go wrong for many different reasons. Conflicts can arise, for example, between the strategic priorities of the parent company’s executives and those of the subsidiary, who are beholden to a different set of public stakeholders.

That’s why attorney Utzschneider recommends that, prior to the IPO, the parent assumes that the carve-out will be completely divested at some point. This means, for instance, that commercial contracts must address what would happen if the subsidiary were acquired by a third party. “A parent company doesn’t want to be stuck in a long-term contract, like an IP-sharing agreement, with a competitor,” he says. For such contingencies, contracts should be of short duration or contain a change-of-control clause.

Indeed, if the carved-out business is an acquired one like VMware and an IPO is envisioned for the future, EMC’s Goulden says its operations and even its sales force should be kept separate from day one of the acquisition. (EMC did exactly that in 2004.) Otherwise, the decoupling effort required may make a carve-out deal too costly, says Goulden.

The carve-outs that perform best, says J. Randall Woolridge, professor of finance at Pennsylvania State University’s Smeal College of Business, are those in which the parent makes it clear to investors that a complete separation between spin-off and parent will happen some time in the future. Investors may see limited upside in a company still majority-owned by a parent, unless the carve-out is really a “seasoning IPO” — a prelude to a full split between the companies. McDonald’s Corp. executed such a transaction in 2006 when it carved out its Chipotle Mexican Grill Restaurants, and then fully divested the business nine months later.

Such a multistage structure provides a better market for a subsidiary’s new stock. In a spin-off, investors in the parent company get a pro-rata distribution of shares in the subsidiary, and “they may just dump the stock,” says Spin-Off Advisors’s Cardilli. With an IPO carve-out, however, the road show can establish an appetite among institutional investors, enabling a better sense of supply and demand for shares, and thus a more accurate valuation.

Still, even that goal underscores the final risk for these deals: success is dependent on the financial markets, often a capricious partner in capital-raising.

Vincent Ryan is a senior editor at CFO.

Editor’s Note:
A previous version of this story incorrectly stated that Hewlett-Packard and IBM received shares in the IPO of VMware. In fact, neither did. CFO regrets the error.

To see a list of 10 of the largest carve-out deals of 2006–2007, click here.

A Comparison of VMware and EMC Corp., January 2008


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