“Partial” Success

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

It was an initial public offering to make any dealmaker drool. When EMC Corp. raised $1.04 billion last August by carving out a 10 percent stake in VMware — the computer “virtualization” business that EMC had acquired just three years earlier for $625 million — it instantly created America’s fourth most valuable public software outfit.

While that kind of payday is not easily duplicated, EMC’s success in taking a slice of VMware public suggests that carve-outs, in which a parent sells a minority stake in an operation through an IPO or rights offering, are again gaining favor after a sluggish few years. The trend is getting a boost from slower corporate earnings growth and today’s weaker merger-and-acquisition market, which make selling shares seem more attractive by comparison, says Bob Profusek, chair of the M&A practice at law firm Jones Day. “I think you are going to see a lot of these deals,” he says, as Wall Street increasingly identifies corporations in which “the whole is worth less than the sum of its parts.”

The benefits to both the carved-out entity and its parent are many. They include access to relatively cheap capital and the creation of a new stock — often with a higher multiple — that can be especially valuable in offering incentive to employees of the smaller company. Further, the parent may reap future tax benefits if the minority-owned subsidiary is later completely divested. (Unlike a classic spin-off, which separates a unit completely from its former owner, a carve-out or “partial spin-out” is taxable to the parent.)

Doubling the Overhead

The tax hit didn’t stop many large companies from capitalizing on the selling of minority interests of units in the late 1990s. AT&T took Lucent public that way in a $2.3 billion IPO, while other carve-outs included DuPont’s of Conoco, News Corp.’s of Fox Entertainment, and General Motors’s of Delphi Automotive. Brick-and-mortar retailers, meanwhile, often used the technique to achieve high dotcom trading multiples for their Internet operations.

Success varied widely then, and that’s still the case with today’s crop. Of the dozen IPOs from carve-outs over the past 12 months, according to IPO research firm Renaissance Capital, at year-end 4 were “broken,” the term for cases in which shares trade below their initial offering price. That was a little better than the results across the broader market; of last year’s 234 IPOs, 45 percent were broken, according to Renaissance.

Even if stock prices boom in a carve-out, though, there can be other negatives. The task of separating two businesses may be sizable, says Al Cardilli, an analyst with Spin-Off Advisors LLC. “You’re duplicating overhead,” he notes. “You have two sets of financials along with the related Sarbox-compliance requirements to worry about, and you have to add the cost of compensating another executive team to run a public company.”

Because so much depends on the vagaries of the stock market, adds Bingham McCutchen LLP partner John Utzschneider, co-leader of the law firm’s corporate, M&A, and securities practice, “issuers have to think long and hard [about] why they’re doing this kind of transaction.”

Economically it might be a good time for equity carve-outs, given what could be a difficult year for raising money by peddling businesses to financial buyers, and the higher cost of debt financing for noninvestment-grade companies. But most experts discourage using a market-timing approach for such deals. “It’s very shortsighted to measure the results based on stock price,” says Cardilli.

Piece Plans

For EMC, selling 10 percent of VMware to the public made sense on several fronts, says EMC finance chief David Goulden. In terms of raising capital, the IPO tapped the high market value for virtualization software (which maximizes a company’s investment in computer services by enabling the machines to support multiple applications). VMware’s revenue growth topped 90 percent each quarter last year, compared with 20 percent for EMC. But Goulden also saw value in having separately traded VMware shares available to compensate employees and prospective engineering talent in competitive Silicon Valley. The shares, he notes, directly reflect their contribution at VMware, rather than at the Hopkinton, Massachusetts-based EMC parent.

“Not surprisingly,” says Goulden, “in conjunction with the IPO VMware has been able to hire a number of high-quality engineers, plus a new CFO.” VMware’s finance chief is Mark Peek, a former senior vice president at Amazon.com. No executives of EMC, including Goulden and CEO Joseph Tucci, own stock in VMware.

The IPO also reinforced the perception that VMware software would remain platform-neutral — vital because VMware works with many direct EMC competitors in servers and storage.

As EMC set things up, it still owns 86 percent of VMware and 98 percent of its voting stock, giving it control over the election of directors and approval of corporate transactions. EMC also has an agreement enabling it to use VMware’s source code and IP, even if EMC wants to develop competing products. Not totally unlike eating your cake and having it too.

“Our bankers told us that 10 percent was the minimum required to do the transaction,” Goulden says, stressing that he does not foresee EMC ever selling off VMware entirely.

EMC also received a repayment of $350 million of VMware’s total $800 million in debt to the parent from the IPO’s billion-dollar-plus in proceeds, and is using other amounts from the stock sale to double a previously announced EMC share-buyback commitment, to $2 billion. Further, EMC has closed on $369 million in “seal of approval” investments that Cisco Systems and Intel had made in VMware before the IPO.

For its part, VMware purchased its newly constructed headquarters in Palo Alto, California, for $133 million. VMware also received about $553 million for working capital.

El Paso Pays Down Debt

While increasing the exposure of a fast-growing business to shareholders may motivate carve-outs like EMC’s, the primary goal for El Paso Corp. in selling a stake in its natural-gas pipeline business was to raise cheaper capital for the parent company, says El Paso CFO Mark Leland.

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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