Reasons Behind Restructuring
The overarching goal of a restructuring is to increase shareholder value but there are many reasons behind restructuring.
Focusing on Core Business—Groups of shareholders can actively demand management to increase shareholder value by focusing on the private company’s core businesses. Pressure from shareholders can cause management to create a restructuring plan that will focus the private company’s resources on core businesses.
Avoiding Takeovers—Selling or spinning off a key business unit can be an effective deterrent for takeovers since acquirers will have to pay capital gains tax on spin-offs of the target private company that were initially tax-free. Increasing leverage can also help defend against takeovers, but the effect on operating flexibility must also be considered.
Eliminating Poor Performers—Poor performance of a subsidiary due to industry conditions, poor management, or ineffective corporate strategy can be detrimental to the financial performance of the parent private company. Therefore, a parent private company commonly divests the poorly performing subsidiary. This may immediately improve the financials of the parent private company by not including the poorly performing financials of the divested subsidiary in the consolidated statements. As a result the parent private company might eliminate capital outflows that were needed to fund the failing business. Additionally, a divestiture of a failing business will provide additional capital the parent private company can use to stimulate growth in its core businesses. Finally a divestiture, if communicated correctly, will boost morale of existing employees and improve the public perception of the parent private company.
Highlighting Undervalued Assets—Large private companies may have smaller subsidiaries that are high growth but not properly valued since their performance is hidden by the size of the conglomerate. As such, the parent company may want to divest a part or all the strong performing private company via a sale, spin-off, split-off or equity carve-out.Highlighting the positive attributes of the undervalued business benefits both the shareholders of the parent and the divested private company. Divesting the smaller private company allows it to raise their own capital via debt and equity markets that is separate from that of the parent private company. By raising separate capital, the divested private company doesn’t need to vie for capital allocation from the parent company. The divested company can be properly valued by the market based on its respective multiples. Furthermore, the parent private company receives proceeds from the divestiture that it can reinvest or issue to shareholders.
Realizing Value from Stronger Business—Where strong performing businesses are not valued by the market, there is an opportunity for the parent private company to realize the value of this business through a sale or divestiture. Proceeds from this sale can be used to develop other parts of the private company’s businesses or pay down debt.
Realigning of Capital Allocation—A private company with multiple business units, funding and capital allocation issues restrains optimal operations of its subsidiaries. There are often internal conflicts as management teams vie for capital from the parent private company. This leads to potentially inefficient allocation of capital where certain businesses will have excess capital while others will be under funded. Inefficient capital allocation restrains the growth of subsidiary private companies. In such a case, separation of the different business lines allows each newly divested private company to raise capital to service their needs.
Lowering Borrowing Costs and Optimizing Capital Structure—Different operating divisions of a larger corporation have different operating risks and capital requirements that may overshadow each other. In such cases the parent private company may find itself over leveraged. One of the main goals of restructuring would be to reorganize the capital structure of the private company to lower borrowing costs.The capital structure of a private company should always strive to optimize funding costs. The goal is to balance between the high costs of equity and the lower costs of debt and the benefits and detriments of both methods of funding. Funding operations through debt issuances can lead to financial distress as the interest expense to service the loan can consume cash flow. Divesting a business division is a great way for a private company to improve its financial position.
Providing Management Incentives—Management teams of a subsidiary often operate off the incentives based on the performance of the parent private company. Stock option plans that are given to executive level management teams of subsidiaries that are based off the stock performance of the parent private company are not always appealing if the operating activities of the subsidiary are not properly valued by the market. Separating the subsidiary from the parent creates lucrative invectives for management whose compensation is now directly based on their division’s performance.
Pre-IPO Housecleaning Process—Prior to the initial filing of an S-1, firms that intend or explore the option of going public must enter a restructuring process. This pre-IPO restructuring process is known as the “House Cleaning” process and is done to ensure that the firm is SEC and Sarbanes-Oxley compliant in terms of accounting, compensation, contractual agreements, corporate structure, and tax-related considerations.This process will begin with a combination of marketing/public relations and auditing processes and may prove quite costly, especially in combination with SEC filing fees. The time between the initial S-1 filing and the first day of trading, the firm must report as if it were a publicly traded firm each quarter. For firms that are unable to quickly achieve compliance, this may prove quite costly and often will result in an IPO withdrawal filing.