Special thanks to Ben Chun for his contributions to this article
Growth is painful. Change is painful. But nothing is as painful as staying stuck somewhere you don’t belong.
– Mandy Hale
In the last installment, we talked about the Dutch Auction Tender Offer, where a company buys back shares based on a reverse auction mechanism as indicated by participating shareholders. Today, we will cover the last type of tender offer: the stock-for-stock tender (also known as a split-off) via a Reverse Morris Trust (“RMT”) or carve-out.
In a split-off, similar to a spin-off, a new company (“SpinCo”) is created from the parent company (“ParentCo”). The distribution of the SpinCo shares is not pro-rata since ParentCo shareholders can choose to either hold their shares in ParentCo or exchange them for shares in the SpinCo. SpinCo shares in this case are either private and subject to a merger with a third-party (a RMT transaction) or are already publicly traded via a previous carve-out. The process gets started when ParentCo announces the terms of the tender offer, and the tender offer period usually lasts for about a month (“Tender Offer Window”). To facilitate the split-off, ParentCo will often offer to exchange SpinCo shares for ParentCo shares at a premium (for example, for every $100 in ParentCo value, you’ll receive $108 in SpinCo value). In more recent split-offs, the exchange ratio between ParentCo shares and SpinCo shares is determined by the Volume Weighted Average Price (“VWAP”) for a specific number of trading days (usually 3), subject to a maximum cap. Presumably, companies have adapted this mechanism in order to avoid any prospects of stock price manipulation during the tender offer period. Typically, if a split-off is oversubscribed (i.e., more shares are tendered by shareholders than the maximum number of shares set to be exchanged), only a certain portion of a shareholder’s tendered shares, usually on a pro-rata basis, will be accepted for exchange (known as proration). However, if you are an “odd-lot” holder (i.e., somebody who owns less than 100 shares, something that we’ve mentioned in previous blog posts), you will be given priority treatment and all of your tendered shares will be accepted for exchange. If you are interested in finding out more about split-offs (and comparing them to spin-offs, another common corporate transaction) please refer to this article here.
With that out of the way, let’s dig into the question: what is a RMT? A Reverse Morris Trust transaction is a strategy that allows a parent company to spin-off or split-off a subsidiary and then combine that subsidiary with a third-party company free of taxes. This transaction is only complete once stockholders of the parent company own at least 50.1% of the stock by vote and value of the newly merged company. A diagram of the RMT transaction is as follows:
Source
An example of a recent split-off exchange offer with a RMT structure was the Ecolab (Ticker: ECL)/Apergy (Ticker: APY/CHX) tender offer that was announced on May 1, 2020 and expired on June 3, 2020. ECL (ParentCo) wanted to split-off its Upstream Energy business (the “ChampionX Business”) and merge it with APY through a RMT transaction. ECL stockholders were given the opportunity to exchange their shares of ECL for shares of ChampionX, a subsidiary created to hold the ChampionX Business. Following the consummation of the exchange offer, the merger of ChampionX and a subsidiary of APY would take place and each share of ChampionX common stock would be converted into one share of APY. For $100 of ECL, stockholders were expected to receive approximately $111.11 of ChampionX common stock (a 10% discount). In order to calculate the final exchange ratio, Ecolab used the average of the daily VWAPs of ECL and APY on May 27th-29th, 2020 (the last full three trading days ending on and including the third trading day preceding the expiration date of the exchange offer). The final exchange ratio was eventually set at 24.6667 shares of ChampionX common stock for each share of ECL. By the end of the exchange offer period, 97,294,237 shares of ECL were validly tendered and 395,463 of these were tendered by odd-lot shareholders. While such odd-lot shareholders were not subject to proration, the remaining validly tendered ECL shares were accepted using the final proration factor of 4.7060%. Shortly after the expiration of the exchange offer, each share of ChampionX was converted into a share of APY, and subsequently Apergy changed its name to ChampionX Corporation under the ticker CHX.
Along with this merger strategy, another type of divestiture mechanism is known as the carve-out, in which a parent company sells some of its shares in its subsidiary to the public through an initial public offering (IPO), ultimately establishing the subsidiary as a standalone company and creating a new set of shareholders in the subsidiary. Oftentimes, a carve-out is followed by the full spin-off or split-off of the subsidiary to the parent company’s shareholders. The exact mechanics of an exchange offer preceded by a carve-out is similar to that of the RMT mentioned above.
To see if there is a viable trading strategy for split-offs, we have gone back and analyzed the results of 32 different split-off exchange offers from 1995 to 2020, encompassing both RMTs and carve-outs. We looked at entry prices (excluding dividends, short interest, and commissions) under two purchase scenarios: assume we purchase ParentCo shares on the date of tender offer announcement (“A”), or the day prior to expiration (“E – 1D”) (usually the last day that one can purchase shares and still be eligible to participate in the tender offer via Notice of Guaranteed Delivery), and then exchange for SpinCo shares in the tender offer. Subsequently, we looked at exit prices of SpinCo assuming a week (usually the earliest date that you can sell the SpinCo shares after the exchange) to three years out from the date of expiration of the tender offer (“E”), and we calculated absolute and relative returns (as compared to the S&P 500 Total Return Index) for each of the 32 historical precedents. Here are our findings:
Split-Off – Summary
Total Return & Relative Return – A
Total Return & Relative Return – E – 1D
Observations
Repeat Customers – Of the 32 transactions, 12 were done by 6 companies (LLY, LMT, WY, PG, CBS, and DHR), with each ParentCo involved in two exchange offers. This likely indicates that they found the split-off tender offer to be an efficient means of divesting from a subsidiary.
Transition From Fixed Exchange Ratio to VWAP – In the beginning, split-offs were done using a fixed exchange ratio. Towards the middle of 2006, VWAP became (and continues to be) the standard in determining the exchange ratio. For 23 cases where the exchange ratio was calculated using the VWAP, 12 (or 52.2%) were calculated at the maximum allotted cap. For 11 other cases, the final exchange ratio settled on average at 94.6% of the maximum. This indicates that ParentCo and SpinCo stock prices generally do not fluctuate too wildly away from bounded ranges.
SpinCo is generally smaller in market value as compared to ParentCo – As to be expected, on average, 64.7% of the shares of SpinCo are offered in a split-off tender exchange, but only 6.8% of ParentCo shares are subject to exchange.
Split-offs have become more popular – The higher the number of ParentCo shares that participate in the tender offer, the lower the proration factor. More recent split-offs (starting with BAX/BXLT in 2016) have had significantly lower proration factors (9.9% on average) as compared to earlier VWAPs tender offers (29.4% on average) and even earlier split-offs with fixed exchange ratios (44% on average).
Survival of the Odd-Lots – Since the odd-lot provision has been in existence for a long time, one could argue that the increasing participation of odd-lot shareholders will eventually drive companies into eliminating the odd-lot language in tender offer documents. However, from what we’ve observed (as seen in the graph below), there does not seem to be a clear upward trend regarding the odd-lot % of the total ParentCo shares tendered over time. There has been a recent increase in the odd-lot % of the total ParentCo shares accepted over time, but there is no definitive trend here either.
To Hedge or Not to Hedge – With the announcement of a tender offer and a maximum exchange ratio, one can analyze a split-off tender offer like a merger arbitrage situation. Essentially, one can go long the ParentCo stock, short the SpinCo at the appropriate exchange ratio (initially at the maximum ratio, and adjusted downward when the final exchange ratio is set), and just capture the spread (we call this the “hedged” return). As you can see, the general movement of this spread decreases from announcement day (13.3% on average) to right before expiration date (7.9% on average). This makes sense as buying the ParentCo stock will drive the ParentCo stock price up, and shorting SpinCo stock will drive the SpinCo stock price down. This “hedged” strategy gives you a “guaranteed” return over ~5 weeks (assuming initiation at A) or ~8 days (assuming initiation at B), but it forgoes the possibility of higher returns if the share price of SpinCo goes up after tender expiration. There are a variety of reasons why this might happen (expectations of increased float, indiscriminate selling by ParentCo shareholders, and hedging from those who participate in the tender offer), and the data of SpinCo price from E – 1D to E + 1W does show positive movement 75% of the time. Generally speaking, you earn 4.7% more (15.5% versus 10.8%) on average if you participate in the exchange offer on Announcement Date unhedged, but at the expense of higher volatility (16% standard deviation versus 4.6% hedged). The results are similar if instead you participate on the day before Expiration Date.
To Go Early or To Go Late – One could initiate a position in a split-off as soon as the transaction is announced, or wait until the final exchange ratio is set. Starting a position immediately after announcement exposes you to a longer period of uncertainty and higher borrowing costs (if hedging), but it also affords you the possibility of dynamically adjusting for the exchange ratio and selling out of your position if you ultimately decide that participating in the tender offer is not worthwhile. Waiting until the final ratio is set reduces a lot of the aforementioned risks, but it also might result in a lower return due to the elimination of some upside. From the data, it seems pretty clear that opening the position right after the initial split-off announcement is the way to go, assuming that you exit the position at the first available instance. You make, on average, 4.4% more on an unhedged basis, and 3.0% more on a hedged basis.
Long-Term out-performance is a coin-flip – Over the longer term, the return you get on participating in split-off tender offers depends on the performance of the SpinCo shares. That leads to an interesting question: do ParentCo stocks outperform the SpinCo stocks after the split-off? The answer is: ParentCo stocks do not outperform SpinCo stocks after the split-off on average, but SpinCo stocks exhibit significantly higher volatility as compared to ParentCo stocks. There is approximately a 50/50 chance whether or not the ParentCo stocks or SpinCo stocks will be up or down 3 years after Announcement Date or Expiration Date. For every Chipotle that found its wings in independence from McDonalds, there is a Blockbuster that flailed into obsolescence after Viacom decided to cut the umbilical cord.
Does Thou Beat Thy Market? – Assuming exit at the first available instance, the answer is almost always yes. If you stretch out the exit to a year or 3 years, then, the answer once again becomes a coin flip or less.
Concluding Thoughts
Stock split-offs are the riskiest type of tender offer given the fluctuation in stock prices for both the ParentCo and the SpinCo. In general, however, it appears that odd-lot shareholders can earn very attractive risk-adjusted returns by buying ParentCo shares close to the Announcement Date, participating in the exchange offer, and selling the SpinCo shares a week after expiration date. Of course, one can “lock in” the profit of the tender offer by shorting SpinCo shares, but you generally earn a lower return in this stance. Furthermore, per IRS guidance, shorting the SpinCo shares is not allowed for accounts that own ParentCo shares in a tax-deferred or tax-free account (i.e. Traditional IRA or Roth IRA). Ultimately, whether or not you decide to hedge, the split-off tender offer should remain a viable strategy for the savvy individual investor going into the future.
