I n t e r n a t i o n a l J o i n t V e n t u r e s , Me r g e r s & A c q u i s i t i o n s

( MB I B 0 4 ) U n i t I V

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Mergers-in the nature of acquisitions and amalgamations
Times are changing and so are corporate strategies. Companies are becoming larger than
ever in an endeavor to control larger markets and in search of new customer bases. There are
many ways in which a company tries to expand. It can either grow horizontally or can
expand vertically. Amalgamation and acquisition are two strategies which allow companies
to become larger and more resourceful. There are people who do not understand the
implications of these two strategies that are very common place in todays market situation.
This chapter attempts to take a closer look at amalgamations and acquisitions to highlight
their differences.
Mergers & Acquisition
Merger: the share holders of two companies deciding to pool the resources of the companies
under a common entity to do the business activity is called merger.
Two companies agree to go forward as a single company rather than separately owned
and operated.
Both companies stocks are surrendered and new stock is issued in its place.
TATA-CORUS-$13 Billion
Daimler- Benz & Chrysler -> Daimler Chrysler.
It is also called as Amalgamation.
Mergers or amalgamation may take two forms
Merger through absorption:
Absorption is a combination of two or more companies into an existing co. All
companies except one lose their identity in a merger through absorption.
Ex: Absorption of Tata Fertilizer Ltd (TFL) by Tata Chemicals Ltd (TCL)
TCL an acquiring co (buyer); survived after merger while TFL an acquired co (a
seller) ceased to exist.
TFL transferred its assets, liabilities and shares to TCL under the scheme of merger.
Mergers through consolidation
Two or more companies combine to form a new company. In this form of merger all
companies are legally dissolved and a new entity is created.
In a consolidation, the acquired company transfers its assets, liabilities and shares to
the new company for cash or exchange of share.


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Ex: Merger or amalgamation of Hindustan Computers Ltd, Hindustan
Instruments Ltd, Indian software co Ltd and Indian Reprographics ltd in 1986
to an entirely new company, called HCL ltd.
Amalgamation:
It is used when two or more companies carries on similar business go into liquidation and a
new company is formed to take over their business.
Takeover:
A takeover generally involves the acquisition of a certain stake in the equity capital of a
company which enables the acquirer to exercise control over the affairs of the company.
Ex: HINDALCO took over INDAL by acquiring a 54% stake in INDAL from its overseas
parent, Alcan. However, INDAL was merged into HINDALCO.

WHAT IS CORPORATE RESTRUCTURING
Corporate restructuring refers to a broad array of activities that expand or contract a
firms operations or substantially modify its financial structure or bring about a significant
change in its organizational structure and internal functioning.
Top 10 Mergers made by Indian companies





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Types of Mergers
1. Horizontal Merger (increases monopoly power)
A Horizontal merger involves two firms operating and competing in the same kind of
business activity.
e.g: Acquisition of American motor by Chrysler in 1987 represents horizontal merger
Combining of book publishers or two manufacturers to gain dominant market share.
2. Vertical Merger
Vertical mergers occur between firms in different stages of production operations
Upstream & Downstream Mergers
Vertical Forward Integration Buying a customer i.e. Indian Rayons acquisition of
Madura Garments along with brand rights.
Vertical Backward Integration Buying a supplier i.e. IBMs acquisition of Daksh
3. Conglomerate Merger
Conglomerate mergers involve firms engaged in unrelated types of business activity.
Product extension mergers (P&G acquires Gillette to expand its product offering in
the household sector and smooth out fluctuations in earning.
Market extension mergers (Pizza Hut a fast food chain restaurant centered in USA,
sought to win Indian customers by opening their restaurant in all most all major urban
centers of India.
Pure Conglomerate mergers (Indian Rayons acquisition of PSI Data Systems.)
Motives Behind Mergers
To achieve Economies of scale
To reduce gestation period of new business
To compete globally
To utilize the liquidity available with the company for achieving growth through
diversification
To acquire and maximize the available managerial skills to increase profits
To diversify the risk
To avail taxation advantage under income tax act 1961
In the public interest (u/s 396 of companies act 1956)




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Theories of Mergers
1. Efficiency theories
a. Differential managerial efficiency
b. Inefficient management
c. Synergy
d. Pure diversification
e. Strategic realignment to changing environments
f. Undervaluation
2. Information and signaling
3. Agency problems
4. Free cash flow hypothesis
5. Market power
6. Taxes
7. Redistribution.
1. Efficiency theories
These theories hold that mergers and other forms of asset redeployment have potential
for social benefits. They generally involve improving the performance of incumbent
management or achieving a form of synergy.
a) Differential managerial efficiency
If the management of firm A is more efficient than the management of firm B and
if after firm A acquires firm b, the efficiency of firm b is brought up to the level of
efficiency of firm A, efficiency is increased by merger
Differential efficiency would be most likely to be a factor in mergers between
firms in related industries where the need for improvement could be more easily
identified.
b) Insufficient management
May simply represent management that is inept in an absolute sense. Almost
anyone could do better
The theory suggests that target management is so incapable that virtually any
management could do better, and thus could be an explanation for mergers
between firms in unrelated industries.
c) Synergy
Synergy refers to the type of reactions that occur when two substances or factors
combine to produce a greater effect together than that which the sum of the two
operating independently could account for. The ability of a combination of two


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firms to be more profitable than the two firms individually. There are two types
of synergy i.e. operating synergy and financial synergy.

Operating Synergy
For e.g.: one firm might be strong in R&D but weak in marketing while another
has a strong marketing department without the R&D capability. Merging the two
firms would result in operating synergy.
Operating synergies are those synergies that allow firms to increase their operating
income from existing assets, increase growth or both. We would categorize operating
synergies into four types.
1. Economies of scale that may arise from the merger, allowing the combined firm to
become more cost-efficient and profitable. In general, we would expect to see
economies of scales in mergers of firms in the same business (horizontal mergers)
two banks coming together to create a larger bank or two steel companies combining
to create a bigger steel company.
2. Greater pricing power from reduced competition and higher market share, which
should result in higher margins and operating income. This synergy is also more
likely to show up in mergers of firms in the same business and should be more likely
to yield benefits when there are relatively few firms in the business to begin with.
Thus, combining two firms is far more likely to create an oligopoly with pricing
power.
3. Combination of different functional strengths, as would be the case when a firm
with strong marketing skills acquires a firm with a good product line. This can apply
to wide variety of mergers since functional strengths can be transferable across
businesses.
4. Higher growth in new or existing markets, arising from the combination of the
two firms. This would be case, for instance, when a US consumer products firm
acquires an emerging market firm, with an established distribution network and brand
name recognition, and uses these strengths to increase sales of its products.
Operating synergies can affect margins, returns and growth, and through these the
value of the firms involved in the merger or acquisition.
Financial Synergy


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With financial synergies, the payoff can take the form of either higher cash flows or a
lower cost of capital (discount rate) or both. Included in financial synergies are the
following:
A combination of a firm with excess cash, or cash slack, (and limited project
opportunities) and a firm with high-return projects (and limited cash) can yield a
payoff in terms of higher value for the combined firm. The increase in value comes
from the projects that can be taken with the excess cash that otherwise would not have
been taken. This synergy is likely to show up most often when large firms acquire
smaller firms, or when publicly traded firms acquire private businesses.
Debt capacity can increase, because when two firms combine, their earnings and
cash flows may become more stable and predictable. This, in turn, allows them to
borrow more than they could have as individual entities, which creates a tax benefit
for the combined firm. This tax benefit usually manifests itself as a lower cost of
capital for the combined firm.
Tax benefits can arise either from the acquisition taking advantage of tax laws to
write up the target companys assets or from the use of net operating losses to shelter
income. Thus, a profitable firm that acquires a money- losing firm may be able to use
the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that
is able to increase its depreciation charges after an acquisition will save in taxes and
increase its value.
Diversification is the most controversial source of financial synergy. In most publicly
traded firms, investors can diversify at far lower cost and with more ease than the firm
itself. For private businesses or closely held firms, there can be potential benefits from
diversification.
Clearly, there is potential for synergy in many mergers. The more important issues
relate to valuing this synergy and determining how much to pay for the synergy.
d) Pure diversification
The firm may simply lack internal growth opportunities for lack of requisite
resources or due potential excess capacity in the industry.
Pure diversification as a theory of mergers differs from shareholders portfolio
diversification. Therefore, firms may diversify to encourage firm-specific human
capital investments which make their employees more valuable and productive;
and to increase the probability that the organization and reputation of the firm will


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be preserved by transfer to another line of business owned by the firm in the event
its initial business declines.
e) Strategic realignment to changing environments
It says that mergers take place in response to environmental changes. External
acquisitions of needed capabilities allow firms to adapt more quickly and with less
risk than developing capabilities internally. Rationale is that by mergers the firm
acquires management skills for needed augmentation of its present capabilities.

f) Undervaluation
It states that mergers occur when the market value of target firm stock for some
reason does not reflect its true or potential value in the hands of an alternative
management. One possibility of undervaluation may be that management is not
operating the company up to its potential. A second possibility is that the
acquirers have inside information. It is not much different from the inefficient
management or differential efficiency theory. It cannot stand alone and requires
an efficiency rationale.
2. Information and signaling
This theory attempts to explain why target shares seem to be permanently
revalued upward even if the offer turns out to be unsuccessful. The merger offer
disseminated information that the target shares are undervalued and the offer
prompts the market to revalue those shares.
No particular action by the target firm or any others is necessary to cause the
revaluation. This is called sitting on a gold mine explanation (Bradley, Desai
and Kim, 1983). The other hypothesis is that the offer inspires target firm
management to implement a more efficient business strategy on its own. No
outside input other that the merger offer itself is required for the upward
revaluation.
3. Agency problems
Agency problems arise basically because contracts between managers (decision or
control agents) and owners (risk bearers) cannot be enforced. May result from
conflict of interest between managers and shareholders or between shareholders
and debt holders


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An agency problem arises when managers own only a fraction of the ownership
shares of the firm. This may cause managers to work less vigorously than
otherwise and consume more perquisites. In large corporations with widely
dispersed ownership, there are no sufficient resources to monitor the behavior of
managers. Takeovers as a solution to agency problems (Fama & Jensen, 1983)
4. Free cash flow hypothesis
Jensens free cash flow hypothesis says that takeovers takes place because of the
conflicts between managers and shareholders over the payout of free cash flows.
He defines free cash flow as cash flow in excess of the amounts required funding
all the projects that have positive NPVs. He states that such free cash flow must
be paid out to shareholders if the firm is to be efficient and to maximize share
price. The payout of free cash flow reduces the amount of resources under the
control of managers and reduces their power resulting in agency costs.
5. Market power
Market power advocates claim that merger gains are the result of increased
concentration leading to collusion and monopoly effects. The theory posts that
mergers take place to increase their market share, means increasing the size of the
firm relative to other firms in an industry.
An objection is often raised against permitting a firm to increase its market share
by merger is that the result will be undue concentration in the industry. On
contrary, some economists hold that increased concentration is generally the result
of active and intense competition.
6. Taxes
Tax implications may be important to mergers, although they do not play a major
role. Carry-over of net operating losses and tax credits, substitution of capital
gains for ordinary incomes are among the tax motivation for mergers.
The unabsorbed losses & depreciation of the amalgamating company shall be
deemed to be the loss or depreciation of amalgamated company for previous year.
Such loss and depreciation shall be set off or carried forward for a period of 8
years and indefinite period respectively by the amalgamated company but subject
to certain conditions as per Indian income tax act 1961.


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Substitution of capital gains for ordinary income: a mature firm with few internal
investment opportunities can acquire a growth firm in order to substitute capital
gains taxes for ordinary income taxes.
The acquiring firm provides the necessary funds which otherwise would have to
be paid out as dividends taxable as ordinary incomes.
7. Redistribution
Value increases in mergers by redistribution among the stakeholders of the firm.
Possible shifts are from debt holders to stock holders and from labor to
stockholders.
Value Creation in Horizontal, Vertical and Conglomerate Mergers
Horizontal Merger
1. Elimination or reduction in competition
2. Putting an end to price-cutting
3. Economies of scale in production
4. R&D, marketing and management
Vertical Merger
1. Lower buying cost of materials
2. Lower distribution costs
3. Assured supplies and market
4. Increasing or creating barriers to entry for potential competitors
Conglomerate Merger
1. Diversification of risk.
Internal & External change forces contributing to M&A activities Corporate
Restructuring
1. Technological changes (technological requirements of firm has increased)
2. Economies of scale and complimentary benefits (growth opportunities among product
areas are unequal)
3. Opening up of economy or liberalization of economy
4. Global economy (increase in competition)
5. Deregulation
6. New industries were created.


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7. Negative trends in some economies.
8. Favorable economic & financial conditions (real time financial planning and control
information requirements have increases).
9. Widening inequalities in income & wealth
10. High valuation on equities.
11. Requirement of human capital has grown relative to physical assets.
12. Increase in new product line.
13. Distribution and marketing methods have changed.
The important methods of Corporate Restructuring are:
1. Joint ventures
2. Sell off and spin off
3. Divestitures
4. Equity carve out (ECO)
5. Leveraged buy outs (LBO)
6. Management buy outs
7. Master limited partnerships
8. Employee stock ownership plans (ESOP)
1. Joint Ventures
Joint ventures are new enterprises owned by two or more participants. They are typically
formed for special purposes for a limited duration. It is a combination of subsets of assets
contributed by two (or more) business entities for a specific business purpose and a limited
duration. Each of the venture partners continues to exist as a separate firm, and the joint
venture represents a new business enterprise. It is a contract to work together for a period of
time each participant expects to gain from the activity but also must make a contribution.
For Example:
GM-Toyota JV: GM hoped to gain new experience in the management techniques of the
Japanese in building high-quality, low-cost compact & subcompact cars. Whereas,
Toyota was seeking to learn from the management traditions that had made GE the no. 1
auto producer in the world and In addition to learn how to operate an auto company in the


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environment under the conditions in the US, dealing with contractors, suppliers, and
workers.
DCM group and Daewoo motors entered in to JV to form DCM DAEWOO Ltd. to
manufacture automobiles in India.
Reasons for Forming a Joint Venture
Build on companys strengths
Spreading costs and risks
Improving access to financial resources
Economies of scale and advantages of size
Access to new technologies and customers
Access to innovative managerial practices
Rational For Joint Ventures
To augment insufficient financial or technical ability to enter a particular line or business.
To share technology & generic management skills in organization, planning & control.
To diversify risk
To obtain distribution channels or raw materials supply
To achieve economies of scale
To extend activities with smaller investment than if done independently
To take advantage of favorable tax treatment or political incentives (particularly in
foreign ventures).
Tax aspects of joint venture.
If a corporation contributes a patent technology to a Joint Venture, the tax consequences may
be less than on royalties earned though a licensing arrangements.
Example:
One partner contributes the technology, while another contributes depreciable facilities. The
depreciation offsets the revenues accruing to the technology. The J.V. may be taxed at a
lower rate than any of its partner & the partners pay a later capital gain tax on the returns
realized by the J.V. if and when it is sold. If the J.V. is organized as a corporation, only its


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assets are at risk. The partners are liable only to the extent of their investment, this is
particularly important in hazardous industries where the risk of workers, production, or
environmental liabilities is high.
2. Spin-off
Spinoffs are a way to get rid of underperforming or non-core business divisions that can drag
down profits.
Process of spin-off
1. The company decides to spin off a business division.
2. The parent company files the necessary paper-work with the Securities and Exchange
Board of India (SEBI).
3. The spinoff becomes a company of its own and must also file paperwork with the SEBI.
4. Shares in the new company are distributed to parent company shareholders.
5. The spinoff company goes public.
Notice that the spinoff shares are distributed to the parent company shareholders. There are
two reasons why this creates value:
1. Parent company shareholders rarely want anything to do with the new spinoff. After all,
its an underperforming division that was cut off to improve the bottom line. As a result,
many new shareholders sell immediately after the new company goes public.
2. Large institutions are often forbidden to hold shares in spinoffs due to the smaller market
capitalization, increased risk, or poor financials of the new company. Therefore, many
large institutions automatically sell their shares immediately after the new company goes
public.
Simple supply and demand logic tells us that such large number of shares on the market will
naturally decrease the price, even if it is not fundamentally justified. It is this temporary
mispricing that gives the enterprising investor an opportunity for profit.
There is no money transaction in spin-off. The transaction is treated as stock dividend & tax
free exchange.



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Split-off:
Is a transaction in which some, but not all, parent company shareholders receive shares in a
subsidiary, in return for relinquishing their parent companys share. In other words some
parent company shareholders receive the subsidiarys shares in return for which they must
give up their parent company shares
Feature of split-offs is that a portion of existing shareholders receives stock in a subsidiary in
exchange for parent company stock.
Split-up:
Is a transaction in which a company spins off all of its subsidiaries to its shareholders &
ceases to exist.
The entire firm is broken up in a series of spin-offs.
The parent no longer exists and
Only the new offspring survive.
In a split- up, a company is split up into two or more independent companies. As a sequel, the
parent company disappears as a corporate entity and in its place two or more separate
companies emerge.
Sell-off:
Selling a part or the entire firm by any one of means i.e. sale, liquidation, spin-off & so on or
General term for divestiture of part/all of a firm by any one of a no. of means: sale,
liquidation, spin-off and so on.
Strategic Rationale
Divesting a subsidiary can achieve a variety of strategic objectives, such as:
Unlocking hidden value Establish a public market valuation for undervalued assets and
create a pure-play entity that is transparent and easier to value
Un-diversification Divest non-core businesses and sharpen strategic focus when direct
sale to a strategic or financial buyer is either not compelling or not possible


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Institutional sponsorship Promote equity research coverage and ownership by
sophisticated institutional investors, either of which tend to validate SpinCo as a
standalone business.
Public currency Create a public currency for acquisitions and stock-based compensation
programs.
Motivating management Improve performance by better aligning management
incentives with Spin Cos performance (using Spin Cos, rather than Parent Company,
stock-based awards), creating direct accountability to public shareholders, and increasing
transparency into management performance.
Eliminating dissynergies Reduce bureaucracy and give Spin Company management
complete autonomy.
Anti-trust Break up a business in response to anti- trust concerns.
Corporate defense Divest crown jewel assets to make a hostile takeover of Parent
Company less attractive
3. Divestures
Divesture is a transaction through which a firm sells a portion of its assets or a division to
another company. It involves selling some of the assets or division for cash or securities to a
third party which is an outsider.
Divestiture is a form of contraction for the selling company, means of expansion for the
purchasing company. It represents the sale of a segment of a company (assets, a product line,
a subsidiary) to a third party for cash and or securities.
Mergers, assets purchase and takeovers lead to expansion in some way or the other. They are
based on the principle of synergy which says 2 + 2 = 5! , divestiture on the other hand is
based on the principle of energy which says 5 3 = 3!.
Among the various methods of divestiture, the most important ones are partial sell-off,
demerger (spin-off & split off) and equity carve out. Some scholars define divestiture rather
narrowly as partial sell off and some scholars define divestiture more broadly to include
partial sell offs, demergers and so on.



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Motives:
Change of focus or corporate strategy
Unit unprofitable can mistake
Sale to pay off leveraged finance
Antitrust
Need cash
Defend against takeover
Good price.
4. Equity Carve-Out
A transaction in which a parent firm offers some of a subsidiaries common stock to the
general public, to bring in a cash infusion to the parent without loss of control.
In other words equity carve outs are those in which some of a subsidiaries shares are offered
for a sale to the general public, bringing an infusion of cash to the parent firm without loss of
control. Equity carve out is also a means of reducing their exposure to a riskier line of
business and to boost shareholders value.
Features
It is the sale of a minority or majority voting control in a subsidiary by its parents to
outside investors. These are also referred to as split-off IPOs
A new legal entity is created.
The equity holders in the new entity need not be the same as the equity holders in the
original seller.
A new control group is immediately created.
Difference between Spin-off and Equity carve outs:
1. In a spin off, distribution is made pro rata to shareholders of the parent company as a
dividend, a form of non cash payment to shareholders. In equity carve out; stock of
subsidiary is sold to the public for cash which is received by parent company
2. In a spin off, parent firm no longer has control over subsidiary assets. In equity carve
out, parent sells only a minority interest in subsidiary and retains control.
An Equity Carve-Out (ECO) is a partial public offering of a wholly owned subsidiary. Unlike
spin-offs, ECOs generate a capital infusion because the parent offers shares in the subsidiary


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to the public through an Initial Public Offering (IPO), although it usually retains a controlling
interest in the subsidiary. Like spin-offs, ECOs have become increasingly popular in the last
several years.
An equity carve-out involves conversion of an existing division or unit into a wholly owned
subsidiary. A part of the stake in this subsidiary is sold to outsiders. The parent company may
or may not retain controlling stake in the new entity. The shares of the subsidiary are listed
and traded separately on the stock exchange. Equity carve-outs result in a positive cash flow
to the parent company. An equity carve-out is different from a spin-off because of the
induction of outsiders as new shareholders in the firm. Secondly equity carve-outs require
higher levels of disclosure and are more expensive to implement.
Benefits of Equity Carve-Out
The potential benefits of equity carve-out include:
1. Pure play Investment Opportunity: Pure plays have been in much demand by investors
in recent years. An ECO, especially for a subsidiary that is not involved in the parents
primary business or industry, increases the subsidiarys visibility as well as analyst and
investor awareness. This enhances its overall value. Investors also like ECO pure plays
because separating the parent and subsidiary minimizes cross-subsidies and other
potentially inefficient uses of capital.
2. Management Scorecard and Rewards: Management is evaluated on a daily basis through
the companys stock price. This immediate, visible scorecard can boost performance by
spurring managers to make timely strategic decisions and concentrate on the factors that
contribute to better shareholder value. Correspondingly, managers are also more likely to
be rewarded for improved results.
3. Capital Market Access: An ECO typically improves access to capital markets for both the
parent and the subsidiary.
Process of Equity Carve-Out
A typical carve-out scenario in the US begins with the parent publicly announcing its
intention to offer securities in a subsidiary or division through an ECO. Since an ECO is a
type of IPO, companies must file an S-1 registration statement with the SEC. Registration
requires three years of audited income statements, two years of audited balance sheets, and


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five years of selected historic financial data. The ensuing process including the preparation
of financial and registration statements, SEC review, responses, and amendments, and
offering marketing normally takes up to six months. Once the SEC reviews and declares it
effective, the parent can sell the offering, either listing the spin-off on an exchange or
providing for trading over the counter.
Either the parent or the carve-out (or both) can receive the IPO proceeds. If the subsidiary
sells the shares, the IPO represents a primary offering. Over 70 percent of the companies in
the researchers sample reported handling the ECO in this manner. If the parent sells the
shares (known as secondary shares), it must recognize the difference between the IPO
proceeds and its basis as a gain or loss for tax purposes. If the subsidiary sells the shares in
the IPO, neither the parent nor the carve-out incurs a tax liability. When the ECO sells the
shares, it often uses some of the proceeds to repay loans to the parent or pay a special
dividend. A relatively small number of ECOs are handled as joint offerings of the parent and
subsidiary.
A study has found that 50 percent of the ECOs used for the proceedings of primary offerings
to repay loans to the parent, 30 percent to be retained, and 20 percent pay to creditors. In
secondary offerings, 50 percent of the parents ECOs retain the proceeds, while 50 percent pay
to creditors. The research indicates that the initial stock market reaction to an ECO
announcement is more favorable if the subsidiary retains the funds.
After the IPO, all transactions between the parent and the subsidiary must be conducted on an
arms- length basis and disclosed in the registration statement. The parent typically continues
to perform certain corporate services, such as investor relations, legal and tax services, human
resources, data processing, and banking services, on a contractual basis.
Characteristics of ECO Candidate
Strong potential ECO candidates have some or all of the following characteristics.
Strong Growth Prospects: If the subsidiary is in an industry with better growth prospects
than the parent, it will likely sell at a higher price/earnings multiple once it has been
partially carved out of the parent.


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Independent Borrowing Capacity: A subsidiary that has achieved the size, asset base,
earnings and growth potential, and identity of an independent company will be able to
generate additional financing sources and borrowing capacity after the carve-out.
Unique Corporate Culture: Subsidiaries whose corporate culture differs from that of the
parent may be good ECO candidates because the carve-out can offer management the
freedom to run the company as an independent entity. Companies that require
entrepreneurial cultures for success can especially benefit from this transaction.
Special Industry Characteristics: Subsidiaries with unusual characteristics are often better
suited to decentralized management decision- making, which may allow management to
respond more quickly to changes in technology, competition, and regulation.
Management Performance, Retention, and Rewards: Subsidiaries that compete in
industries where management retention is an issue and targeted reward systems are
required can benefit from an ECO.
Scenario after Equity Carve-Outs
While analyzing a sample of ECOs, researchers found important increases in sales, operating
income before depreciation, total assets, and capital expenditures. However, they believe
these improvements owe less to newly gained efficiencies than to the carve-outs growth after
going public. This is because the relative growth rates were not positive or statistically
significant.
Note that ECOs, like spin-offs, are subject to a great deal of takeover activity. In the sample,
50% of the ECOs were acquired within three years. An analysis of returns for these
companies suggests that ECOs that are taken over perform better than average, while those
that are not perform worse than average. Nonetheless, even the latter outperform, on average,
in other types of firms. Overall, it is clear that ECOs earn significantly positive abnormal
stock returns for up to three years after the carve-out. Parents, on the other hand, earn
negative stock returns.
As with spin-offs, these higher-than-normal stock returns are associated with better operating
performance and corporate restructuring activity. As a restructuring device, ECOs clearly
seem to lead to better operating performance (on average) and greater increases in
shareholder value.


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In a study of equity carve-outs by J P Morgan, it was found that carve-out firms in which the
parent firm announced that a spin-off would follow at a later date, outperformed the market
by 11% for a period of 18 months after the initial public offering, while carve-out firms
without spin-off announcements underperformed the market by 3%. Equity carve outs
involve the sale of an equity interest in a subsidiary to outsiders. This sale may not
necessarily leave the parent in control of the subsidiary. Post carve-out, the partially divested
subsidiary is operated and managed as a separate firm.
Disadvantages of Equity Carve-Outs
The biggest disadvantage of carve-outs is the scope for conflict between the two companies
as operation level conflict occurs because of the creation of a new group of financial
stakeholders by the mangers of the carved-out company. The requirements of these
stakeholders differ from those of the original stakeholders. This conflict can hinder the
performance of both firms. The stock performance of a company that has carved out 70 to
100 percent is better than that of a company that has carved-out less than 70 percent. This
indicates that lack of separation between the two entities prevents the carved-out entity from
reaching its potential.
5. Leveraged Buyout
A buyout is a transaction in which a person, group of people, or organization buys a company
or a controlling share in the stock of a company. Buyouts great and small occur all over the
world on a daily basis.
Buyouts can also be negotiated with people or companies on the outside. For example, a large
candy company might buy out smaller candy companies with the goal of cornering the
market more effectively and purchasing new brands which it can use to increase its customer
base. Likewise, a company which makes widgets might decide to buy a company which
makes thingamabobs in order to expand its operations, using an establishing company as a
base rather than trying to start from scratch.
In a leveraged buyout, the company is purchased primarily with borrowed funds. In fact, as
much of 90% of the purchase price can be borrowed. This can be a risky decision, as the
assets of the company are usually used as collateral, and if the company fails to perform, it


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can go bankrupt because the people involved in in the buyout will not be able to service their
debt. Leveraged buyouts wax and wane in popularity depending on economic trends.
The buyers in the buyout gain control of the companys assets, and also have the right to use
trademarks, service marks, and other registered copyrights of the company. They can use the
companys name and reputation, and may opt to retain several key employees who can make
the transition as smooth as possible. However, people in senior management may find that
they are not able to keep their jobs because the purchasing company does not want redundant
personnel, and it wants to get its personnel into key positions to manage the company in
accordance with their business practices.
A leveraged buyout involves transfer of ownership consummated mainly with debt. While
some leveraged buyouts involve a company in its entirety, most involve a business unit of a
company. Often the business unit is bought out by its management and such a transaction is
called management buyout (MBO). After the buyout, the company (or the business unit)
invariably becomes a private company.
What Does Debt Do? A leveraged buyout entails considerable dependence on debt.
What does it imply? Debt has a bracing effect on management, whereas equity tends to have
a soporific influence. Debt spurs management to perform whereas equity lulls management to
relax and take things easy.
Risks and Rewards, The sponsors of a leveraged buyout are lured by the prospect of wholly
(or largely) owning a company or a division thereof, with the help of substantial debt finance.
They assume considerable risks in the hope of reaping handsome rewards. The success of the
entire operation depends on their ability to improve the performance of the unit, contain its
business risks, exercise cost controls, and liquidate disposable assets. If they fail to do so, the
high fixed financial costs can jeopardize the venture.
Purpose of debt financing for Leveraged Buyout
The use of debt increases the financial return to the private equity sponsor.
The tax shield of the acquisition debt, according to the Modigliani-Miller theorem with
taxes, increases the value of the firm.


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Features of Leveraged Buyout
Low existing debt loads;
A multi- year history of stable and recurring cash flows;
Hard assets (property, plant and equipment, inventory, receivables) that may be used as
collateral for lower cost secured debt;
The potential for new management to make operational or other improvements to the firm
to boost cash flows;
Market conditions and perceptions that depress the valuation or stock price.
Examples:
1. Acquisition of Corus by Tata.
2. Kohlberg Kravis Roberts, the New York private equity firm, has agreed to pay about
$900 million to acquire 85 percent of the Indian software maker Flextronics Software
Systems is the largest leveraged buyout in India.
6. Management buyout
In this case, management of the company buys the company, and they may be joined by
employees in the venture. This practice is sometimes questioned because management can
have unfair advantages in negotiations, and could potentially manipulate the value of the
company in order to bring down the purchase price for themselves. On the other hand, for
employees and management, the possibility of being able to buy out their employers in the
future may serve as an incentive to make the company strong.
It occurs when a companys managers buy or acquire a large part of the company. The goal
of an MBO may be to strengthen the managers interest in the success of the company.
Purpose of Management buyouts
From management point of view may be:
To save their jobs, either if the business has been scheduled for closure or if an outside
purchaser would bring in its own management team.


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To maximize the financial benefits they receive from the success they bring to the
company by taking the profits for themselves.
To ward off aggressive buyers.
The goal of an MBO may be to strengthen the managers interest in the success of the
company. Key considerations in MBO are fairness to shareholders price, the future business
plan, and legal and tax issues.
Benefits of Management buyouts
It provides an excellent opportunity for management of undervalued cos to realize the
intrinsic value of the company.
Lower agency cost: cost associated with conflict of interest between owners and
managers.
Source of tax savings: since interest payments are tax deductible, pushing up gearing
rations to fund a management buyout can provide large tax covers.
Leveraged Buyout (LBO) is defined as the acquisition by a small group of investors,
financed largely by borrowing. This acquisition may be either of all stock or assets, of a
hitherto public company. The buying group forms a shell company to act as the legal entity
making the acquisition. This buying group may enter into stock purchase deal or asset
purchase deal. Under the stock purchase device the shareholders sell their stock in the target
company to the buying group and then the two firms may be merged. Under the asset
purchase mode, the target company sells its assets to the buying group. This exercise aims at
generating enormous increases in the market value and value gains for shareholders both who
own the firm before the restructuring and after the restructuring.
The leveraged buyouts differ from the ordinary acquisitions in two main ways: firstly, a large
fraction of purchase price is debt financed through junk bonds and secondly, the shares of
LBOs are not traded on open markets. In a typical LBO programme, the acquiring group
consists of a small number of persons/organisations/ sponsored by buy out specialists ,etc.
This group, with the help of certain financial instruments like high yield high risk debt
instruments, private placement instruments, bridge financing etc. acquire all or nearly all of
the outstanding shares of the target firm. An attractive candidate for acquisition through
leveraged buyout should possess three basic attributes:


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1. It must have a good position in industry with sound profit history
2. The firm should have a relatively low level of debt and high level of bankable assets
3. It must have stable and predictable cash flows and adequate working capital.
The buyout group may or may not include current management of the target firm. If the
group does so, the buyout may be regarded as management buyoutor MBO. In other
words, when the managers buy their company from its owners deploying debt, leveraged
buyout is called management buyout.
A Management Buyout (MBO) is simply a transaction through which the incumbent
management buyouts all or most of the other shareholders. The management may take on
partners, it may borrow funds or it can organize the entire restructuring, on its own. An
Management Buyout (MBO) begins with arrangement/raising of finance. Thereafter, an
offer to purchase all or nearly all of the shares of a company not presently held by the
management has to be made which may necessitate a public offer and even delisting.
Consequent upon this, restructuring may be affected and once targets have been achieved,
then the company can go public again.
7. Master Limited Partnership
Master Limited Partnerships are a type of limited partnership in which the shares are
publicly traded. The limited partnership interests are divided into units which are traded as
shares of common stock. Shares of ownership are referred to as units.
MLPs generally operate in the natural resource (petroleum and natural gas extraction and
transportation), financial services, and real estate industries.
The advantage of a Master Limited Partnership is it combines the tax benefits of a limited
partnership (the partnership does not pay taxes from the profit the money is only taxed
when unit holders receive distributions) with the liquidity of a publicly traded company.
There are two types of partners in this type of partnership:
1. The limited partner is the person or group that provides the capital to the MLP and
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2. The general partner is the party responsible for managing the Master Limited
Partnerships affairs and receives compensation that is linked to the performance of the
venture.
8. Employees Stock Option Plan (ESOP)
An Employee Stock Option is a type of defined contribution benefit plan that buys and holds
stock. ESOP is a qualified, defined contribution, employee benefit plan designed to invest
primarily in the stock of the sponsoring employer. Employee Stock Options are qualified
in the sense that the ESOPs sponsoring company, the selling shareholder and participants
receive various tax benefits. With an ESOP, employees never buy or hold the stock directly.
Features:
Employee Stock Ownership Plan (ESOP) is an employee benefit plan.
The scheme provides employees the ownership of stocks in the company.
It is one of the profit sharing plans.
Employers have the benefit to use the ESOPs as a tool to fetch loans from a financial
institute.
It also provides for tax benefits to the employers.
The benefits for the company: increased cash flow, tax savings, and increased productivit y
from highly motivated workers.
The benefit for the employees: is the ability to share in the companys success.
How it works?
Organizations strategically plan the ESOPs and make arrangements for the purpose.
They make annual contributions in a special trust set up for ESOPs.
An employee is eligible for the ESOPs only after he/she has completed 1000 hours
within a year of service.
After completing 10 years of service in an organization or reaching the age of 55, an
employee should be given the opportunity to diversify his/her share up to 25% of the total
value of ESOPs.