Canada: Using Spin-Outs To Bridge Valuation Gaps

While companies are reportedly sitting on piles of cash (so much so, that it has become somewhat of a political issue with Canadian cabinet ministers and the Governor of the Bank of Canada urging companies to spend this "dead money"), one might expect such companies to be free spenders when it comes to acquisitions. However, persistent economic uncertainty has made potential purchasers reluctant to spend accumulated cash on acquisitions, and we expect this trend to continue until an economic recovery is firmly established.

In the M&A area, this reluctance to overspend is often coupled with the fact that a target company may have, in addition to its desirable assets, other assets that are less attractive, at least from the prospective acquirer's perspective. This is particularly true in the resource sector where smaller exploration companies will often have a number of properties at different stages of development. If one or two properties prove to be promising and attract the attention of a major resource company, there may be a wide gulf between the value that the target company puts on its other properties and the value that the acquirer is willing to pay for them. Indeed, in many cases the acquirer may view them as superfluous and have no interest in continuing their exploration or development.

Of course, the easiest answer might be for the target to simply sell the valuable asset and keep the other assets and continue their development. This is not always advantageous to the shareholders, however, as such a sale often triggers a taxable event for the target and there may be no tax-effective way to flow the sale proceeds into the hands of shareholders. Similarly, the use of earn-outs (or, in a public company context, contingent value rights), the tool often used to bridge valuation gaps, is not well-suited to long-term projects like mine or oil and gas projects. A spin-out transaction may be a possible alternative solution.

Under a spin-out coupled with an M&A transaction, the acquirer purchases the shares of the target company, but the assets which the acquirer doesn't want are contemporaneously spun-out of the target into a new company, the shares of which are distributed to the target shareholders as part of the transaction. Thus, the target shareholders get paid full value for the target's core assets but also are able to continue to participate in the development of the other assets. Similarly, the acquiror only has to pay for what it actually wants. Such spin-out transactions can often be completed in a reasonably tax-effective manner, depending on the facts.

For these reasons, we anticipate spin-outs will continue to be a feature of M&A in 2013 as a tool for bridging value gaps in acquisition transactions. Beyond their use in M&A, we can also expect that spin-outs will continue to appear as a way of enhancing value within diversified enterprises: see for example the pending Loblaw Companies Limited spin-out of its real estate into a new REIT and the coming proxy battle to push Agrium Inc. to spin out its farm store business.

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