Creating Value through Spin-offs
A Case Study on Ingevity
The current pandemic and resulting economic crisis have placed a premium on capital. After almost a decade of economic tailwinds, uncertainty stemming from the novel Coronavirus severely limited access to capital earlier this year. The Federal Reserve intervened to boost the liquidity in the corporate bond market and corporations responded by issuing over a trillion dollars in bonds, far surpassing last year’s rate.
The constraints many corporations now face raise the need for maximizing the efficient use of capital. Going forward, strengthening balance sheets, and focusing on core operations will be essential for future financial success. Previously optimal business structures will likely require restructuring and elements of a corporation that were not previously constrained, may now very well be. Consequently, business segments that would suffer from diminished management focus or a reduction in internal funding may become spin-off candidates for a firm. The same is true for embedded businesses that are perceived to be undervalued by the market.
When strategically sound and properly executed, corporate spin-offs can create shareholder value in almost any economic environment. In the volatile debt and equity markets, spin-offs could prove more valuable than ever.
Why a Spin-off?
As the former CEO of Ingevity, I have first-hand experience with a successful spin-off. Ingevity was spun out of WestRock and was Forbes #1 spin-off in 2016.
A spin-off is the creation of an independent company through the creation and distribution of new shares of an existing business or division. It is a means of divesting a business with its shares distributed to the existing shareholders of the parent company. From a strategic perspective, a spin-off may be desired for many reasons: the parent company could be trying to narrow its business focus, shed a mature business, or put greater management focus on a division with faster growth and higher profitability. Regardless, they are designed to enhance strategic focus and enable efficient allocation of capital, allowing the “spinco” to seize opportunities that create shareholder value.
Often the spin-off structure is chosen because of its tax implications. This was precisely the case for Ingevity. Ingevity was spun-out as a tax-free transaction with parent company shareholders receiving one share of Ingevity for every six shares they held in WestRock.
Spin-offs can also result from shareholder activism. This, too, was the case for Ingevity. In early 2015, MeadWestvaco (MWV), one of the predecessor companies to WestRock, announced the intent to spin out its Specialty Chemicals division. That spin had long been contemplated but was hastened by an activist shareholder that had taken a stake in MWV.
The chemicals division was a higher margin, faster-growing “specialty” company embedded in a much larger, commodity paper, and packaging business. The rationale for the spin was that the value of the chemicals business inside the parent was being suppressed. This resulted in a much lower multiple of its earnings than warranted due to what is commonly known as a “conglomerate discount.” Ingevity’s future share performance as an independent company later proved this thesis to be true.
Success is Not Guaranteed
Corporate spin-offs have a long track record of success. In fact, through March of 2019 from its inception in 2002, the Bloomberg US Spin-Off Index has produced a total return of 973% versus 342% for the S&P 500 Index. The outperformance is largely attributed to greater management focus and accountability as standalone companies. Independence can also bring financial and strategic flexibility.
Yet, not all spin-offs are a success. Some are not structured to succeed, or at least not with the same odds of success. Often they are underperforming businesses with legacy liabilities (legal, pension, environmental, or other) and heavily levered with debt. Sometimes this is done to allow the parent to have a cash take out in the transaction.
So, why was Ingevity’s spin-off so successful when many other corporate carve-outs fail to outperform? Ingevity was a high performing division of WestRock whose earnings were being undervalued by the market. This fact alone increased Ingevity’s odds of success. In addition, the company was structured to succeed, not fail. That structuring offers a number of important lessons.
Key Takeaways from a Successful Spin-off
WestRock realized that Ingevity’s earnings and growth potential would be more highly valued by equity markets with Ingevity as an independent company. My key takeaways from our successful spin-off include:
Establish an Independent Leadership Team and Governance Structure Early
A full nine months prior to the spin, I was brought on board and tasked with leading Ingevity through the spin process and to serve as the future public company CEO. Within the next month, we appointed the CFO and General Counsel, along with the other members of the initial leadership team. This ensured that by the time of the spin, leadership had taken hold of the reins. The team understood the business, had reviewed and made needed changes to the strategy and organization, and had developed and articulated a clear investment thesis. Simultaneously, we laid out the corporate governance framework, largely a “lift and shift” of policies and practices from our predecessors, and initiated the search for board members.
Establish a Dedicated Project Team and Augment with Outside Expertise
Corporate carve-outs are complex transactions. By the time I arrived at Ingevity, the effort to “stand up” the company was well underway. The project task list, identified through a disciplined process, included some 3,500 discrete items to be executed, most associated with “disentangling” the business from the parent.
A talented team of employees from WestRock and Ingevity, supplemented with top advisors (tax, accounting, legal, and investment banking) had been assembled, relieved of prior duties, and focused solely on executing the spin-off. Cooperation between employees from WestRock and Ingevity was critical to project execution. Moreover, an independent project team enabled the rest of the organization to remain focused on running the business.
Secure Critical Supply Chain Contracts
Ingevity had remained part of its parent organization for so long because a key raw material for the Performance Chemicals segment, crude tall oil (CTO), is a by-product of the soft-wood, a kraft pulping process employed to generate fiber for paper making. As a standalone entity, it was critical for Ingevity to secure, long-term supply of this strategic raw material.
Ultimately, Ingevity was spun out of WestRock with a 10-year supply agreement for CTO that would represent approximately 50% of its needed supply at capacity. Importantly, the pricing mechanism within the supply agreement was designed to ensure that Ingevity sourced the CTO overtime at a competitive price. Agreements were also put in place to ensure WestRock provided needed transition services at reasonable costs until Ingevity could establish independent capability or supply.
Refrain from Overburdening the Business with Legacy Liabilities
The company was spun out with few legacy liabilities, almost none on the environmental side — unusual for a chemical company — and only its fair portion of pension liability.
Place Only Modest Leverage on the Business
The business was launched with a capital structure and balance sheet adequate for its needs. Financial leverage was kept to a reasonable level, with debt-to-EBITDA of about 2.5 times. To put this in perspective, since going public, Ingevity has sought to maintain a leverage ratio of 2.0 to 2.5 times net debt to EBITDA, a level that is not unusual for similar companies.
Ensure the Assets are Fairly Valued
Another factor that played to Ingevity’s favor was that WestRock ensured Ingevity’s assets were appropriately valued prior to separation. In the second half of 2015, the Performance Chemicals segment of Ingevity experienced a significant downturn, resulting in a decline in earnings. The decline in earnings, coupled with WestRock’s reassessment of the book value of Ingevity, resulted in WestRock taking an impairment on the value of the business. This, in turn, resulted in lower initial market capitalization.
Ingevity’s earnings later began to improve as we executed the turn around of the Performance Chemicals segment and delivered promised growth in Performance Materials. When earnings improved, there was much more “upside” in the stock than there otherwise would have been.
Ensure Cooperation between “Parent” & “Child”
In a corporate spin-off, or carve-out of any kind, the relationship between “the parent” and “the child” is critically important. In the beginning of the process, everyone is effectively “on the same side of the table.” However, as the new company moves closer to independence, its duty shifts increasingly to the success of the new company, while the parent wants to ensure that inordinate value is not given away.
As a result, negotiation of supply agreements, ownership of assets and liabilities, and on-going services agreements, can become tenuous. The key to successfully resolving these delicate issues is for the leadership of both companies to focus on maximizing the value creation for shareholders. WestRock and Ingevity leadership were successful in navigating this divide.
How the Spin-off Fared
Financially…
Ingevity went public on May 16, 2016. The opening trade, pre-regular market, was at $23.00. With ~42 million shares outstanding, the initial market capitalization was under $1 billion. Because Ingevity was a small-cap growth company being spun out of a large-cap, high dividend parent company we expected we would rotate to a different investor base than WestRock. As a result, it was believed that the Ingevity share price, like for many carve-outs, would sag for a period post-spin until a new investor base could be established. That never happened. Over the next three years, the share price peaked at more than $115/share. The value of the company reached its current peak in early 2019 at almost $5.0 billion. Ingevity subsequently became a performance leader among specialty chemical stocks.
And Non-Financially…
At the same time, the company improved its safety performance to what should be among the top quartile of American Chemistry Council companies, with a 38% improvement in recordable injuries during 2019 alone. It issued its first-ever sustainability reports in 2018 and 2019. Ingevity invested significantly in the greater Charleston, S.C. region, where it is headquartered, and in other communities where it operates, through its IngeviCares philanthropy program.
The company’s culture, always a differentiator, has become a real competitive advantage as a result of a sustained effort to drive higher levels of employee engagement. The company’s efforts to “connect people to purpose” through the IngeviWay, an expression of the company’s purpose, identity, vision, and values, are a means to engage employees’ “hearts” as well as “heads and hands.”
Conclusion
Ingevity is a strong example of value creation resulting from a spin-off. That value resulted from a reappraisal of the company’s growth and earnings outside the corporate parent (i.e. the removal of the conglomerate discount it suffered under MWV and WestRock). It benefitted from the focus of having independent management, and from the financial and strategic flexibility that came with its independence.
In today’s era of capital constraints and market dislocation, the spin-off process will remain an important consideration. Today’s markets are in flux, but over time as markets settle, firms will find spin-offs and other forms of corporate restructuring as key value-added techniques. The elements of successful restructuring from previous periods can offer important markers for success as this Ingevity case study shows.
About the Author
D. Michael Wilson serves as the Chief Executive Officer of Prince International) and as a director of ASP Prince Holdings, LLC. Prince (www.princecorp.com) is a leading global supplier of specialty minerals that bring color, energy and enhanced functionality to everyday products. From 2015 to 2020 Michael served as the President, CEO and as a director of the specialty chemicals company Ingevity. He has deep specialty chemical and minerals experience having also served in executive roles at Albemarle Corporation and FMC as well as the board of Vulcan Materials. He has also served on the boards of the American Chemistry Council, the National Association of Manufacturers, and the Philadelphia and Greater Charleston Metro Chambers of Commerce. Michael has also served on the board of a number of philanthropic organizations including The United Way of Greater Charleston, Philabundance, and the Philadelphia Art Museum Corporate Executive Board. He currently serves on the board of the Lowcountry Food Bank and is a member of the Governance Committee. In 2020 he established the D. Michael Wilson Foundation to benefit the Lowcountry Food Bank, the South Carolina Aquarium, and Reading Partners South Carolina, among other causes. The fund also provides support to the Plastic Free Waters initiative at the SC Aquarium. He has a BS in Chemistry and an MBA from UNC-Chapel Hill. Wilson has been recognized for corporate leadership in the Charleston Business Magazine. You can learn more about Michael’s interests and activities at www.dmichaelwilson.com.
Learn more about D. Michael Wilson’s philanthropy efforts at:
· D. Michael Wilson Foundation Website
