LM04 Corporate Restructuring IFT Notes

LM04 Corporate Restructuring 2025 Level II Notes LM04 Corporate Restructuring 1. Introduction ........................................................................................................................................................ 2 2. Corporate Evolution, Actions, and Motivations .................................................................................... 2 Corporate Life Cycle and Actions .................................................................................................................... 2 Motivations for Corporate Structural Change ............................................................................................ 3 Types of Corporate Restructurings ................................................................................................................ 4 3. Evaluating Corporate Restructurings ....................................................................................................... 7 Initial Evaluation ................................................................................................................................................... 8 Preliminary Valuation ......................................................................................................................................... 8 4. Modeling and Valuation .............................................................................................................................. 11 Pro Forma Weighted Average Cost of Capital ......................................................................................... 13 Summary................................................................................................................................................................ 15 Required disclaimer: IFT is a CFA Institute Prep Provider. 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All rights reserved 1 LM04 Corporate Restructuring 2025 Level II Notes 1. Introduction This learning module covers:  Types of corporate restructurings, how they relate to the corporate life cycle, and the motivations for pursuing them.  A process for evaluating corporate restructurings from the perspective of an investment analyst.  Case studies demonstrating the evaluation process for each major type of corporate restructuring. 2. Corporate Evolution, Actions, and Motivations Corporate Life Cycle and Actions Companies tend to follow a life cycle composed of four stages: start-up, growth, maturity, and decline. This is illustrated in Exhibit 1 from the curriculum. From an investor’s perspective, mature companies should operate until returns fall below the investor’s required rate of return. They should then liquidate the firm and return capital to the investors. However, most corporate managers and boards take actions to change their destiny. These actions include: investment, divestment, and restructuring.    Investment involves actions that increase the size of the company. For example, the acquisition of another company. Divestment involves actions that decrease the size of the company. For example, the sale of a business segment for cash. Restructuring does not alter a company’s size but improves its cost and financing structure. For example, improving productivity to bring profitability to peer levels. Motivations for Corporate Structural Change Exhibit 3 from the curriculum lists the typical motivations for corporate structural change. © IFT. All rights reserved 2 LM04 Corporate Restructuring 2025 Level II Notes The motivations can be issuer specific or can also be caused by broader macroeconomic or industry changes, known as top-down drivers. Investment Actions Issuer-specific motivations Top-down drivers Divestment Actions • Realize synergies • Focus operations and business lines • Increase growth • Valuation • Improve capabilities or secure • Liquidity needs resources • Regulatory • Opportunity to requirements acquire an undervalued target • High security prices • Industry shocks Restructuring Actions • Improve returns on capital • Financial challenges, including bankruptcy and liquidation Instructor’s Note: We will discuss the top-down drivers in this section and the issuerspecific motivations in the next section. High security prices:   Corporate structural changes tend to be pro-cyclical. They increase during economic expansions when security prices rise, and decrease during recessions when security prices fall. Three possible explanations for the connection between security prices and corporate transaction activity are: o Greater CEO confidence: High and rising security prices are associated with high and rising CEO confidence. CEOs are more likely to take large actions when they are confident about the future. o Lower cost of financing: Higher bond prices imply lower interest rates and higher equity prices imply lower equity risk premiums; i.e. higher security prices imply a lower cost of financing. o Management and board know that their stock is overvalued: If a company believes that its stock is overvalued, it can use equity-financed acquisitions, sales or spin-offs to exchange overvalued stock and realize value. Industry shocks:  Regulator changes, technological changes, or changes in the growth rate of the industry are collectively known as industry shocks.  Corporate restructuring activity tends to come in industry-specific waves during periods of industry shocks. Companies pursue corporate structural changes to adapt to disruptions in their competitive environment. © IFT. All rights reserved 3 LM04 Corporate Restructuring 2025 Level II Notes Types of Corporate Restructurings Corporate restructuring can be classified as one of nine types as shown in Exhibit 5 from the curriculum. Most types will fall under the general categories of investment, divestment, and restructuring. LBOs are a special type of restructuring that has elements of all three categories. Investment Actions: Equity Investments, Joint Ventures, and Acquisitions Issuer specific motivations for investment actions include:     Realize synergies: Synergies refer to the combination of two companies being more valuable than the sum of the parts. Synergies can arise from lower costs (cost synergies) or increased revenue (revenue synergies) or both. Increase growth: For example, acquiring an established but faster-growing company can increase a company’s consolidated revenue growth. Improve capabilities or secure resources: For example, a corporation may be dependent on another company for inputs or for distribution of its products. By acquiring that company, the acquirer can increase its vertical integration, which can result in lower costs and lower risks. Opportunity to acquire an undervalued target: Companies can take advantage of market mispricing to acquire undervalued targets. The three main types of investment actions are: © IFT. All rights reserved 4 LM04 Corporate Restructuring    2025 Level II Notes Equity investments: o Refers to a company purchasing a material (but less than 50%) stake in another company. o Both companies maintain their independence. o Reasons for equity investments include: establishing a strategic partnership between companies, taking an initial step towards an eventual acquisition, or investing by an investor company into a company it believes is undervalued Joint ventures: o Two or more companies form and jointly control a new, separate company. Each participant contributes assets, employees, know-how, and other resources to the joint venture company. o Both companies maintain their independence and continue to do business apart from the JV but share the JV’s profits or losses. o JVs are commonly used while conducting business in new markets. A company with a well-established product or service will form a JV with another company with local business expertise. Acquisitions: o One company (the acquirer) purchases most or all of another company’s (the target’s) shares to gain control of the entire company, or a segment of the other company, or a specific group of assets. o After the acquisition is complete, the target ceases to exist as an independent company and becomes a subsidiary of the acquirer. Divestment Actions: Sales and Spin Offs Issuer specific motivation for divestment actions include:  Focus operations and business lines: As a result of acquisitions or internal expansion over time companies often operate across multiple business lines. To improve performance, management may separate these businesses, either by selling them to another company or spinning them off into independent companies. This allows management to focus their attention and effort on the core business.  Valuation: Companies with many business divisions usually trade at a valuation that is lower than the sum of its part. This is due to a conglomerate discount that investors attach to such companies. In such situations, a business division could fetch a higher valuation from the capital market if it were independent instead of inside the parent company.  Liquidity needs: Unsustainable financial leverage can prompt a company to sell one or more of its businesses for cash and use the proceeds to reduce its leverage.  Regulatory requirements: Regulators may force divestments to avoid anti-competitive conduct and to safeguard against companies building cartels and monopolies. The two main types of divestments are: © IFT. All rights reserved 5 LM04 Corporate Restructuring   2025 Level II Notes Divestiture: o This is the other side of the acquisition. The target sells the entire company, a business segment, or a group of assets to the acquirer. o After the sale, the seller is no longer exposed to the divested business. o The capital obtained from the divestiture can be reallocated to a better use or returned to investors. Spin off: o A business segment is spun off into a new independent company. o The goal is to increase management and employee focus, and to remove any incompatibilities between the parent and the company that was spun off. Restructuring Actions: Cost and Balance Sheet Restructuring and Reorganization Issuer specific motivations for restructuring actions include:   Opportunistic improvement: Actions that alter the business model, trim the cost structure, or modify the composition of the balance sheet—all with the intention to improve returns on capital. For example, franchising. The asset owner can divest the asset and license the intellectual property to a third-party operator. Franchising shifts away many business risks from the franchisors to the franchisees. Forced improvement: Actions taken to enhance returns on capital when profitability falls below investors’ required rate of return. The three main types of restructuring actions are:   Cost restructuring: o Refers to actions taken to reduce costs by improving operational efficiency and profitability, with the goal of raising margins to historical levels or to those of comparable industry peers. o Two common ways of reducing costs are outsourcing and offshoring. o Outsourcing is the business practice of hiring a party outside a company to perform services or create goods that were traditionally performed in-house by the company's own employees and staff. o Offshoring refers to relocating operations from one country to another, mainly to reduce costs through lower labor costs or to achieve economies of scale through centralization, while still maintaining operations within the corporation. Balance sheet restructuring: o Alters the composition of the balance sheet by either shifting the asset composition, changing the capital structure, or both. o Two common balance sheet restructuring transactions are sale leasebacks and dividend recapitalization. o In a sale leaseback, an asset owner sells an asset to a lessor for cash and immediately signs a lease agreement for its use, typically for the asset’s remaining economic life. As a result, the asset owner receives cash up front, no longer owns © IFT. All rights reserved 6 LM04 Corporate Restructuring  2025 Level II Notes the asset, but still retains the right to use it in the future as the lessee. o A dividend recapitalization occurs when a corporate issuer restructures the debtequity mix via debt-financed dividends or share repurchases. The goal is to lower the issuer's weighted average cost of capital by replacing expensive equity with cheaper debt. Reorganization: o This is a court-supervised restructuring process where a bankruptcy court assumes control of the company and oversees an orderly negotiation process between the company and its creditors for asset sales, conversion of debt to equity, refinancing and so on. o The reorganization process is different from the liquidation process, which typically occurs when the reorganization process has failed to achieve its objectives and the company is still unable to pay its debts. Leveraged Buyouts      LBOs are a special type of restructuring that has elements of investment, divestment, and restructuring. In an LBO, an acquirer uses significant debt to finance the acquisition of a target and then pursues restructuring actions with the goal of exiting the target through a sale or public listing. LBOs are typically carried out by ‘buyout funds’ (a special category of PE funds) that specialize in these types of transactions. The investment returns are a function of four variables: the purchase price, the amount of leverage, free cash flow (FCF) generated during the ownership period, and the exit price. After the exit, the target typically has a significantly more leveraged capital structure than before the LBO. 3. Evaluating Corporate Restructurings The evaluation of corporate restructurings is composed of four phases as shown in Exhibit 12 from the curriculum. © IFT. All rights reserved 7 LM04 Corporate Restructuring 2025 Level II Notes Initial Evaluation The initial evaluation of a corporate restructuring involves answering four questions:     What is happening? Why is it happening? Is it material? When is it happening? To answer the first two questions an analyst can read the issuer’s press release, securities filings, conference call transcripts, and relevant third-party research, if available. The third question is determining materiality. Materiality is defined by both size and fit. One rule of thumb for what constitutes a “large” acquisition is that the total transaction value exceeds 10% of the acquirer’s enterprise value prior to the transaction. Fit refers to the alignment of the current structural change with earlier actions, previously announced strategies, and the analyst’s own expectations for the issue. For example, a company making a small acquisition of a company in a different industry or different business model could be interpreted as management changing its strategy or admitting, through their actions, that the issuer’s existing business model has problems. The last question focuses on timing. There can be a substantial time delay of at least several quarters between the announcement of the transaction and its completion. The length of the timeline depends on the size and complexity of the transaction. Preliminary Valuation If a restructuring is material, an analyst should conduct a preliminary valuation of the target to check if the management is using stakeholder resources optimally. Three valuation methods commonly used in this step are: comparable company analysis, comparable © IFT. All rights reserved 8 LM04 Corporate Restructuring 2025 Level II Notes transaction analysis, and premium paid analysis. Comparable Company Analysis The steps for the comparable company approach are: 1. Define a set of comparable firms. Include companies in similar industries that have similar size and capital structure. 2. Calculate various relative value measures based on the current market price of the comparable companies. For example, EV/EBITDA, P/S, P/E, P/CF, etc. 3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value. The comparable company analysis is often used to assess the value of targets in spin offs rather than acquisitions. This is because in acquisitions, acquirers pay a premium for control and the acquisition price typically exceeds the price estimated by this method. The advantages and disadvantages of the comparable company analysis method are: Advantages:  This method provides a reasonable approximation of the target company, since it is based on the assumption that similar assets have similar market values.  Most of the required data is readily available.  Estimates of value are derived directly from the market, unlike the DCF method which is based on many assumptions and estimates. Disadvantages:  In some cases, a comparable set of listed companies can be difficult to find or may not exist.  The method is sensitive to market mispricing. If comparable companies are overvalued, it will result in a target company value that is too high.  It provides an estimate of fair stock price, not the fair takeover price. A fair takeover premium must be estimated separately. Comparable Transaction Analysis The steps for the comparable transaction approach are: 1. Collect a sample of recent and relevant takeover transactions. 2. Calculate various relative measures like P/E, P/CF, P/B based on prices actually paid in the deals (not current market prices). 3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value. Unlike comparable company analysis, the valuation multiples in comparable transaction analysis include takeover premiums, because they reflect historical acquisitions. © IFT. All rights reserved 9 LM04 Corporate Restructuring 2025 Level II Notes Example (This is based on Example 8 from the curriculum.) An analyst is using the comparable transaction analysis method to estimate the fair value for a target company. He has assembled a sample containing companies involved in acquisitions within the same industry in which the target operates. These companies have all been acquired in the past two years. Details on the acquisition prices and relevant pricing variables are shown below. Valuation Variables 1 2 3 Acquisition share price ($) Earnings per share ($) 35.00 2.12 16.50 0.89 87.00 4.37 Cash flow per share ($) 3.06 1.98 7.95 Book value per share ($) Sales per share ($) 9.62 15.26 4.90 7.61 21.62 32.66 The next step in the process is to calculate the multiples at which each company was acquired: Ratio 1 2 3 Mean P/E 16.5 18.5 19.9 18.3 P/CF 11.4 8.3 10.9 10.2 P/BV 3.6 3.4 4.0 3.7 P/S 2.3 2.2 2.7 2.4 After reviewing the distribution of the various values around their respective means, the analyst is confident about using the mean value for each ratio because the range in values above and below the mean is reasonably small. Based on his experience, the analyst believes that cash flows are a particularly important predictor of value for companies in this particular industry. Therefore, instead of finding an equally weighted average, the analyst decides to apply more weight to the cash flow multiple. Target Target Comparable’s Mean Estimated Weight Weighted Company Company Valuation Multiple Takeover Estimates Valuation Multiples Paid Value Variables Earning per $2.62 P/E 18.3 $47.95 20% $9.59 share Cash flow per $4.33 P/CF 10.2 $44.17 40% $17.67 share Book value $12.65 P/BV 3.7 $46.81 20% $9.36 per share © IFT. All rights reserved 10 LM04 Corporate Restructuring Sales per $22.98 P/S share Weighted Average Estimate 2025 Level II Notes 2.4 $55.15 20% $11.03 $47.65 The advantages and disadvantages of the comparable transaction analysis method are: Advantages:  Estimates of value are derived directly from values recently established in the market unlike DCF method which is based on many assumptions and estimates.  There is no need to estimate a separate takeover premium. It is derived directly from the comparable transactions. Disadvantages:  Enough comparable transactions may not be available. If data from related industries is used, it may not be accurate for the specific industry under study.  Historical valuation multiples also reflect historical macroeconomic conditions, such as the business cycle, interest rates, tax rates etc. An adjustment may be required if the present macroeconomic conditions have changed.  If past transactions were mispriced, then the mispricings will be carried over. Premium Paid Analysis To estimate or judge a sale value or acquisition price for a listed issuer, an analyst could also calculate an estimated takeover premium. The takeover premium is the amount by which the takeover price for each share of stock must exceed the current stock price in order to entice shareholders to relinquish control of the company to an acquirer. This premium is usually expressed as a percentage of the stock price and is calculated as: PRM = (DP − SP) SP where: PRM = takeover premium (as a percentage of stock price) DP = deal price per share of the target company SP = stock price of the target company To calculate a relevant takeover premium, analysts compile a list of takeover premiums paid for companies similar to the target in the recent past. 4. Modeling and Valuation The next step of the evaluation process is creating pro forma financial statements that include the effect of the restructuring. The process for creating pro forma financial statements depends on the type of restructuring and situational specifics. For example, Exhibit 14 from the curriculum illustrates the process © IFT. All rights reserved 11 LM04 Corporate Restructuring 2025 Level II Notes for an acquisition. The steps in this process are: 1. The financials for the acquirer and target are combined. 2. The effect of financing the transaction—debt issuance, increased interest expense, share issuance, lower cash—is included. 3. The effect of synergies or the lack of synergies and incompatibilities in forecasted revenues and costs is projected. 4. The effect of any divestitures, either voluntarily or involuntarily as required by regulators as a condition of approving the acquisition, are incorporated. 5. Adjustments are made for recognition of goodwill and the increase in the book value of the target’s assets and liabilities to fair value. These steps can also be presented in terms of how they impact the lines on the pro forma income statement. This is shown in Exhibit 15 from the curriculum. Revenue Pro Forma Income Statement (Acquisition) Modeling 1. Combine acquirer and target revenues. 2. Add revenue synergies or subtract the cost of incompatible activities (dis-synergies). © IFT. All rights reserved 12 LM04 Corporate Restructuring 2025 Level II Notes Operating expenses 1. Combine acquirer and target operating expenses. 2. Subtract cost synergies or add the cost of incompatible activities (dis-synergies). Depreciation and amortization 1. Combine acquirer and target depreciation and amortization. 2. Add amortization of acquired intangible assets. Other expense or income 1. Combine acquirer and target other expense or income. Interest expense 1. Start with current acquirer interest expense. 2. Add increased interest from new debt issuance and revised interest rate. Income taxes 1. EBT-weighted average of tax rates of acquirer and target; estimate usually provided by issuer 1. Start with current acquirer shares outstanding 2. Add shares from any share issuance Shares outstanding Pro Forma Weighted Average Cost of Capital The pro forma financial statements contain most of the inputs needed for a DCF valuation model. Another key variable that is needed is the required rate of return to discount the estimated cash flows. This rate is typically estimated using the WACC approach. The WACC for an issuer is determined by the weights of different capital types and the constituent costs of capital. This is illustrated in Exhibit 16 from the curriculum. Analysts should note that a restructuring can change both the weights and the costs of each type of capital. While it is easy to estimate the change in weights, estimating the changes in the costs of debt and equity is challenging. The costs of capital are influenced by several factors both inside and outside the issuer, such as:  Profitability © IFT. All rights reserved 13 LM04 Corporate Restructuring     2025 Level II Notes Volatility Leverage Assets that can serve as collateral Prevailing interest rates Restructurings change the costs of capital by changing these factors. For example, an acquisition that increases leverage and decreases profitability will result in a higher cost of capital. Investment-grade issuers will structure restructuring transactions such that their investment-grade rating is maintained and their WACC is minimized. This is because, moving from an investment-grade to a speculative-grade credit rating can result in a several hundred basis point increase in WACC. Instructor’s Note: Sections 5, 6, and 7 present case studies of corporate restructurings based on real-world events. These case studies demonstrate how to apply the concepts covered in this reading. For a better understanding of these concepts, we recommend that you read these cases directly from the curriculum. © IFT. All rights reserved 14 LM04 Corporate Restructuring 2025 Level II Notes Summary LO: Explain types of corporate restructurings and issuers’ motivations for pursuing them. Corporate restructuring can be classified as one of nine types as shown in Exhibit 5 from the curriculum. Exhibit 3 from the curriculum lists the typical motivations for corporate structural change. Investment Actions Issuer-specific motivations Top-down drivers Divestment Actions • Realize synergies • Focus operations • Increase growth and business lines • Improve • Valuation capabilities or secure • Liquidity needs resources • Regulatory • Opportunity to requirements acquire an undervalued target • High security prices • Industry shocks Restructuring Actions • Improve returns on capital • Financial challenges, including bankruptcy and liquidation LO: Explain the initial evaluation of a corporate restructuring. The evaluation of corporate restructurings is composed of four phases as shown in Exhibit © IFT. All rights reserved 15 LM04 Corporate Restructuring 2025 Level II Notes 12 from the curriculum. LO: Demonstrate valuation methods for, and interpret valuations of, companies involved in corporate restructurings. Three valuation methods commonly used in preliminary valuation step are: comparable company analysis, comparable transaction analysis, and premium paid analysis. LO: Demonstrate how corporate restructurings affect an issuer’s EPS, net debt to EBITDA ratio, and weighted average cost of capital. In the modeling and valuation step an analyst creates pro-forma financial statements that include the effect of the restructuring. The process for creating pro forma financial statements depends on the type of restructuring and situational specifics. The WACC for an issuer is determined by the weights of different capital types and the constituent costs of capital. A restructuring can change both the weights and the costs of each type of capital. The costs of capital are influenced by several factors both inside and outside the issuer. Restructurings change the costs of capital by changing these factors. LO: Evaluate corporate investment actions, including equity investments, joint ventures, and acquisitions. Refer to the case studies in Section 5 of the curriculum. LO: Evaluate corporate divestment actions, including sales and spin offs. Refer to the case studies in Section 6 of the curriculum. LO: Evaluate cost and balance sheet restructurings. Refer to the case studies in Section 7 of the curriculum. © IFT. All rights reserved 16