Merger proxies are quite revealing. I have closely read the merger proxy in which ABC Radio Business is to be spun off from Disney (NYSE:DIS) to Disney shareholders and then merged into Citadel Broadcasting (CDL). This deal was structured as a reverse Morris trust which enabled both the shareholders of Disney and Disney to escape any taxation.
But to structure a reverse Morris Trust, it is necessary that a larger entity be merged into a smaller entity. Pre-merger Citadel's equity was valued more highly than ABC radio stations. So, how did the companies manage to structure this deal as tax free? A special dividend will be paid to only Citadel shareholders prior to the merger with the ABC Radio Business, thus increasing debt and shrinking Citadel's equity and enabling Disney to have a greater than 50% equity interest in the merged Citadel-ABC entity.
Earlier this week I did some work on the $325 million investment of a private equity firm into Palm (PALM) in return for a 25% interest in Palm. Here also a special dividend was paid out to Palm shareholders, at the same time that their equity interest was reduced to 75%. This special dividend was promoted as being very shareholder friendly by both providing shareholders with a cash payout while allowing them to retain an interest in the new entity's equity.
In reality, though, the special dividend functioned to shrink shareholder equity of Palm so that the private equity firm would have to pay less than it would have otherwise for a comparable percentage stake in the entity. Had the special dividend not been instituted, in order to gain a 25% stake in Palm, the private equity firm would have had to pony up some $550 mn, as opposed to the $325 mn it did pay.
So in both these cases the aim was to shrink existing shareholder equity: In the first case so that the parent spinning off a subsidiary would avoid tax, and in the second case so as to make it cheaper for a PE firm to gain a large voting interest in a public company. In both cases the special dividends were promoted as being shareholder friendly. In both cases, I believe the special dividends were structured so as to enable transactions to proceed. After all, shareholders could simply have sold their shares to raise cash had they so desired.
Since the special dividends served to foist increased debt on both companies, other than in providing the discipline that all debt forces on managers, I can see no particular benefit to the shareholders involved other the lesser tax owed on dividends than capital gains. Still, I think these tax benefits to shareholders were not the primary motivation: Getting the deals done was the primary motivation. A company choosing an innovative deal structure in order to get a deal done does not in of itself make that company a long or a short. At Insight, we believe though that understanding the structure of deals is important to understanding valuation which is key for investment decisions.