Topic 9: Do spin offs create value for shareholders?

Spin off refers to the act of separating a unit of a larger organization and establishing it as a separate business. Just like mergers and acquisitions are carried out under the belief that the combination of two entities may generate a new entity whose value is greater than the sum of the parts, at the opposite end of the spectrum, spin offs are carried out when a firm believes that its overall value would increase if one of its components were separated and established as an individual entity. When a spin off is carried out, shareholders of the parent company are typically compensated for the decrease in value of their holdings after the spin off with a quantity of shares of the new entity proportional to their holding of shares of the parent company. From an investor’s point of view, the advantage brought about by a spin off is the ability to manage separately the exposure to different businesses: for instance, investors would have benefited from the proposed spin off of the personal computer division of HP in the sense that this would have enabled them to make distinct decisions about their exposure to the enterprise software business of the parent company and to the hardware business of the spun off unit (Menn and Palmer, 2011). In addition to this, shareholders may benefit from the fact that while the assets of the unit are transferred entirely to the new entity, the parent company remains liable for the debt of the old entity.

But is there empirical evidence on the benefits of spin offs? A broad range of empirical studies demonstrate that both the mother company and the spun off unit on average increase in value after being separated; while such research has traditionally focused on developed markets (Veld and Veld-Merkoulova, 2004), research has recently found similar results in developing markets. Md Hamid (2010), for instance, has analyzed 25 corporate spin-offs in Singapore and has quantified the overall benefit as an increase in the value of the parent company by 15.73 percent. This is made up of a 6.62 percent increase, which accrues to the spun off unit, and a 9.11 percent increase that accrues to the original firm.

Having established the existence of benefits for both parties, how do spin offs exactly create value for shareholders? Berger and Ofek (1995) have found extensive evidence of the existence of a discount in the stock price of the conglomerate, compared to individual units; a spin off thus appears as a straightforward method to redeem the value embedded in the organization. In this context, it is suggested that the increase in value in the spun off unit is brought about by the increase in business focus of the single firm.

Schipper and Smith (1983) suggest that efficiency tends to improve in the spun off unit because shareholders can supervise more closely senior management than they could do in a conglomerate context; in this sense, they find that asymmetric information exists between the managerial team of a conglomerate and the market. In this sense, spin off may be a good solution to manage agency issues within an organization.

Siddiqi and Warganegara (2003) find that spin offs are a good solution to ensure efficient capital allocation: within a multi-divisional firms, a unit with high growth opportunities may be unable to obtain the capital it requires due to the existence of political behavior and asymmetrical information. The likelihood of a spin off increases with the growth differential between the unit itself, and the rest of the organization. As this grows, the opportunity cost of capital misallocation increases and will eventually offset the efficiencies brought about by the lower borrowing rate on offer to the conglomerate.

Further research from Pyo (2007) indicates that changes in executive compensation have an important role in creating value in a spin off unit, particularly where management is replaced during the spin off process. He finds evidence that pay-performance sensitivity increases in spun off units and that spin offs are used as opportunities to establish new systems of managerial compensation.

In addition to this, spin offs may increase the value of a unit by changing the way in which it accesses the market. For instance, AMR Corporation, parent company of American Airlines, is currently planning the spin off of its loss making regional franchise American Eagle (Lemer, 2011). The most important consequence for American Eagle in its spin off from AMR would be its ability to operate as an independent airline with an independent value proposition in the market. Currently, a large quantity of customers may be avoiding American Eagle due to its alignment with American Airlines; in a competing environment like the American one, dominated by alliance networks, a regional airline with poor economics like American Eagle may struggle to attract customers due to the alliance that it belongs in. Once it will be spun off, American Eagle will be able to provide regional connections to a number of network carriers, thus exploiting synergies. A good example of this is Alaska Airlines, that has maintained its independent status to avoid being restricted by the partnership with a carrier.

So why do conglomerates still exist? Conglomerates create value by exploiting synergies between the units they are made up of, often bringing together very different types of expertise. Talking about Siemens, for instance, the Economist (2010) notes:

“It [Siemens] can, for example, audit a company’s energy use and suggest improvements that will then pay for themselves out of savings. Many rivals already do this. But few offer to finance the capital spending and guarantee the energy savings, as Siemens does.”

However, the competitive landscape changes quickly and companies need to maintain a flexible approach to their portfolio of activities. In this sense, just like mergers and acquisitions allow companies to respond to changes in competitive landscapes by adding to their portfolio, spin offs allow them to release competences that have become redundant within the strategic jigsaw.

 

References:

  • Berger, P.G. and Ofek, E. (1995). Diversification’s effect on firm value. Journal of Financial Economics, 37, p.39–65;
  • Economist (2010). Siemens: A giant awakens, The Economist, 9th September.
  • Hollowell, B. (2009). The long-term performance of parent firms and their spin-offs. The International Journal of Business and Finance Research, Vol.3(1), p.119-129;
  • Lemer, J. (2011). American Eagle closer to spin off from AMR. Financial Times, available online at http://www.ft.com/intl/cms/s/0/7b0b3058-c459-11e0-ad9a-00144feabdc0.html#axzz1gLaPAnFT ;
  • Md Hamid, U. (2010). Corporate spin-offs and shareholders’ value: evidence from Singapore. The International Journal of Business and Finance Research, Vol.4(4), p.43-58;
  • Menn, J. and Palmer, M. (2011). HP chief hails PC unit despite spin-off plans, Financial Times, available online at http://www.ft.com/intl/cms/s/2/da0853fc-ce44-11e0-99ec-00144feabdc0.html#axzz1gLaPAnFT ;
  • Pyo, U. (2007). Enhancing Managerial Incentives and Value Creation: Evidence from Corporate Spinoffs. Journal of Economics & Finance, Vol.31(3), p.341-358;
  • Schipper, K. and A. Smith, (1983). Effects of Recontracting on Shareholder Wealth: The case of voluntary spin-offs. Journal of Financial Economics, Vol.12(3), pp. 437-467;
  • Siddiqi, M. and Warganegara, D. (2003). Using Spinoffs to Reduce Capital Misallocations. Review of Quantitative Finance and Accounting, Vol.20(1), p.35-47;
  • Veld, C. and Veld-Merkoulova, Y. (2009). Value Creation Through Spin-offs: A Review of the Empirical Evidence. International Journal of Management Reviews, Vol.11(4), p.407-420.

 

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