Academic journal article Financial Management

The Choice of Going Public: Spin-Offs vs. Carve-Outs

Academic journal article Financial Management

The Choice of Going Public: Spin-Offs vs. Carve-Outs

Article excerpt

Considerable research has attempted to explain the motivations that underlie organizational changes, such as mergers and corporate asset divestitures, and to quantify the efficiency gains that result from those transactions. For example, Jensen (1993) argues that the merger and acquisition wave of the 1980s was a response to overcapacity and a lack of internal control mechanisms within organizations and resulted in more efficient organizations. Scholes and Wolfson (1992) demonstrate that transfers of assets from corporations into publicly traded partnerships were predictable, given changes in tax policy. Schipper and Smith (1983 and 1986) document positive market reactions to the announcements of both equity carve-outs and spin-offs of corporate as sets. This is consistent with the view that these transactions result in increased operating efficiencies.

The purpose of this paper is to explore the underlying motivations behind the corporate decision as to how to divest assets, either through a spin-off or an equity carve-out. Three questions are investigated:

* Do divesting firms differ in any systematic manner conditional on the divestiture method chosen?

* Are there differences in the type or quality of assets transferred that would explain that choice?

* Does the future performance of either the corporation or the divested assets indicate that either type of transaction leads to improved operating efficiencies?

There are three major differences between spin-off and carve-out divestitures. First, shares in a spin-off are distributed to existing shareholders; a carve-out establishes a new set of shareholders. Second, stocks issued through a carve-out generate positive cash flow to the firm; a spin-off does not have immediate cash flow consequences. Third, firms that divest through a carve-out incur significantly greater out-of-pocket expenses and are subject to more stringent disclosure requirements by the SEC. In our sample, for instance, we find that the direct costs (investment banking and exchange fees) associated with a typical carve-out are more than three times that of a spin-off. The greater scrutiny requires additional management time and entails auditing fees when the carve-out strategy is chosen. These differences lead us to suggest several possible reasons why a corporation may choose one method over the other.

One possibility is that asymmetric information between insiders (the parent company) and outsiders plays a crucial role in the decision as to how to create the new firm. If management believes that the divested assets are undervalued, then it is more likely to choose the spin-off route and leave the undervalued assets in the hands of current shareholders. Second, the choice may be influenced by the parent corporation's need for cash, either to finance growth opportunities, to distribute cash to shareholders, or to repay debt. In this case, the firm will prefer the carve-out route. The third possibility is that, because of the higher disclosure standards and the higher costs involved in a carve-out transaction, firms with low-quality assets or firms that are highly leveraged may not find the capital market accessible. Therefore, such firms will divest through a spin-off.

Since the first hypothesis relates management's beliefs about the divested assets' quality to the divestiture method, it is important to obtain a surrogate for those beliefs. A common way to deduce insiders' a priori beliefs about the future prospects of the newly formed subsidiary is to examine the extent to which they invest their own money in the new venture (e.g., Leland and Pyle, 1977). Inferring insiders' beliefs about the investment quality of the disposed assets through their holdings in the newly created firm is confounded, however, by tax and control considerations. The parent firm must retain a 50% (80%) ownership level in a corporate subsidiary if it wants to maintain control and include the firm in its consolidated financial statements (tax return). …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.