Academic journal article Financial Management

Value Creation from Equity Carve-Outs

Academic journal article Financial Management

Value Creation from Equity Carve-Outs

Article excerpt

J. Randall Woolridge (*)

Using a large sample of equity carve-out events during the 1980s and 1990s, we find that rivals of carve-out parent firms display negative announcement-period returns. This finding distinguishes the divestiture gains hypothesis from the asymmetric information hypothesis. Additional tests provide further support for the divestiture gains hypothesis. Operating performance improvements for both parents and their carved-out subsidiaries are evident.

Announcements of equity carve-outs produce positive stock returns for parent firms (see, e.g., Schipper and Smith, 1986; Klein, Rosenfeld, and Beranek, 1991; and Mulherin and Boone, 2000). Two general explanations are suggested for these parent firm gains.

Schipper and Smith (1986) conjecture that equity carve-outs result in divestiture gains due to separate financing for the subsidiary's investment projects, a more efficient set of contracts between shareholders and managers, and the creation of pure-play stocks. The authors provide no evidence concerning this divestiture gains explanation beyond the observed announcement returns.

Nanda (1991), in an extension of Myers and Majluf (1984), develops a signaling model in which firms raise capital through equity carve-outs when parent firm shares are relatively undervalued and subsidiary shares are relatively overvalued. The good news for parent investors is that the parent shares are not overvalued, at least when compared to subsidiary valuation. Since the parent is typically several times larger than the subsidiary, this leads to an increase in parent share price.

Empirical tests of the divestiture gains hypothesis and the asymmetric information hypothesis provide some support for both hypotheses. Allen and McConnell (1998) examine the use of the carve-out stock offering proceeds for a sample of 188 equity carve-outs over 1978-1993 and find that announcement-period gains for parents are higher if the proceeds are paid out than if they are retained. These results provide some support for the divestiture gains hypothesis. Vijh (1999), using a sample of 336 equity carve-outs over the 1980 to 1997 time period, evaluates three-year returns of parent and subsidiary stocks after issue; some evidence is found that the long-term returns are related to the number of business segments before carve-out, which is used as a proxy for divestiture gains arising from the refocusing of parent and subsidiary operations. Mulherin and Boone (2000) and Allen (1998) also find divestiture gains in equity carve-outs. Mulherin and Boone (2000) study a sample of 125 equity carve-outs over 1990-1 999 and conclude that the positive wealth effects associated with equity carve-out announcements are due to synergistic gains. Allen's (1998) examination of the long-run stock performance, operating performance, and incentive-based compensation of Thermo Electron and its 11 equity carve-outs reveals improvements in all areas.

In contrast to the above studies, Slovin, Sushka, and Ferraro (1995), using a sample of 36 equity carve-outs over 1980-1991, find that share prices of equity carve-out rival firms react negatively to carve-out announcements. They interpret this finding as support for the Nanda (1991) model. The carve-out announcement signals to investors that managers believe the carve-out (and, by extension, the entire industry) is overvalued.

While all this research offers some understanding of parent announcement-period gains, no one attempts to determine whether the gains reflect divestiture gains alone, asymmetric information alone, or a combination of the two. Vijh (2002) provides the first contribution toward this end, with joint but separate tests. He asserts that divestiture gains should increase with increasing size of the subsidiary assets relative to the combined assets. Nanda's (1991) model suggests the opposite.

Vijh (2002) finds a direct relation between announcement-period returns and the ratio of subsidiary assets to non-subsidiary assets, thus lending support to the divestiture gains hypothesis. …

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