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Overview of the Existing Corporate Spin-off Literature

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The analysis of the American economic history shows us that the first major mergers and acquisitionstook place during the 1960’s. This merger wave was motivated by two main factors; first, the desire ofthe management teams to found corporate empires and to entrench themselves, the second reasonis the believe that diversification would maximize shareholder value (J. G. Matsusaka, 1993). Eventhough this model has proven to be successful in the past, it is now believed to be outdated in mosteconomies as it could be destroying value for shareholders. To counter the effect of this potential lossin shareholder value, some companies undergo a specific type of divestiture, a spin-off. A spin-offenables a company to divest a unit into a separated listed company. To have a better understandingof the different drivers leading to spin-offs, the following literature review will analyze the differentmotives provided by academics to describe why companies undergo these divestitures.

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Description of Corporate Spin-offs

A spin-off occurs when a firm distributes to its existing shareholders all the common stock it owns in acontrolled subsidiary, thereby creating a separate publicly traded company (Rosenfeld, 1984). Throughthese transactions, shareholders in the parent company receive an equivalent number of shares in thedivested unit to be compensated for the loss in equity of their pre-spin-off shares. These divisivetransactions both on the shareholder and the corporate level are particularly interesting events in theacademic world as it enables a comparison between the parent firm and the divested unit (in terms ofperformance metrics).

Motivations for Corporate Spin-offs

The main motivation for companies to undergo a spin-off is the belief that the separation of the twoentities will lead to a higher value for the shareholders than if they are merged. These expectationsare against the perfect capital markets theory under the Modigliani-Miller (1958) assumptions. In fact,such type of divestitures should have no influence on the business value. However, in practice, severalmotives explain why companies undergo spin-offs. The first explanation is the restructuring motive. Through spin-offs, companies can refocus on their core activities and by the same time get rid of theunderperforming units. The second motive that could be advanced is an increased financialtransparency. Through a reduction in complexity, companies can provide capital markets with betterand more transparent information. Finally, a last motive that could be advanced is the regulatorymotivations. In some cases, companies can reduce their tax obligations through spin-offs.

Value Creation Through Corporate Spin-offs

Impact of Spin-off Announcement on Stock Prices

A great paradox that can be observed in the financial sector is the increase in aggregate market valuethat can sometimes be observed both at the time of spin-offs and mergers announcement. Those twooperations that are opposite in terms of actions undertaken by the firms tend to have the same positivemarket reaction. When for a merger the positive market reaction can be explained by the potentialsynergies that could result from the operation, for the spin-offs it is not that obvious why theaggregated value of the separated entities should be superior to the combined entity. In an articledating back to 1983, Hite and Owers try to explain why this increased valuation should not make sense.

As described by the authors (Hite & Owers, 1983) through several observations, it should not bepossible that the post spin-off entities gain in aggregate value. A first point raised by the authors is thata spin-off brings additional costs. A lot of legal work needs to be done at the time of the transaction. Examples cited are the registration and distribution of new shares. Another cost that tends to beoverlooked is the loss of the economies of scale at the time the firms will need to raise capital fromthe external markets. With less collateral and diversification in the new entities, there are higher risksinvolved for the external investors. Finally, and it speaks for itself, in case there were any synergiesbetween the two entities, they will be lost once the spin-off will have taken place. Hite and Owers(1983) point out that spin-offs have serious effects on the existing contracts. The redeployment of theassets among the two separated entities is believed to seriously affect the existing contracts, and thisis even more true for the bondholders. They see the collaterals for their invested money beingseparated in new entities with no guarantee that the cash flows will be redistributed in the same way. In case the cash flows are not well distributed among the new entities, the bond price should logicallydrop making the bondholders lose wealth at the time of the announcement. At the other hand, in casethe cash flows are fairly distributed among the entities, the bond price should remain constant as thereshould not be any additional risk of bankruptcy for the firms.

The suggestions made by Hite and Owers (1983) to explain why a spin-off announcement should havea negative effect on the stock price around the announcement, have however been proven to bewrong. In fact, a lot of studies have been made over the years and they tend to find similarities in theirresults. In the following table are summarized the findings for the studies focusing on the spin-offs thathave taken place in the United States (the same market that will be studied in our analysis). All studiesare observing the Cumulative average Abnormal Return (CAR) for the stock around the spin-offannouncement. The different studies made over the past decades find relatively similar results around the spin-offannouncement. This is particularly interesting since their samples cover a period over more than fortyyears leading to the observation that there has in fact been a positive return on the wealth of theshareholders around the spin-off announcements.

Ex-post impact of spin-off on long-term performance of stocksIn addition to the short-term effect of spin-off announcements (computed with the CumulativeAbnormal Return methodology), previous researchers have also observed the long-term effect of aspin-off on the stock performance. The methodologies used in these studies are the buy-and-holdabnormal returns (BHAR) approach and the calendar-time portfolio regression (CTPR). The long-termreturns have not been studied as widely as the short term returns of spin-off announcements as it isnot that clear to which extend the spin-off is responsible for the stock performance after a certaintime. There is in fact a high chance that additional external factors affecting the company have a higherresponsibility than the spin-off to explain abnormal returns. Despite these uncertainties, Cusatis, Milesand Woolridge (1993) were the firsts to have provided the empirical evidence that investing in eitherthe post-spin-off parent company or the new spun off standalone entity on the long term providessuperior investment performance than the market. Since their findings in 1993, this strategy has oftenbeen described by the press as highly profitable. In fact, even some professional portfolio managershave started using it based on the evidence provided by the previously cited men.

But is it an absolutetruth? The research by Cusatis et al. (1993) focuses on the stock market return of the spun-off entity, the postspin-off parent company and the combination of both entities. Their analyses which is based on asample of spin-offs that occurred during the period 1965-1988 observes the stock returns for periodsup to three years after the spin-off. The three authors find significantly positive abnormal returns forboth entities in the post spin-off stage. One of the explanations provided for the abnormal returns isthe corporate restructuring activities that takes place during the post spin-off period. In fact, Cusatiset al. (1993) observe that takeover operations are much stronger for both the spin-offs and the postspun-off parents than for other firms that they had in their control group.

This observation makessense as firms that undergo spin-offs generally do so to allow both entities to refocus on their coreoperations, enabling them by the same occasion to improve their operating performance. Through thespin-off, the standalone entity becomes a pure player again and by focusing on a specific niche, itbecomes an interesting target for other firms wishing to grow through external growth operations. The authors thus believe that spin-offs create a lot of value for shareholders, mainly due to tworeasons: the operational improvement that often occurs in a post spin-off stage and the increasedtakeover activity due to the improved operational performance and the refocusing of the entities on aniche.

In 2001, McConnell, Ozbilgin and Wahal have analyzed the strategy developed by Cusatis et al. (1993)based on a different sample. They have looked at the stock returns of spun-off entities and post spinoffparent firms during the seven years following the spin-off announcement. The sample they haveused, and which has been selected using the exact same methodology used by Cusatis et al. wascollected for the period 1989 to 1995. Following the paper by Cusatis et al. this strategy should haveresulted in an excess return over the market, however McConnell et al. have slightly different results. McConnell et al. believe as stated in their article that the research by Cusatis et al. is filled withambiguities. Examples could be the failure to present an exact investment strategy, the methodologyused to measure excess returns and finally the significance threshold.

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