R ecent years have witnessed a large number of spin-offs, for example Sears and ITT in the US and Hanson in the UK. The announcement of these and other spin-offs has generally been accompanied by an increase in the value of the original business. In a spin-off one or more divisions of a quoted company have been detached from the original parent to become independent entities that are separately quoted on the stock market, yet remain owned, at least initially, by the shareholders of the original business.
Since a spin-off represents the division of a whole into parts, the increase in value that generally accompanies the announcement of a spin-off suggests that investors view the parts as being worth more separately than as part of the whole. Why this should be so is of particular interest at a time when many companies are busy restructuring, selling assets or divisions, buying others, merging with, acquiring, or being acquired by other organizations.
A number of explanations have been suggested for spin-offs. Many of these are reflected in comments made after the announcement of the split-up of Hanson. It was
then said that "head office was finding it increasingly difficult to assess the underlying performance of electricity and chemical companies in the group, making it harder to set them tough but realistic financial targets’. In addition ‘people like the chairman of Quantum and SCM, two divisions that were spun off, would be much more motivated, with their personal wealth linked directly to the performance of their businesses through share options’ and that ‘separately listed, the chemical offshoot will be an inviting target for a big European or American chemical group’. The first comment illustrates the view that spin-offs serve to remedy the loss of focus inherent in large, diversified groups; the second that they make possible the provision of better incentives to managers; and the third that spin-offs facilitate the transfer of assets to those who value them most.
The preceding explanations are examined in part in the accompanying article by Katherine Schipper and Linda Vincent (see page 85). This article looks in detail at a further explanation which centers on the role of spin-offs in improving the information available to investors and managers.
This is suggested by comments that appear to imply that companies comprising various divisions operating in different businesses with differing prospects are undervalued for informational reasons, and that spin-offs serve to remedy this undervaluation. For example, TTT’s fast-growing leisure business’ was said to be ‘submerged by the more staid manufacturing and insurance businesses’ before the group’s decision to split itself into three parts. Similar remarks were directed at Chase Manhattan, the US bank, whose estimated break-up value, ranging from $55—$75 per share, was in sharp contrast to its market value of $35 per share before its merger with Chemical Bank. It was said that ‘the trouble for Chase is that the virtues of its best businesses ... have been shrouded in the lackluster performance of the group. As a result, the value of the whole has failed to keep pace with the sum of the parts’. In contrast, Sears Roebuck’s spin-off of Dean Witter has been described as ‘creating pieces that people will be able to understand so that the stock can fetch a fairer value’.
That investors appear to undervalue most diversified businesses is a well-known phenomenon, referred to as the ‘conglomerate discount’. A reason often advanced for this is the ‘opaqueness’ of conglomerates, a term that is strongly suggestive of informational considerations. This article examines two ways in which informational considerations may lead to a conglomerate discount and thereby explain why spin-offs, which serve to transform the conglomerate’s divisions into independent businesses, should lead to increases in value. Both are related to the role of share prices in transmitting information about a company’s prospects or a division, or the value of their assets to investors and managers.
Consider the transmission of information to managers. Evidence of such communication is suggested by the near constant attention paid by managers to their company’s share price, which reflects investors’ views of the business, its strategy and its management. These are, eventually if not immediately, taken note of by the company’s management or the board or by raiders who may attempt to acquire it. Thus, the poor share-price performance of those oil companies that maintained extensive exploration programs in the second part of the 1980s following the near collapse of the price of oil in 1986 eventually led their managers to reduce exploration programs and increase their reserves by buying other oil businesses rather than
through exploration. These examples indicate that information transmitted by share prices is used by managers. This is true of both multiple-business conglomerates and single-business companies.
The share price of the former does, however, communicate information about the combined prospects of a multiplicity of generally unrelated businesses, whereas that of the latter provides information about the prospects of a single business. Managers of conglomerates therefore face the difficult task of inferring investors’ views of the prospects of each of their multiple businesses from a single share price. They do so only very imperfectly.
The quality of their decisions is thus reduced by the imperfect information available to them. This lowers the value of conglomerates and results in the conglomerate discount. A spin-off of a division, or a complete split-up of a conglomerate, in which a single price pertaining to a multiplicity of businesses is replaced by multiple prices relating to single and separate businesses, creates value by making better decisions possible. But share prices also communicate information to investors. Indeed, their role in communicating information to investors may well be more important than in communicating data to managers. That is because the direct communication of information to managers is feasible but clearly impossible to literally millions of existing and potential investors.
As noted by Sanford Grossman in 1976, when each investor has only imperfect information about a company’s prospects and the value of its assets, its share price will aggregate the information of all investors and communicate information of higher quality than initially possessed by each single investor. The higher quality information provided through the share price diminishes all investors’ uncertainty about the company’s prospects and the value of its assets and increases the price they are willing to pay for its shares.
Although the quality of the information every investor has is improved by trading in shares, it nonetheless remains lower in the case of multiple-business conglomerates than in that of single-business companies. Investors, as are managers, are confronted with the task of inferring the prospects of multiple businesses from a single share price. The lower quality of their information decreases the price they are willing to pay for the conglomerate’s shares, again leading to the conglomerate discount. That a spinoff is viewed as serving to remedy the resulting undervaluation was true, for example, of New World Development, the Hong Kong conglomerate, which announced the spinoff of its hotel management and infrastructure divisions in summer of 1995. The Financial Times reported that ‘New World believes the restructuring ... will make the group easier for investors to understand and release value in operations that has hitherto been masked by a complex and opaque corporate structure’.
Note this could refer to information communicated by accounting numbers and cash flows as well as by prices, to the extent that accounting figures and cash flows are aggregated at corporate rather than divisional level. But any undervaluation resulting from the possibly excessive aggregation of accounting numbers or cash flows can be remedied simply by reporting the relevant information at the divisional level and need not involve a spin-off. A spin-off is, by contrast, essential to achieving an increase in the quality of the information communicated through prices.
The above informational considerations suggest the conglomerate discount should
2 • Corporate finance
be largest for those that are the most diversified. The difficulty of inferring the prospects of each of the multiple businesses of a conglomerate from the single share price is greatest when the conglomerate’s businesses are least related. The value created by demergers and spin-offs should therefore be greatest for those spun-off divisions that most differ from the parent. Daley and others find this to be the case. Indeed, they find that same-industry spin-offs, in which both the spun-off division and the parent belong to the same industry, create no value, and that only cross-industry spin-offs do so.
Interestingly, Slovin and others find that the value of the competitors to a division of a group increases following the announcement of the division’s spin-off, suggesting that the information released by a spin-off is of value not only to the company or the division involved but also to its competitors.
But spin-offs have costs as well as benefits, most clearly where there are significant synergies between a conglomerate’s divisions. Such synergies would be foregone in a spin-off. Significant synergies appear to exist in the case of General Electric of the US, for example, which is essentially a highly profitable conglomerate with a large number of businesses, ranging from aero-engines to financial services.
More importantly, spin-offs should not be viewed as panaceas. This is most clearly illustrated by the case of Hanson. Since most organizations have adopted strict financial controls after the takeover wave of the 1980s, the scope for value creation through take-overs and imposing such controls has dramatically decreased, in turn decreasing the growth prospects of acquisitive conglomerates such as Hanson.
An unmistakable signal of the decreased growth prospects was Hanson’s announcement, concurrently with the disclosure of the demerger, that the demerged businesses would adopt dividend policies in line with those of their industries. This new policy implied a drastic cut in dividend, unmistakably a negative signal. Hanson’s share price fell as a result, in spite of the spin-off.
To conclude, spin-offs are at least partly motivated by informational considerations related to the role of share prices in communicating information to investors and managers. They are most desirable when the divisions of a conglomerate are least related, because the improvement in the quality of the information communicated by prices is greatest in such cases. They are not, however, a cure-all, and certainly cannot offset the poor prospects of a division or a company.
Quotations are from the Financial Times and The Economist.
‘Spin-offs: tax comparison with an asset sale’ dwelt primarily on the tax implications of a spin-off. But what are the other advantages of this form of corporate restructuring? Michel Habib says that better focus and better management incentives are among the widely discussed benefits, but on this page he concentrates on the way spin-offs improve the information available to investors and managers. He argues that they are most desirable when the divisions of a conglomerate are least related, because the improvement in quality of the information communicated by prices is greatest in such cases.
Spin-offs: why information flows better
Suggested further reading
Daley, I., Mehrotra, V. and Sivakumar, R., (1995), ‘Corporate spin-offs: Trash or treasure’ working paper 5-95, University of Alberta.
Grossman, S.J. ‘On the efficiency of competitive stock markets where traders have diverse information’ Journal of Finance 31, 573-585.
Habib, M.A., Johnsen, D.B. and Naik, N.Y., ‘Spin-offs and Information’ working paper, London Business School.
Nanda, V. and Narayanan, M.P. ‘Dissentangling value: Misvaluation and the scope of the firm’ working paper, University of Michigan.
Schipper, K. and Smith, A., (1983), ‘Effects of recontracting on shareholder wealth: the case of voluntary spin-offs’, Journal of Financial Economics 12, 437-487.
Slovin, M., Sushka, M. and Ferraro S., (1995), ‘A comparison of the information conveyed by equity carve-outs, spin-offs, and asset sell-offs’, Journal of Financial Economics 37, 89-104.
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Richard Leftwich is Fuji Bank and Hellor Professor of Accounting and Finance at the University of Chicago Graduate School of Business. His research interests include audit qualifications, bond ratings, corporate charter changes and block trades.
Alvin Carley is Practice Professor of Accounting at the Wharton School of the University of Pennsylvania.
3 ■ Accounting