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Spin-offs widen investors’ choice by allowing them to invest in just one part of the business. More important, spin-offs can improve incentives for managers. Companies sometimes refer to divisions or lines of business as “poor fits.” By spinning these businesses off, management of the parent company can concentrate on its main activity.17 If the businesses are independent, it is easier to see the value and performance of each and reward managers accordingly. Managers can be given stock or stock options in the spun-off company. Also, spin-offs relieve investors of the worry that funds will be siphoned from one business to support unprofitable capital investments in another.
Announcement of a spin-off is generally greeted as good news by investors.18 Investors in U.S. companies seem to reward focus and penalize diversification. Consider the dissolution of John D. Rockefeller’s Standard Oil trust in 1911. The company he founded, Standard Oil of New Jersey, was split up into seven separate corporations. Within a year of the breakup, the combined value of the successor companies’ shares had more than doubled, increasing Rockefeller’s personal fortune to about $900 million (about $15 billion in 2002 dollars). Theodore
Roosevelt, who as president had led the trustbusters, ran again for president in 1912:19
“The price of stock has gone up over 100 percent, so that Mr. Rockefeller and his associates have actually seen their fortunes doubled,” he thundered during the campaign. “No wonder that Wall Street’s prayer now is: ‘Oh Merciful Providence, give us another dissolution.’ ”
Why is the value of the parts so often greater than the value of the whole? The best place to look for an answer to that question is in the financial architecture of conglomerates. But first, we take a brief look at carve-outs, asset sales, and privatizations.
Carve-outs
Carve-outs are similar to spin-offs, except that shares in the new company are not given to existing shareholders but are sold in a public offering. Recent carve-outs include Pharmacia’s sale of part of its Monsanto subsidiary, and Philip Morris’s sale of part of its Kraft Foods subsidiary. The latter sale raised $8.7 billion.
Most carve-outs leave the parent with majority control of the subsidiary, usually about 80 percent ownership.20 This may not reassure investors who worry about
17The other way of getting rid of “poor fits” is to sell them to another company. One study found that over 30 percent of assets acquired in a sample of hostile takeovers from 1984 to 1986 were subsequently sold. See S. Bhagat, A. Shleifer, and R. Vishny, “Hostile Takeovers in the 1980s: The Return to Corporate Specialization,” Brookings Papers on Economic Activity: Microeconomics (1990), pp. 1–12.
18Research on spin-offs includes K. Schipper and A. Smith, “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spin-offs,” Journal of Financial Economics 12 (December 1983), pp. 409–436; G. Hite and J. Owers, “Security Price Reactions around Corporate Spin-off Announcements,” Journal of Financial Economics 12 (December 1983), pp. 437–467; and J. Miles and J. Rosenfeld, “An Empirical Analysis of the Effects of Spin-off Announcements on Shareholder Wealth,” Journal of Finance 38 (December 1983), pp. 1597–1615. P. Cusatis, J. Miles, and J. R. Woolridge report improvements of operating performance in spun-off companies. See “Some New Evidence that Spin-offs Create Value,” Journal of Applied Corporate Finance 7 (Summer 1994), pp. 100–107.
19D. Yergin: The Prize, Simon & Schuster, New York, 1991, p. 113.
20The parent must retain an 80 percent interest to consolidate the subsidiary with the parent’s tax accounts. Otherwise the subsidiary is taxed as a freestanding corporation.
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lack of focus or a poor fit, but it does allow the parent to set managers’ compensation based on the performance of the subsidiary’s stock price.
Some companies carve out a minority interest in a subsidiary and later sell or spin off the remaining shares. For example, Sara Lee, the food company, carved out a 19.5 percent stake in the luxury leather goods retailer Coach in 2000. The
remaining 80.5 percent of the Coach shares were sold to Sara Lee stockholders in 2001.21
Perhaps the most enthusiastic carver-outer of the 1980s and 1990s was Thermo Electron, with operations in healthcare, power generation equipment, instrumentation, environmental monitoring and cleanup, and various other areas. At yearend 1997, it had seven publicly traded subsidiaries, which in turn had carved out 15 further public companies. The 15 were grandchildren of the ultimate parent, Thermo Electron.22
Some companies have distributed tracking stock tied to the performance of particular divisions. This does not require a spin-off or carve-out, only the creation of a new class of common stock. For example, in 1997 Georgia Pacific distributed a special class of shares tied to the performance of its Timber Group. The company noted that having two classes of shares “provides the opportunity to structure incentives for employees of each Group that are tied directly to the share price performance of that Group.”23
Asset Sales
The simplest way to divest an asset is to sell it. Asset sale refers to the acquisition of part of one firm by another. The record asset sale is Comcast’s acquisition of AT&T Broadband, AT&T’s cable television division, for $42 billion in 2001.
We have mentioned the sale of AT&T’s credit card division to Citibank. Asset sales are common in the credit card business. The largest credit card issuers, including Citibank, MBNA, and First USA, grew during the 1980s and 1990s by acquiring the credit card operations of hundreds of smaller banks.
Asset sales are also common in manufacturing. Maksimovic and Phillips examined a sample of about 50,000 U.S. manufacturing plants each year from 1974 to 1992. About 35,000 plants in the sample changed hands during that period. About one-half of the ownership changes were the result of mergers or acquisitions of entire firms. The other half of the ownership changes came about by asset sales, that is, sale of part or all of a division. On average, about 4 percent of the plants in the sample changed hands each year, about 2 percent by merger or acquisition, and about 2 percent by asset sales.24
21Sara Lee stockholders were allowed to exchange Sara Lee shares for Coach shares. The terms of the exchange gave Sara Lee’s stockholders the opportunity to get Coach shares at a discount, so all of the Coach shares were issued in short order.
22In 1998 Thermo Electron announced a plan to consolidate several of its children and grandchildren in order to move to a less complicated structure. In 2001, it began to spin off some of its peripheral operations as separate companies.
23Georgia Pacific Corporation, Proxy Statement and Prospectus, November 11, 1997, p. 35. The Timber Group was sold to Plum Creek Timber Company in 2001. Timber Group tracking stock was exchanged for Plum Creek shares.
24V. Maksimovic and G. Phillips, “The Market for Corporate Assets: Who Engages in Mergers and Asset Sales and Are There Efficiency Gains?” Journal of Finance 56 (December 2001), Table I, p. 2030.
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Announcements of asset sales are good news for investors in the selling firm, and productivity of the assets sold increases, on average, after the sale.25 It appears that asset sales transfer business units to the companies that can manage them most effectively.
Privatization
A privatization is a sale of a government-owned company to private investors. For example, the government of Germany originally owned Volkswagen but sold it in 1961. Britain sold British Telecom in 1984. The United States sold Conrail in 1987.
Most privatizations are more like carve-outs than spin-offs, because shares are sold for cash, not distributed to the ultimate “shareholders,” that is, to the people of the selling country. But several former Communist countries, including Russia, Poland, and the Czech Republic, privatized by means of vouchers distributed to citizens. The vouchers could be used to bid for shares in newly privatized companies. Thus the companies were not sold for cash, but for vouchers.26
Privatizations raised enormous sums for selling governments. France raised $17.6 billion in two share issues for France Telecom in 1997 and 1998. Japan raised over $80 billion in the privatization of NTT (Nippon Telephone and Telegraph) in 1987 and 1988. Privatizations have also been common in airlines (e.g., Japan Airlines and Air New Zealand) and banking (e.g., the French bank Paribas).
The motives for privatization seem to boil down to the following three points:
1.Increased efficiency. Through privatization, the enterprise is exposed to the discipline of competition and insulated from political influence on investment and operating decisions. Managers and employees can be given stronger incentives to cut costs and add economic value.
2.Share ownership. Privatizations encourage share ownership. Many privatizations give special terms or allotments to employees or small investors.
3.Revenue for the government. Last but not least!
There were fears that privatizations would lead to massive layoffs and unemployment, but that does not appear to be the case. While it is true that privatized companies operate more efficiently and thus reduce employment, they also grow faster as privatized companies, which increases employment. In many cases the net effect on employment is positive.
On other dimensions, the impact of privatization is almost always positive. A review of research on privatization concludes that privatized firms “almost always become more efficient, more profitable, . . . financially healthier and increase their capital investment spending.”27 It seems clear that changing from state to private ownership is in general a valuable change in financial architecture.
25See Maksimovic and Phillips, op. cit.
26There is extensive research on voucher privatizations. See, for example, M. Boyco, A. Shleifer, and R. Vishny, “Voucher Privatizations,” Journal of Financial Economics 35 (April 1994), pp. 249–266; and R. Aggarwal and J. T. Harper, “Equity Valuation in the Czech Voucher Privatization Auctions,” Financial Management 29 (Winter 2000), pp. 77–100.
27W. L. Megginson and J. M. Netter, “From State to Market: A Survey of Empirical Studies on Privatization,” Journal of Economic Literature 39 (June 2001), p. 381.
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inefficient control of old-fashioned managers and place them under men schooled in the new management science.”30
There was some truth in this. The most successful early conglomerates did force dramatic improvements in some mature and slackly managed businesses. The problem is, of course, that a company doesn’t need to be diversified to take over and improve a lagging business.
Third, conglomerates’ wide diversification meant that their top managements could operate an internal capital market. Free cash flow generated by divisions in mature industries could be funneled within the company to other divisions with profitable growth opportunities. There was no need for fast-growing divisions to raise financing from outside investors.
There are some good arguments for internal capital markets. The company’s own managers probably know more about its investment opportunities than do outside investors, and transaction costs of issuing securities are avoided. Nevertheless, it appears that attempts by conglomerates to allocate capital investment across many unrelated industries are more likely to subtract value than add it. Trouble is, internal capital markets are not really markets but combinations of central planning (by the conglomerates’ top management and financial staff) and intracompany bargaining. Divisional capital budgets depend on politics as well as pure economics. Large, profitable divisions with plenty of free cash flow may have more bargaining power than growth opportunities; they may get generous capital budgets while smaller divisions with good prospects but less bargaining power are reined in.
Berger and Ofek estimate the average conglomerate discount at 12 to 15 percent.31 Conglomerate discount means that the market value of the whole conglomerate is less than the sum of the values of its parts. The chief cause of this discount, at least in Berger and Ofek’s sample, seemed to be overinvestment and misallocation of investment. In other words, investors were marking down the value of the conglomerates’ shares from worry that their managements would make negativeNPV investments in mature divisions and forego positive-NPV opportunities elsewhere.
Conglomerates face further problems. Their divisions’ market values can’t be observed independently, and it is difficult to set incentives for division managers. This is particularly serious when managers are asked to commit to risky ventures. For example, how would a biotech startup fare as a division of a traditional conglomerate? Would the conglomerate be as patient and risk-tolerant as investors in the stock market? How are the scientists and clinicians doing the biotech R&D rewarded if they succeed? We don’t mean to say that high-tech innovation and risktaking is impossible in public conglomerates, but the difficulties are evident.
Internal Capital Markets in the Oil Business Misallocations in internal capital markets are not restricted to pure conglomerates. For example, Lamont found that, when oil prices fell by half in 1986, diversified oil companies cut back capital investment in their non-oil divisions.32 The non-oil divisions were forced to “share
30Quoted in A. Chandler and R. S. Tetlow, eds., The Coming of Managerial Capitalism, Richard D. Irwin, Inc., Homewood, IL: 1985, p. 746.
31P. Berger and E. Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37 (January 1995), pp. 39–65.
32O. Lamont, “Cash Flow and Investment: Evidence from Internal Capital Markets,” Journal of Finance 52 (March 1997), pp. 83–109.
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Managers’ compensation wouldn’t depend on divisions’ market values because no shares in the divisions would be traded and plans for sale or spin-off would not be part of the conglomerate’s financial architecture.
The advantages of LBO partnerships are obvious: strong incentives to managers, concentrated ownership (no separation of ownership and control), and limited life, which reassures limited partners that cash flow will not be reinvested wastefully.
These advantages carry over to other types of private equity partnerships, including venture capital funds. We do not say that this financial structure is appropriate for most businesses. It is designed for change, not for the long run. But traditional conglomerates don’t seem to work well for the long run, either.
Conglomerates around the World
Nevertheless, conglomerates are common outside the United States. In some emerging economies, they are the dominant financial structure. In Korea, for example, the 10 largest conglomerates control roughly two-thirds of the corporate economy. These chaebols are also strong exporters so that names like Samsung and Hyundai are recognized worldwide.
Conglomerates are common in Latin America. One of the more successful, the holding company36 Quinenco, is in a dizzying variety of businesses, including hotels and brewing in Chile, pasta making in Peru, and the manufacture of copper and fiber optic cable in Brazil.
Why are conglomerates so common in such countries? There are several possible reasons.
Size You can’t be big and focused in a small, closed economy: The scale of oneindustry companies is limited by the local market. Scale may require diversification. There are various reasons why size can be an advantage. For example, larger companies have easier access to international financial markets. This is important if local financial markets are inefficient.
Size means political power; this is especially important in managed economies or in countries where the government economic policy is unpredictable. In Korea, for example, the government has controlled access to bank loans. Bank lending has been directed to government-approved uses. The Korean conglomerate chaebols have usually been first in line.
Undeveloped Financial Markets If a country’s financial markets are substandard, an internal capital market may not be so bad after all.
“Substandard” does not just mean lack of scale or trading activity. It may mean government regulations limiting access to bank financing or requiring government approval before bonds or shares are issued.37 It may mean information inefficiency: If accounting standards are loose and companies are secretive, monitoring by outside investors becomes especially costly and difficult, and agency costs proliferate.
36A holding company owns controlling blocks of shares in two or more subsidiary companies. The holding company and its subsidiaries operate as a group under common top management.
37In the United States, the SEC does not have the power to deny share issues. Its mandate is only to assure that investors are given adequate information.