Bottom Line: When firms want to shed a subsidiary, they must decide whether to spin off or sell the business. New research shows that selling, rather than spinning, may be the more profitable option.
To spin off or to sell off, that is the question. In the life of most large firms, there comes a time when managers face the dilemma of how to divest subsidiary businesses that are either underperforming or outgrowing the resources of their parent company. Should managers spin off these divisions and create a new publicly traded firm, distributing the resulting stock to shareholders? Or should they sell these businesses to another company for cash or stock, and divvy out the taxable proceeds?
Researchers have proposed several factors that may induce a firm to choose either a spin-off or a sell-off strategy, including their level of operating risk, tax structure, board size, cash flow, and degree of diversification. But a new study from researchers at Suffolk University examines not only the factors that induce a firm to choose one strategy over another, but also how they fare following their corporate restructuring.
The authors studied more than 4,500 sell-offs and spin-offs undertaken by large U.S. firms from 1980 through 2011, excluding liquidations, joint ventures, and partial sales. Combining several databases, they tracked the companies’ stock returns and financial data before and after their divestitures. They also applied a widely used index that tracks investors’ optimism or pessimism about firms’ economic prospects and the stock market in general.
Firms’ divestiture decisions are driven by a complex combination of factors, the authors found, such as their valuation in the eyes of investors, the mood of the stock market, and the performance of the subsidiary business units set to be separated from the parent company. And these trends hold firm even after considering more specific information about individual firms, such as their financial constraints, their size, and the level of knowledge insiders and outsiders possess about the divested business.
All else being equal, firms make out much better financially when they cut ties with a subsidiary business than when they set it up as its own external entity, the analysis showed; additionally, outside observers tend to significantly undervalue firms that spin off their assets, compared with those that sell off subsidiary businesses. Investors judged the pre-divestiture worth of the spinning firms to be much lower than the intrinsic value calculated by company insiders — managers at these firms seemed to think that their spun-off business units had some kind of potential value that exceeded what the market believed that value was.
Outside observers tend to significantly undervalue firms that spin off their assets.
In this sense, spin-offs bear great resemblance to initial public offerings (IPOs), the authors posit, because they create a new firm that can be traded on the stock market. And as with IPOs, investor sentiment — whether the market is hot or cold on the new company — plays a large role in determining the fate of emerging businesses. Indeed, the authors found that divesting firms tend to spin off assets during times when investors are generally upbeat on the market’s outlook, and are more likely to sell when there’s a negative appraisal of the economy.
Assets that are performing well, however, tend to command a higher value when spun off — sometimes even eclipsing their pre-divestiture assessment — than they would if sold, largely because of the tax burden that accompanies a sale. Firms are more likely to sell off assets that are underperforming, because the firms realize higher immediate after-tax returns from shedding floundering business units.
But even though one might expect the sell-off strategy to prove detrimental or to signal failure, firms that divest their assets this way experience significantly better long-term operating and stock performance than companies that choose to spin off their subsidiary units, the authors found. When it comes to stripping struggling business units from the parent firm, getting cash in hand appears to be more valuable, over the long term, than receiving stock options.
Indeed, the average firm in the sample realized a loss of about US$372 million in stock during the year after spinning off a business, whereas those that sold off a subsidiary unit earned about $210 million in value for shareholders. (The pattern also held true for two- and three-year estimates of firms’ post-divestiture valuations.)
Although investors greet the news of both types of divestitures in a positive manner, and despite the long-term economic gains the authors found associated with sell-offs, investors are much more likely to back firms that announce spin-offs. Nevertheless, the fact that investors still react optimistically when firms disclose their intentions to sell off subsidiary divisions suggests that they understand that the benefits of selling underperforming assets can outweigh the loss that comes with waving the white flag and admitting to investors that a business unit needs to be cut loose.
Source: “Corporate Divestitures: Spin-offs vs. Sell-Offs,” by Alexandros P. Prezas and Karen Simonyan (both of Suffolk University), Journal of Corporate Finance, Oct. 2015, vol. 34