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Equity Carve-outs

Motives, implementation and the reaction of the stock market

Diplomarbeit 2001 105 Seiten

BWL - Investition und Finanzierung



Table of Figures

List of Tables


1.1. Problem
1.2. Approach

2.1. Diversification effect on firm value
2.1.1. History of diversification
2.1.2. Value reducing aspects of a diversified company
2.1.3. Value enhancing aspects of a diversified company
2.1.4. Overall effect of diversification
2.2. Classification of Equity Carve-outs and related alternatives
2.2.1. Spin-off
2.2.2. Equity Carve-out
2.2.3. Tracking Stock
2.2.4. Comparison of Spin-offs, Carve-outs and Tracking Stocks

3.1. Motives
3.1.1. Access to the capital market
3.1.2. To improve visibility and market transparency
3.1.3. Acquisition currency
3.1.4. Taxation issues/ accounting issues
3.1.5. Maintaining control of and benefiting from the subsidiaries’ growth
3.1.6. Increasing strategic flexibility
3.1.7. Stock options and other equity incentives as compensation forms
3.1.8. Corporate culture
3.1.9. Others
3.2. Risks and additional costs of an Equity Carve-out
3.2.1. Risks
3.2.2. Costs
3.3. The best choice – a Carve-out ?

4.1. The planning of an Equity Carve-out
4.2. Going Public
4.2.1. IPO process
4.2.2. Pricing
4.3. Investor Relations
4.4. Country-specific issues of Equity Carve-outs
4.4.1. United States
4.4.2. Great Britain
4.4.3. Germany

5 CASE STUDY: Commerzbank and Comdirect
5.1. Introduction
5.2. Motives and advantages of carving-out Comdirect
5.3. Implementation
5.3.1. Preparation
5.3.2. Valuation and future potential
5.3.3. Ownership structure
5.3.4. Pricing

6.1. Prior surveys about the stock price reaction of Equity Carve-outs
6.2. Hypotheses and predictions
6.3. Database
6.3.1. Sources of data
6.3.2. Data requirement
6.3.3. Sample selection
6.4. Method
6.4.1. Observation period
6.4.2. Announcement day
6.4.3. Definition of Return Simple return Continuously compounded return
6.4.4. Measuring abnormal returns Market Model Market Adjusted Returns Model Cumulative (Average) Abnormal Return
6.5. Significance of empirical study
6.5.1. Significance of market model
6.5.2. Significance of CAARs
6.6. Empirical results
6.6.1. Announcement returns of overall sample
6.6.2. Announcement returns in bear and bull markets


Appendix A – IRC § 355

Appendix B – U.S. Offering timetable

Appendix C – Market segments Germany

Appendix D – Nasdaq requirements

Appendix F – Online Brokerage Average

Appendix G – Significance of Market Model

Appendix H – Major Market Indices

Appendix I – Cumulated Abnormal Returns (bull market)

Appendix J – Cumulated Abnormal Returns (bear market)


Table of Figures

Figure 1 Equity Carve-out structure

Figure 2 IPO ownership structure – Comdirect

Figure 3 CAAR for 24 parent corporations (overall sample)

Figure 4 CAAR with support line

Figure 5 CAARs for overall sample and its two subsamples

List of Tables

Table 1 Equity Separation Comparison

Table 2 The IPO process

Table 3 Time Table of IPO placement process

Table 4 Comdirect – History

Table 5 Studies about price sensitivity of the parent stock

Table 6 Overall sample of considered corporations

Table 7 Observation period

Table 8 CAARs and percentage of positive Carve-outsp


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Chapter ONE


1.1. Problem

As especially in the 1990s corporations today still reconsider their organisational and ownership structures to become more competitive and profitable. Corporate restructuring[1], however, is not a value creating mechanism per se, but it can enhance corporate flexibility and focus the company on its main line of business. During a restructuring process, the parent firm has several options and choosing the right one in order to be successful is probably one of the most challenging tasks for the management. Options can be utilised to reduce ownership through a Carve-out or eliminate involvement in a Spin-off or Asset Sell-off. A rather unknown form, the Tracking Stock, will also be mentioned and explained. They all added a new dimension to the corporate landscape.

Typically, the corporation’s aims of restructuring are to create shareholder value.[2] In the last two decades, the tendency was to strengthen the focus on its core businesses and becoming more and more a ‘pure player’[3] in its extreme form. The potential of divestiture[4] activities during the next years will still be very high, if one imagines that only in Germany the 30 DAX companies own around 4.500 subsidiaries.[5]

1.2. Approach

One particularly interesting alteration of firm boundaries involves a parent firm partially divesting its ownership stake in a subsidiary via an Equity Carve-out. Equity Carve-outs have become widely known tools for corporations that shed divisions, which are no longer part of their core business. Especially during the last years high growth segments with tremendous potential could be unlocked through this form of divestiture. One of the main advantages for the parent is that it can still benefit from the growth of its subsidiary, by selling only a portion of the new entity in an IPO. Furthermore the subsidiary can gain new resources through a capital increase and operate independently.

Chapter two will first give an insight about the effect of diversification on firm value and then discuss various forms of restructuring, such as Spin-offs, Equity Carve-outs and Tracking stocks. The aforementioned Equity Carve-out is then taken into closer consideration in chapter three, which discusses why and under which circumstances and motives companies may utilise this form. Thereafter, chapter four shows the reader how to implement an Equity Carve-out. Emphasis will lie on the IPO process, the legal, tax and accounting issues for various countries, as well as on the importance of Investor Relations.

Finally, the empirical part of this paper will be a survey about ‘the stock price reaction of the parent company, if it announces an Equity Carve-out of one of its subsidiaries’.[6] So far, theoretical arguments, as well as empirical surveys, mainly manifest the hypothesis, that shareholders gain from corporate Equity Carve-outs.[7] By analysing a substantial body of Carve-outs test results will be compared with former surveys and new conclusions can be added to the perpetual research in Equity Carve-outs.


2.1. Diversification effect on firm value

Chapter 2.1.1 gives an overview about the history of diversification, focusing on the general opinion whether diversification releases shareholder value or not. Chapter 2.1.2 and 2.1.3 will then present arguments about the reduction and enhancement of value of diversified corporations. The last section 2.1.4 discusses the arguments and values overall effects.[8]

2.1.1. History of diversification

During the 1960s and 1970s, it was commonly believed that conglomerates[9] increase shareholder value and therefore most of the articles on this topic were addressed to the positive effects of diversification[10], whereas recent studies rather concentrate their attention to the costs of diversified companies.[11] During the last two decades most surveys have shown that diversified firms are traded at a market discount, meaning that, on average, the sum of the stand-alone business is greater than the entirety.[12] Thus, the market value of a diversified company would be less than the sum of the (hypothetical) market values of the single subsidiaries. No wonder that during the last few years firms focused their attention on their core business through, for example Equity Carve-outs or Spin-offs.[13]

2.1.2. Value reducing aspects of a diversified company

Cross-subsidisation and Overinvestment

A key disadvantage of a conglomerate is, that profits are often not given to the stockholders as dividends, but kept within the firm and invested inefficiently in lines of business with poor investment opportunities (overinvestment).[14] Furthermore, cross-subsidisation permits weak divisions to get resources from better-performing units and supports the establishment of inefficient segments.[15]

Information asymmetry

Investors have an increasing demand for inside information, especially if the business activities within a diversified corporation show major differences in growth, risk and profitability. In the case of Spin-offs, Carve-outs or similar forms, the firm has the chance to increase the transparency to the outside world. Thus, investors are more attracted to companies with less asymmetric information.

Within the corporation, decentralised firms also show a high potential for misalignment between divisional and central management.[16] The statement derives from the argument that information in a conglomerate is more dispersed. Thus the diversified company as a whole is less profitable than their separate business units.

Attracting high potential

High potentials and leading people of the industry mostly only want to work in a segment where the company is a key player. So, a conglomerate has no problems in acquiring the best people for its core business, but hardly finds them for one of its unattractive side businesses.[17]

Focus on Core business

A diversified Corporation is active in several businesses and cannot focus much on its main line of business, where it has its competence.

2.1.3. Value enhancing aspects of a diversified company

Economies of Scale/ Scope

The main intention of a diversified company is the effect of synergies[18] between the separate business units. Most common synergies are “Economies of Scale” and “Economies of Scope” effects. Economies of Scale is an economic principle saying that if you produce more quantity, the production cost of each unit decreases[19], whereas Economies of Scope is a theory, expressing that the average total cost decreases, as a result of increasing the number of different goods produced.[20]

On the other hand, the bigger a company is, the more complex the structures, and the danger of diseconomies of scale arises. Impacts can be that decisions are not made on time, too much bureaucracy and a lack of quick communication in large firms.[21]

Higher borrowing power[22] and less cost of capital

Another positive value driver of a diversified company is the higher borrowing power and the potential of negotiating lower interest rates. Firms with unused borrowing power and larger free cash flows, however, are more likely to undertake a project with an unexpected negative net present value, because they seem to be more riskier and careless, due to the fact that, contrary to a smaller firm, a value decreasing investment does not threat their existence.[23]

Lower taxation

On average, a conglomerate pays less tax than its business units would, if they were to operate on their own. This effect arises, because a stand-alone business would have to pay tax when earnings are positive and cannot equalise the payments with units that are performing negatively. This disadvantage, however, is reduced by the tax code’s carry back and carry forward possibility, but it is not eliminated.[24]

Internal Capital markets

Diversified companies have the potential of valuable internal capital markets so that resources from cash rich units with poor growth opportunities can be transferred to cash demanding divisions with better investment opportunities.[25] The effectiveness of internal markets, however, depends on the quality of the management[26] that faces the problem of overinvestment and cross-subsidisation, as mentioned in chapter 2.1.2.

2.1.4. Overall effect of diversification

Altogether it is hard to give a conclusive prediction about the overall effects of diversification and whether a stockholder sees diversification as positive or negative. Nevertheless the general press opinion, that Equity Carve-outs can unlock shareholder value[27], is confirmed by recent studies[28] about diversification, which show a Conglomerate Discount.[29]

Underlining this, restructuring has received increasing attention by firms recently[30] and the tendency of today’s management is to concentrate on divestitures to unlock shareholder value. Chapter 2.2 examines more closely three forms of divestitures, namely being Spin-offs, Equity Carve-outs and Tracking Stocks. They are still becoming more and more popular as restructuring alternatives, and for maintaining efficiency during this decade.

However, there is need for a systematically and professionally organised management in order to succeed in divesting assets,[31] since it is not a value creating mechanism per se. A recent study by A.T. Kearney reveals significant performance differences as an effect of divestitures, which they found to depend on the company’s management.[32] As a conclusion, A.T. Kearney mentions seven rules to follow, in order to have positive effects.[33]

2.2. Classification of Equity Carve-outs and related alternatives

Chapter 2.1. discussed, whether the market values diversification or not. Since most recent literature finds that, on average, diversified firms trade at a market discount, the question arises as to what level a company has to restructure in order to release shareholder value. In fact, if corporate restructuring creates value always depends on the individual case and whether any of the following forms of reorganising a corporation makes sense.

Restructuring charges are taken by firms as part of an excessive effort to make them more efficient and profitable. This chapter analyses and distinguishes three forms[34] of corporate divestiture such as Spin-offs, Equity Carve-outs and Tracking Stocks. In the 1990s especially, they have become an attractive choice for companies seeking to deconglomerate and focus on core business:

2.2.1. Spin-off

The Spin-off[35] is a form of a corporate divestiture, where the parent company creates a separate subsidiary that is legally independent[36], with its own board of management and its own autonomy of decision. The shares are distributed to existing shareholders on a pro rata[37] basis in form of stock dividends.[38] Traditionally, 100 % of the new subsidiary are distributed to the existing shareholders[39], meaning that someone who owns 10% of the parent corporation also gets 10% of the subsidiary’s shares. It is, however, also possible to sell part of the entity to other investors, which is tax-free in the United States if at least 80% of the new company remains in the parent corporation’s shareholders hands.[40]

If the company thereby does not meet the IRS Section 355 Code[41] requirements, it can be made liable for the full taxes. Detailed regulations of the IRC[42] are listed in Appendix A and important facts are underlined. A Spin-off, however, which is in general always structured to be tax free[43], is often used to unlock shareholder value by showing the real value of the subsidiary without triggering any taxable gain. In Germany, a Spin-off always has to be taxed as a dividend, but, as an exception an international Spin-off can be constructed without paying tax.[44]

2.2.2. Equity Carve-out

“An Equity Carve-out[45] involves the sale of a portion of the firm via an equity offering to outsiders. In other words new shares of equity are sold to outsiders, which give them ownership of a portion of the previously existing firm. A new legal entity is created. The equity holders in the new entity need not be the same as the equity holders in the original seller. A new control group is immediately created.”[46]

The shares to ‘outsiders’ are offered through an IPO[47], but the parent usually keeps the majority of the ownership.[48] It also provides strategic directions and central resources, while the subsidiary has its own board of management and its own financial statement. Even though the two companies act separately, they often remain in complex partnerships regarding ownership structures (residual claims to cash flows) and the overlap of former management duties.[49] Not only do these relationships exist at the initial Carve-out, but many also exist as long-term arrangements.

In an Equity Carve-out the parent company sells a partial interest of its subsidiary in an IPO and benefits through the cash of the new subsidiary’s stakeholders.[50] In the U.S. the parent usually sells less than 20 % in a Carve-out in order to maintain control and preserve the tax and accounting consolidation over the subsidiary.[51] Consequently the amount of capital raised by the parent in an Equity Carve-out is limited.[52] If a quote of more than 50% of the subsidiary is kept by the parent company they still have the majority of votes and, in most countries, have the opportunity to include the subsidiary in a consolidated financial statement.[53] Legal, accounting and taxation issues for Germany, Great Britain and the U.S. will further be compared in chapter 4, however.

Figure 1 visualises an example of a 20 % Carve-out:

illustration not visible in this excerpt

Figure 1: Equity Carve-out structure.[54]

2.2.3. Tracking Stock

A corporation also has the possibility to sell its stake through a Tracking Stock[55]. The formation of an equity structure based on Tracking Stocks is, in some respects, similar to a Spin-off or Carve-out, but with considerable differences. A Tracking Stock is a form of equity that is intended to track the performance of a particular business line within the firm. The separate classes of stock are publicly traded and are tied to the earnings performance of a business unit.[56] The separate division operates under the parent’s management team and board of directors,[57] but the parent company separates the unit’s bookkeeping from the main company’s finances, and the new stock ‘tracks’ the result of the new business. Usually, Tracking Stocks do not have full voting rights and, in legal terms, the shareholders do not own the company. Thus, the stock market usually trades the shares with a market discount.[58]

The company Spin-off Advisors L.L.C.[59] suggest that “from an investor’s point of view, we would prefer to ´own the thing that owns the thing´”[60], which clearly means that their belief is, that a Tracking Stock is an unattractive investment opportunity. Nevertheless, Tracking Stocks have recently gained an unexpected popularity and media attention, because they allow a diversified company to highlight their higher growth and high-tech subsidiaries business to investors, in hope to unlock shareholder value.[61] Moreover, a very attractive point of owning a Tracking Stock is that a high-flying growth subsidiary with less risk is owned, because it usually has the backing of an established corporation: The underlying assets are, for instance retained by the parent company and the tracked company can draw on the company’s credit standing to borrow money. Another major advantage of a Tracking Stock is the ability to offset taxable profits by using either the parents’ or the subsidiaries’ net operating losses.[62]

2.2.4. Comparison of Spin-offs, Carve-outs and Tracking Stocks

What Spin-offs, Carve-outs and Tracking Stocks have in common is that they increase transparency of the company for the outside world and eliminate inefficient cross-subsidies by creating a focused organisation, in which operating performance and compensation are more closely matched.

Contrary to a Tracking Stock, Carve-outs and Spin-offs create a new entity with the right to elect a new board of management, the right to claim against the assets of the new company, as well as the right to vote on significant decisions.[63] On the other hand a Tracking Stock tends to profit more from synergy effects[64], because it still depends very much on the parent. The negative aspect about the obedience is that an investor of a Tracking Stock segment can never be sure if the parent company’s management that still controls the subsidiary continues to operate in his best interest.[65]

Three very important differences between Spin-offs and Carve-outs are, that firstly through a Carve-out you address a new set of stockholders with the IPO, whereas in a Spin-off, the shares are traditionally handed out to existing shareholders as a dividend.[66] Secondly, because of the pro rata distribution a Spin-off does not have immediate cash flow consequences, whereas in a Carve-out the parent receives cash through the IPO sale.[67] Thirdly, after a Spin-off, the parent loses legal and economical control over the subsidiary, whereas in a Carve-out only a minority of the stake is usually offered to the public.[68] Thus, in a Carve-out, the parent - contrary to a Spin off - still retains control over the subsidiary after the IPO placement, aligned with reciprocal interdependencies.[69] Lastly, Carve-outs are more expensive[70] and are subject to more disclosure requirements by the SEC or similar authorities.[71]

A further advantage for the parent that carves-out its division, is that it can profit from the subsidiary through its stake, in case the management expects the subsidiary to perform better than its peers. Therefore, investors usually consider a Carve-out to be bullish in case the majority of assets remains by the parent, whereas a Spin-off may be considered as an abandonment of assets.

Table 1 furthermore itemises the differences based on US law on the next page.

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Table 1: Equity Separation Comparison.[82]


Due to the size of this paper, only motives of carving-out its business are analysed. Motives of the different forms of divestitures, however, are very similar[83] and may overlap with the in chapter 2.1.2 mentioned value reducing aspects of a diversified company. However, they will be mentioned again out of the view of an Equity Carve-out. Motives can generally be identified as sources of value creation, even though there are risks that occur by carving-out its business that are mentioned in section 3.2. Chapter 3.3. then analyses, whether a Carve-out is the right choice, taking the trade-off between motives and risks into consideration.

3.1. Motives

3.1.1. Access to the capital market

In an Equity Carve-out the subsidiary has the possibility of finding its ideal shareholder base and can even gain new financial resources through a capital increase. On the other hand, the parent can improve its capital structure through reorganisation.[84] Furthermore, the popularity of both companies rises through the IPO process and the public listing, which may mainly help the subsidiary in various fields such as marketing products, obtaining better financing conditions and attracting new investors, as well as more qualified employees.[85] An Equity Carve-out also allows the parent company to realise cash through the IPO sale, which can be attractive for companies who need money, but do not have access to debt and equity capital markets on a low cost basis.[86] Even after the Carve-out, the parent can sell part of its entity through secondary offerings and react quickly on cash requirements.[87] The subsidiary benefits, by being able to fund early development stages, which is often essential in a high growth sector and fast moving environment.[88]

Acting apart from its parent, the subsidiary has also the ability to react faster in market environments and to use first mover advantages, which is just one critical factor in the fast moving e-business environment. Barnes & Noble’s online bookshop for example, could not act as flexible as its carved out and did not have as many business process improvements at the time it was still tied to its parent company.[89]

3.1.2. To improve visibility and market transparency

Through the separation of a higher growth or quality sector, the corporation is more visible and a ‘purer player’ from an investor’s point of view. It allows a more appropriate investor evaluation.[90] Thus, many of these transactions are motivated by investors’ desire to have investment clarity pertaining to the parent and the subsidiary, because it brings transparency into how investors value different parts of a business.

In addition, analysts often specialise in industrial sectors and therefore the carved-out firm can be covered[91] more easily.[92] For example investors valued the Carve-out of the online subsidiary like an internet company on a revenue growth basis, whereas its parent was traded based on earnings per share.[93] As a result the subsidiary showed a significantly higher value than the implied value of both corporations before the transaction.[94]

In the past, motives of restructuring often arose through market pressure because of, say, a low market evaluation of the corporation, or because the share lost attention by analysts and investors.[95] “A Carve-out focused investors’ attention on the prospects of a subsidiary, whose activities and growth opportunities might otherwise have been overlooked. Investors are better able to spot the ‘diamond in the rough’, because the now separately traded subsidiary reports its own financial information.”[96] This argumentation leads to a recommendation for subsidiaries that are in particular regarded as very attractive to carve-out: “Subsidiaries whose activities and opportunities are overlooked by the parent’s equity analysts and investors can be good candidates. These companies should benefit from the information flow created by the Carve-out.”[97]

3.1.3. Acquisition currency

Through the Carve-out the parent can establish an orderly market for the new issue by selling a small piece first. According to this explanation, the parent avoids flooding the market with a large number of shares in a full Carve-out. Furthermore, the IPO process gives an incentive for Investment Banks to market and support the issue.

The separate equity structure of Equity Carve-outs also gives the subsidiary’s management the opportunity to use their stock as an acquisition currency.[98] Through the new acquisitions, they can expand their business faster, which is often essential in high growth segments. On the other hand the management looses influence due to equity dilution after the transaction.

3.1.4. Taxation issues/ accounting issues

Tax and accounting issues may be one of the most important subjects in a restructuring process and depend on the individual case. The framework of tax and accounting issues are considered in table 1 and in chapter 4.4.

3.1.5. Maintaining control of and benefiting from the subsidiaries’ growth

The parent company chooses how much they would like to offer to the public. In some cases, it might be reasonable to carve-out only a minor part of the subsidiary, in order to still benefit from the expected positive stock performance after the IPO.[99] Most of the time, the parent keeps the majority to be able to retain effective control over the subsidiary. In any case, however, the IPO leads to a decentralisation of competence in the subsidiary, with the advantage that the new management can react more efficiently in the market environment. Profitable investments can be recognised earlier and realised more easily which supports growth and success of the subsidiary.

3.1.6. Increasing strategic flexibility

Being legally and economically independent, the publicly listed subsidiary enjoys advantages, such as being able to freely choose new business partners with self-negotiated articles of agreement.[100] AT&T, for example, split of Lucent Technology and NCR to enhance the division’s ability to sell equipment to competitors of AT&T.[101] This example is mentioned in various papers, since the market value of AT&T, before the restructuring in 1995, was just
$ 75 billion, whereas one year after the split-off, the three separately traded corporations had more than doubled their combined market capitalisation.[102]

3.1.7. Stock options and other equity incentives as compensation forms

In a smaller, carved-out company, the managerial decisions can have significant impact on the stock price performance, whereas in a larger corporation the stock price hardly reacts on a division manager’s efforts. Therefore, it makes sense to initiate equity compensation such as stock option programs to provide superior incentives and retain management talent.[103] Other equity incentives that are typically offered to the upper management may be bonus payments derived from revenues, or returns. Often, a corporation needs those forms of compensation to tie the best people of the industry. In a traditional corporation, higher management retention is not as easy to implement as in a carved-out, more innovative subsidiary. Often a long-term incentive compensation plan is critical to keeping management and employees motivated. Today, many smaller companies establish such plans shortly after formation.

3.1.8. Corporate culture

Innovative subsidiaries acting in high growth segments often have different work ethics and corporate identities than larger, more traditional corporations. Hence, a lot of resources are frequently spent to bear down the differences and to support various cultures in highly diversified corporations. Smaller and innovative companies may differ for instance in the 24/7 life-style, the higher wages at the end of the month, as well as the quick decision-making.[104] Thus, those reasons lead in some corporations to carve-out the subsidiary to encourage the new spirit.

3.1.9. Others

General principles about the value-reducing aspects of diversified companies such as cross-subsidisation, overinvestment and information asymmetry[105], which are in this paper presented in chapter 2.1, can partly be transferred and therefore do apply as motives for Carve-outs. They will not be listed separately.

3.2. Risks and additional costs of an Equity Carve-out

3.2.1. Risks

Is the subsidiary attractive enough for investors and analysts? - Can we lose high-performing managers or key technical staff because of uncertainty that comes along with restructuring? – In order to succeed after the transaction, these concerns have to be answered before a Carve-out takes place.

The subsidiary faces even more uncertainty when carving-out its business: Although in most cases the majority of ownership still belongs to the parent, doubt arises whether the company has the power to keep up with the pressure from competitors, vendors, consumers and analysts, to name but a few, and finally, whether it has the ability to survive independently.[106] Another handicap can arise through a conflict of interest between the parent and the subsidiary, since the carved-out firm has a new group of shareholders with possibly different interests in the company than the parent.[107] Sub optimal decisions for both companies can be the consequence.

In the past a handicap for going public companies was, that the top management has been so busy with initiation and implementing the IPO that they could hardly focus on their daily work activities, which lead to problems within the company.

3.2.2. Costs

The costs that arise through an Equity Carve-out are not only the nonrecurring cost for the IPO, but also the costs for new technical systems and departments such as human resources and accounting. So far, those resources have mostly been provided by the parent company. It is not unusual, though, to still use the resources of the parent on a contractual basis. Services can include human resource, IT, investor relations as well as certain tax and legal services.[108] Additional administrative costs for financial reporting and market communication are also required for a publicly listed company.

Furthermore, costs for an initial public offering are around 4 to 7 percent of the issue volume. Those massive expenses go to Investment Banks, as well as Advisor and Consulting companies, and underline the fact that an Equity Carve-out has to be carefully calculated before the decision is made.[109]

3.3. The best choice – a Carve-out ?

Recapitulating, positive arguments of restructuring its business prevail. However, the restructuring minded company has to go through a careful analysis, in which it weighs strategic, competitive, valuation and other factors. Then it compares them with the pros and cons of alternative strategies, such as Spin-offs and IPO Carve-outs.

Before a Carve-out is taken into consideration, the management has to make sure that their division or subsidiary is the ideal candidate to introduce to the market. Investors are usually attracted, if most of the motives mentioned above apply to the subsidiary. The main points are to have strong growth prospects, to be able to use borrowing capacity independently, to have a different, more innovative corporate culture than its parent and to have unique and innovative industry characteristics.[110]

The management of both companies also bears the responsibility to act wisely, especially under consideration of a sensible market environment. Basic rules of how to deal with the public are essential. Thus Investor Relation plays an important role for the long-term stock price performance of the subsidiary. Chapter 4.3 will therefore shortly explain the importance of Public Relations and Investor Relations work.


[1] The term ‘corporate restructuring’ stands for financial and portfolio restructuring. Financial restructuring is to structure the gearing of equity capital and borrowed capital, whereas in a portfolio restructuring the firm decides about involvement and changes of portfolio investments ( i.e. subsidiaries). See Achleitner, A.K. (2000), p.1. Equity Carve-outs are one form of financial restructuring.

[2] In the past, unwilling restructuring has also taken place, because of antitrust or law regulations. A good example is the discussion about splitting Microsoft into two independently operating companies. Some managers also use restructuring as a defensive measurement against hostile take-overs. See Achleitner, A.K. (2000), p.13.

[3] The single focus business or a ‘pure play’ is the extreme form and means, in investor terms, to have the main intention to operate a separate, high growth stand-alone business. See JP Morgan (1997), p.1.

[4] “Divestiture” is to sell part of the corporation to a third party, mostly another firm. Objects can be assets, lines of products, divisions or subsidiaries. The selling corporation gets new capital, whereas the buyer expands its business. An Equity Carve-out is very similar to a divestiture, except that equity interest in the subsidiary is sold through an IPO to outsiders. See Copeland, T.E./ Weston, J.F. (1994), p.679; Gaughan, P.A. (1996), p.2; Weston, J.S. et al. (1990), p.224. Thus this thesis will regard an Equity Carve-out as one form of divestiture.

[5] See Chapeaurouge, A. (1999), p.1.

[6] Due to the size of this paper there is no empirical survey in the case of Spin-offs and Target Stocks. These two forms, however, will be explained and compared shortly. The use of terms is not always the same in German and English literature nor in practice. German literature sometimes uses the term Spin-off, to mean a Carve-out. See Nick, A. (1994), p.81; Hennigs, R. (1995), p.6; Lewis, T.G. (1994), p.95. This paper strictly distinguishes between Spin-offs and Carve-outs as defined in chapter 2.2.

[7] Various studies that underline this hypotheses will be discussed later.

[8] Diversification means, that a company does not only concentrate on its core business, but has several ongoing projects. It’s business units have operative relationships and interdependencies. See Jansen, S.A. (2000), p.75; Brigham, E.F. et al. (1999), p.944.

[9] A conglomerate is an extreme form of a diversified company, where the business units are unrelated to each other and therefore have no positive correlation. See Brigham, E.F. et al. (1999), p.800. In the following chapters no distinction is made between conglomerates and diversified companies.

[10] See Copeland, T.E. et al. (1990), p.23; however a study of Kaplan/ Weisbach in 1992 analysed 271 large acquisition and found that 43.9 % of acquisitions fail and are divested again after an average of 7 years. See Kaplan, S./ Weisbach, M. (1992), pp.107.

[11] See Berger, P.G./ Ofek, E.O. (1995), p.40; Zuta, S. (1999), p.3; Lang, L./ Stulz, R. (1994), pp.1248; Servaes, H. (1996), p.1201; Blumers, W. (2000), p.589.

[12] In 1995 Berger/ Ofek compared stand alone values for business units with the actual value of the firm, and found, that, on average, the whole company was worth 13 to 15 % less than the sum of its parts. The comparison was made during 1986-1991. The main reason for the discount is seen in overinvestment and cross-subsidisation. See Berger P.G./ Ofek E. (1995), p.39; Zuta, S. (1999), pp.13. Studies with similar results were made by Comment, R./ Jarell, G.H. (1995), pp.67; Lang, L./ Stulz, R. (1994), pp.1248 and Servaes, H. (1996), pp.1201.

[13] See Prezas, A. et al. (2000), p.125; Comment, R./ Jarell, G.H. (1995), pp.68; Chapeaurouge, A. (1999), p.1.

[14] See Billett, M.T./ Mauer, D.C. (2000), p.1458; Zuta, S. (1999), p.15; Stulz, R.M. (1990), p.3.

[15] See Billett, M.T./ Mauer, D.C. (2000), p.1459; Meyer, M. et al. (1992), p.10.

[16] See Berger, P.G./ Ofek, E.O. (1995), p.40; Myerson, H. (1982), p.68; Harris, M. et al. (1982), p.605.

[17] See Anslinger, P.L. et al. (2000), p.101.

[18] Synergy effects arise, if the value of the company is enhanced by capitalistic measures such as an acquisition, or a merger. (2+2=5 effect). See Brigham, E.F. et al. (1999), p.797; Scharlemann, U. (1996), p.23; Mehta, S. (2001), p.5. The first model that can be labelled to respond to synergy effects goes back to Coase. See Coase R.H. (1937), pp.386. Contrary to the synergy effect a Spin-off or Carve-out is often described as the 4 – 2 = 3 effect. See Hite, G./ Owers, J. (1983), p.410.

[19] See Downes, J./ Goodman, J.E. (1995), pp.158; Frank, R. (1997), pp.366; Arentzen, U./ Winter, E. (1997), p.993; Nieschlag, R. et al (1994), p.136.

[20] See Nieschlag, R. et al (1994), p.136.

[21] See Schenk, G. (1997), pp.213.

[22] If the management makes too much use of its borrowing power the leverage effect must be taken into consideration. Companies in the 1980s, for instance, took excessive advantage of their credit lines, so that the companies were higher leveraged, with negative effects on the investors and creditors. See Donaldson, G. (1998), p.613.

[23] See Jenson, M.C. (1986), p.323.

[24] See Majd, S./ Myers, L. (1987), p.23.

[25] See Weston, J.F. (1970), p.67; Stein, J. (1997), p.113.

[26] Bad working internal capital markets can easily turn into overinvestment and cross-subsidisation as seen in chapter 2.1.2.

[27] See Stow, R. (1999), p.99; Allen, J.W./ McConnell, J.J. (1998), pp.163.

[28] On average diversified firms trade at a significant discount to the sum of the stand alone divisions. See Berger, P.G./ Ofek, E. (1995), p.40; Comment, R./ Jarrell, G.A. (1994), pp.68 discuss that issue heavily; Lang, L./ Stulz, R.M. (1994), pp.1249.

[29] See Copeland, T.E et al. (1990), p.41; Lewis, T. (1994), pp.84; Comment, R./ Jarell, G.H. (1995), pp.67; Berger, P.G./ Ofek, E. (1995), pp.39.

[30] See Comment, R./ Jarell, G.H. (1995), pp.67.

[31] See Scheiter, S./ Rockenhäuser, J. (2000), p.35.

[32] AT Kearney took a large sample of divestitures during 1993 through 1998. See Scheiter, S./ Rockenhäuser, J. (2000), p.35.

[33] Key rules to follow in order to have positive effects are (1) first to evaluate the “Best Owner” of the business unit in order to maximize synergies and then (2) second to identify and contact buyers to get an attractive selling price. (3) To carve-out the segment to assure ‘stand alone’ capabilities, before starting the selling procedure. (4) To actively communicate the disinvesting process within the company, to shareholders and to the public. (5) To generate a timetable of actions and ensure swift restructuring. (6) To guarantee that the management supports the action, as well as to (7) build an infrastructure with professional resources, such as an M&A division. See Scheiter, S./ Rockenhäuser, J. (2000), p.35.

[34] See Anslinger, S. et al. (1999), pp.17; Anslinger, S. et al. (2000), p.100. Other forms of divestitures such as an Asset Sell-off or a Split-up will not be taken into closer consideration in this paper. In a Sell off a subsidiary, division or product line is sold to one or more, typically privately negotiated investor. See Alexander, G. et al. (1984), p.503. Unlike in a Spin-off, the parent receives cash through the transaction. See Desai, H./ Jain, P.C. (1999), p.76; Schleifer, A. et al. (1992), p.1344; A Sell-off implicates only little public disclosure. A Split-up is a Dmerger of the parent company into at least two companies. See Achleitner, A.K. (2000), p.8.

[35] See Jones, H. (2000), p.13(b).

[36] In some German Literature a Spin-off terms a subsidiary that is legally dependent on the parent. See Nadig, L. (1992), p.11.

[37] “Pro rata” is the Latin expression for “according to the rate” and means that everyone gets the same proportion. See Downes, J./ Goodman, J.E. (1995), p.445.

[38] See Hite, G./ Owers, J. (1983), p.410; Miles, J./ Rosenfeld, J. (1983), p.1597; Slovin, M. et al. (1995), p.91; Brigham, E.F. et al. (1999), p.826; Schenk, G. (1997), p.213. Traditionally, in a pure Spin-off, all of the common shares are distributed to the parent cooperation´s shareholders in form of stock dividends, so that after the transaction there are two separate firms with the same shareholder base. See Slovin, M. et al. (1995), p.91; Miles, J. et al. (1983), p.1597; Downes, J./ Goodman, J.E. (1995), p.546. Other forms of a Spin-off are the distribution of shares through a leveraged buyout, or an employee stock ownership plan. See Downes, J./ Goodman, J.E. (1995), p.546.

[39] See JP Morgan (1997), p.1; McKenna, M.R. (2000), p.65; Achleitner, A.K. (2000), p.5.

[40] See Lamont, O.A./ Thaler, R.H. (2000), p.8; Spin-off Advisor L.L.C. (2000), p.1; Slovin, M.B. et al. (1995), p.91; Tax issue based on U.S. Law.

[41] See Appendix A; IRS = Internal Revenue Service; The IRS Section 355 Code identifies three types of divestitures: Split-ups, Split-offs, and Spin-offs. It mainly requires issues such as maintaining control of the subsidiary, ensuring that the two firms are still engaged in business with each other and that the Spin-off is not only used simply as a means to escape tax payments. Also see Miles, J.A./ Woolridge, J.R. (1999), p.4.

[42] The IRC(Internal Revenue Code) are tax regulations from the Internal Revenue Service of the USA, shown in Appendix A.

[43] See Cusatis, P. et al. (1993), p.295.

[44] See Achleitner, A.K. (2000), p.6.

[45] Equity Carve-outs are sometimes also called Split-offs, Spin-outs or partial IPOs.

[46] Copeland, T.E./ Weston, J.F. (1994), p.679.

[47] See Ascarelly, S. (2000), p.1; IPO is the short form of “Initial Public Offering”. This process will be explained in chapter 4.

[48] See Stavros, R. (2000), p.3; Cashman, M.A. (1999), p.49; McKenna, M.R. (2000), p.64, Miles, J.A./ Woolridge, J.R. (1999), p.1; Lamont, O.A./ Thaler, R.H. (2000), p.7.

[49] See Brigham, E.F. et al. (1999), p.826; Schipper, K./ Smith, A. (1986), pp.153.

[50] See Dunkin, A. (1998), p.12; Achleitner, A.K. (2000), p.12; Weston J.F. et al. (1990), p.234; Michaely, R./ Shaw, W. (1995), p.5; Krishnaswami, S./ Subramaniam, V. (1999), p.74.

[51] See LEK Consulting (2001), p.2; Stow, R. (1999), p.101; Logue, D.E. et al. (1996), p.51; Lamont, O.A./ Thaler, R.H. (2000), p.8; Miles, J.A./ Woolridge, J.R. (1999), p.4; Elder, J./ Westra, P. (2000), p.39. Also see chapter 2.2.1 and Appendix A.

[52] As mentioned, Spin-offs can be tax-free to both, the parent firm and to its shareholders. In order to be tax-free, Spin-offs need to comply with Internal Revenue Code Section 355, which requires that the parent owns (prior to the Spin-off) at least 80 percent of the subsidiary. Thus, if a firm plans a Carve-out followed by a tax-free Spin-off, it is necessary to carve-out less than 20 percent of the subsidiary.

[53] See Michaely, R./ Shaw, W. (1995), p.6. Advantages of a 75% quote compared to a 50 % quote are discussed in Hennigs, R. (1995), pp.37. If more than 50 % are sold, the transaction is called a “Subsidiary IPO” or “Partial Public Offering”. See Achleitner, A.K. (2000), p.7. The market usually sees a Carve-out of more than 50 % as critical, because investors may interpret that the parent wants to get rid of the subsidiary. Volk, G. (1999), p.123.

[54] Own resources.

[55] Also called alphabet, letter or target stocks. The name arose from Lehman Brothers in the 1990s, when they assisted USX Corporation in restructuring. See Billett, M.T. et al. (2000), p.146; See Neish, S. (1995), p.28.

[56] See McKenna, M.R. (2000), p.66.

[57] See McKenna, M.R. (2000), p.66.

[58] See McKenna, M.R. (2000), p.67.

[59] Spin-Off Advisor L.L.C. is an independent investment research boutique from Chicago.

[60] Spin-off Advisor L.L.C. (2000), p.1.

[61] See Scherreik, S. (2000), p.1.

[62] See Anslinger, P.L. et al. (1999), p.20; around 50 % of the Companies with Tracking stocks take advantage of this rule. See Anslinger, P.L. et al. (1999), p.20.

[63] See Elder, J./ Westra, P. (2000), p.36; Anslinger, P.L. et al. (1999), p.16.

[64] See Natusch, I. (1997), p.1144; Neish, S. (1995), p.29; See Chapter 2.1.3.

[65] See Wahrenburg, M. (2000), p.36.

[66] See Elder, J./ Westra, P. (2000), p.38; Michaely, R./ Shaw, W. (1995), p.5.

[67] See Achleitner, A.K. (2000), p.12; Weston J.F. et al. (1990), p.234; Michaely, R./ Shaw, W. (1995), p.5; Krishnaswami, S./ Subramaniam, V. (1999), p.74.

[68] See Weston J.F. et al. (1990), p.234; Michaely, R./ Shaw, W. (1995), p.5; Boone, A. (2000), p.4.

[69] See Brigham, E.F. et al. (1999), p.826; Schipper/ Smith for example show that the parent is at least represented by one member of the ‘Board of Directors’ of the subsidiary in 56 of 57 analysed Equity Carve-outs. See Schipper, K./ Smith, A. (1986), pp.153.

[70] Approximate Investment Banking overall costs are around 6.5 % for a Carve-out and 2.0 % for a Spin-off. As a consequence, low quality firms may find the carving-out decision too costly relative to the outcome.

[71] See Michaely, R./ Shaw, W. (1995), pp.5. Similar authorities are in Germany the ‘Börsenaufsichtsbehörde’ and in Great Britain the ‘Financial Services Authority’.

[72] See Miles, J.A./ Woolridge, J.R. (1999), p.3.

[73] See Miles, J.A./ Woolridge, J.R. (1999), pp.4.

[74] If the corporation considers the requirements under Section 355 of the Internal Revenue Code, shown in Appendix 1, the corporation is generally allowed to distribute to shareholders the appreciated stock of its wholly owned subsidiary without paying tax.

[75] The taxation issue of Tracking Stocks has not been finally decided by the IRS yet. See Bauer, M. (2000), p.144; Banham, R. (1999), p.48; Levinsohn, A. (2000), p.66. So far, the issuer of Tracking Stocks stated exemption from taxation, but with the note in the prospectus that there might be a tax payment afterwards. Concerning Tracking Stocks the IRS did not rule specifically on this issue, yet. It is not clear whether the stock is seen a part of the parent or the tracked subsidiary. See McKenna, M.R. (2000), p.66.

[76] See Michaely, R./ Shaw, W. (1995), p.6; Miles, J.A./ Woolridge, J.R. (1999), p.37.

[77] See Achleitner, A.K. (2000), p.12.

[78] The carved-out company, however, has the chance to acquire cheap capital by a capital increase though the IPO, which is very common; however, a capital increase is also possible in case of Tracking Stocks or Spin-offs.

[79] Besides the low transaction costs, a Tracking stock also saves money because there is no need for a new board of directors and a consolidated tax report can be maintained. See McKenna, M.R. (2000), p.67.

[80] See Desai, H./ Jain, P.C. (1999), p.76; Achleitner, A.K. (2000), p.7.

[81] See Achleitner, A.K. (2000), p.10.

[82] See L.E.K. Consulting (2000), pp.1; Achleitner, A.K. (2000), pp.1; Desai, H./ Jain, P.C. (1999), p.76; Bauer, M. (2000), p.144; Banham, R. (2000), p.48; Levinsohn, A. (2000), p.66; McKenna, M.R. (2000), p.66; Amihud, Y./ Baruch, L. (1981), pp.697; Miles, J.A./ Woolridge, J.R. (1999), p.3.

[83] Motives in the literature of Spin-offs, Tracking Stocks and other forms of divestitures will also be taken into consideration and mentioned, if arguments can be transformed into an Equity Carve-out motive.

[84] See Hennigs, R. (1995), pp.90.

[85] See Ahlers, M. (1998), p.43; Volk, G. (1999), p.122; Rödl, B./ Zinser, T. (1999), p.82.

[86] See Volk, G. (1999), p.122; Allen, J.W./ McConnell, J.J. (1998), p.163; Miles, J.A./ Woolridge, J.R. (1999), p.38. However the study of Michaely/ Shaw couldn’t support the hypothesis, that the organisation’s need for cash is the driving motive of an Equity Carve-out. See Michaely, R./ Shaw, W. (1995), p.6; Miles, J.A./ Woolridge, J.R. (1999), p.38.

[87] See Schroders (1999), p.21.

[88] See LEK Consulting, (2001), p.3.

[89] See LEK Consulting, (2001), p.4.

[90] See Wahrenburg, M. (2000), p.35; Schroders (1999), p.4; Volk, G. (1999), p.123; LEK Consulting (2001), p.4; Natusch, I. (1995), pp.71; Powers, E. (2000), p.3; Nick, A. (1994), p.138.

[91] Analysts at investment banks ‘cover’ stocks by analysing the firm and the market environment, writing research reports about specific companies and proposing to investors whether to buy, hold or sell the share.

[92] See Ahlers, M. (1998), p.43.

[93] See Stow, R. (1999), p.100; McKenna, M.R. (2000), p.64.

[94] See McKenna, M.R. (2000), p.64; Stow, R. (1999), p.100.

[95] See Anslinger, P.L. et al (2000), p.101.

[96] Lindberg, E.B./ Blanton, P.B. (1991), p.3.

[97] Lindberg, E.B./ Blanton, P.B. (1991), p.6.

[98] See LEK Consulting (2001), p.3.

[99] See Schoders (1999), p.5.

[100] See Schenk, G. (1997), p.214.

[101] See Anslinger, P.L. et al. (1999), p.18. AT&T split its operations into three publicly traded firms: AT&T, Lucent Technologies and NCR, which was announced in 1995. Technically, the transaction has been a traditional Spin-off and so the argument of serving a competitor may not be as valuable in the case of an Equity Carve-out.

[102] See Anslinger, P.L. et al. (1999), p.16.

[103] See LEK Consulting (2001), p.3; Rödl, B./ Zinser, T. (1999), p.83. An example for a stock option plan can be found in Harrer, H./ Heidermann, D. (2001), pp.139.

[104] See LEK Consulting (2001), p.3.

[105] The argument, however, that can be derived from Information Asymmetry Theory is that rationally acting investors react negatively on the announcement of an Equity Carve-out, because through information asymmetry the manager (being an insider) would only consider this form of divestiture, if he thinks the stock market overvalues his subsidiary. Thus in case of this being the only effect considered, a transparent capital market would react with negative price effects on the announcement of a Carve-out. See Schipper, K./ Smith, A. (1976), p.170. Myers/ Majluf embrace this theory with a capital increase. Myers, S.C./ Majluf, N. (1984), pp.187. Nanda finds in 1991 that Information Asymmetry is reduced by a Carve-out through the investors ability to determine the true value of the parent’s assets in place. See Nanda, V. (1991), pp.1717.

[106] See Anslinger, P.L. et al. (1999), p.18.

[107] See McKenna, M.R. (2000), p.64.

[108] See Miles, J.A./ Woolridge, J.R. (1999), p.39.

[109] See Appendix B.

[110] See Miles, J.A./ Woolridge, J.R. (1999), p.40.


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Titel: Equity Carve-outs