Unlocking value by improving transparency: The case of spin-offs

Abstract

A spin-off is a type of divestiture where a conglomerate separates one or more of its divisions by distributing shares with equity claims specific to those divisions. These shares are not sold, but simply issued to the current shareholders of the conglomerate, similar to a stock dividend distribution. We present a formal model that shows that under information asymmetry, spin-offs are the optimal method to divest divisions of a firm. When firms operate in very different industries, analysts and other market participants sometimes fail to understand or recognize sources of value clearly. Thus, a divestiture by an undervalued firm could allow for improved valuation due to the market being able to discern value more clearly. Our model demonstrates that unlike other modes of divestiture such as asset sales and equity carve-outs, spin-offs are uniquely optimal for eliminating such undervaluation. The intuition lies in the fact that mitigating information asymmetry requires that the individual divisions of a conglomerate trade as separate entities in the market, allowing for analyst-following by analysts with industry-specific expertise. There is also more credible disclosure of operational and financial details of the now separated independent entities. These improvements in firm transparency lead to better recognition of value by the market. Although there is such separation of entities in asset sales and equity carve-outs, these are costly modes of divestiture for the firm since they involve the valuation and sale of undervalued assets prior to separation of divisions and correction of undervaluation. Spin-offs do not impose this cost because there is no sale of assets prior to separation. Our formal model shows that conglomerates needing to raise capital, but undervalued because of information asymmetry, will find it optimal to separate their divisions through a spin-off, eliminate the undervaluation, and then raise capital once the undervaluation is corrected.