Value Creation of Spin-offs and Carve-outs

Table of Contents

1 Introduction
1.1 Motivation
1.2 Research Question and Objectives
1.3 Contribution
1.4 Demarcation
1.5 Structure

2 Fundamentals of Spin-offs and Carve-outs
2.1 Type of Restructuring Transactions
2.1.1 Spin-offs
2.1.2 Carve-outs
2.2 Strategic Implications
2.2.1 Diversification
2.2.2 Restructuring and Refocusing
2.2.3 Barriers for Restructuring Transactions
2.3 Operational Implications
2.4 Legal Implications
2.4.1 Spin-offs
2.4.1.1 USA
2.4.1.2 Germany
2.4.1.3 Switzerland
2.4.2 Carve-outs
2.4.2.1 USA
2.4.2.2 Germany
2.4.2.3 Switzerland
2.5 Governance Implications
2.5.1 Spin-offs
2.5.1.1 USA
2.5.1.2 Germany
2.5.1.3 Switzerland
2.5.2 Carve-outs
2.5.2.1 USA
2.5.2.2 Germany
2.5.2.3 Switzerland
2.6 Accounting Implications
2.6.1 US GAAP
2.6.2 IFRS
2.6.3 German Commercial Code and German GAAP
2.6.4 Swiss GAAP ARR
2.6.5 Spin-offs
2.6.5.1 US GAAP
2.6.5.2 IFRS
2.6.6 Carve-outs
2.6.6.1 US GAAP
2.6.6.2 IFRS
2.7 Tax Implications
2.7.1 Spin-offs
2.7.1.1 USA
2.7.1.2 Germany
2.7.1.3 Switzerland
2.7.2 Carve-outs
2.7.2.1 USA
2.7.2.2 Germany
2.7.2.3 Switzerland
2.8 Other Implications
2.9 Appraisal of Implications

3 Models and Empirical Studies on Spin-offs and Carve-outs
3.1 Models on Spin-offs and Carve-outs
3.1.1 Moral Hazard
3.1.1.1 Shareholders vs. Management
3.1.1.2 Shareholders vs. Debtholders
3.1.2 Adverse Selection and Signaling
3.1.3 Spin-offs
3.1.3.1 Information Asymmetry Reduction
3.1.3.2 Asset Substitution
3.1.4 Carve-outs
3.1.4.1 Information Asymmetry Reduction
3.1.4.2 Timing and Window of Opportunity
3.2 Empirical Studies on Spin-offs and Carve-outs
3.2.1 Announcement Effect
3.2.1.1 Spin-offs
3.2.1.2 Carve-outs
3.2.1.3 Initial Day of Trading Effect
3.2.2 Long-term Stock Market Effects
3.2.2.1 Spin-offs
3.2.2.2 Carve-outs
3.2.2.3 Timing
3.2.3 Price Multiples Effects
3.2.4 Operating Performance Effects
3.2.4.1 Spin-offs
3.2.4.2 Carve-outs

4 Hypotheses on the Value Creation of Spin-offs and Carve-outs .
4.1 Type of Transaction: Spin-offs vs. Carve-outs
4.2 Place of Transaction: European vs. US Transactions
4.3 Strategic Business Portfolio Restructuring
4.3.1 Operating Performance Gains
4.3.2 Strategic Gains
4.3.3 Industrial Focus
4.3.4 Geographical Focus
4.3.5 Incentive Alignment
4.3.6 Independence of Subsidiary
4.3.7 Relative Size of Transaction
4.4 Timing & Financing Needs
4.4.1 Stock Market Timing
4.4.2 Relative Valuation Timing
4.4.3 Operating Performance Timing
4.4.4 Financing Needs
4.5 Outsiders’ Information Asymmetry Reduction

5 Empirical Tests of the Value Creation Effects of Spin-offs and Carve-outs
5.1 Data Sources and Sample of Transactions
5.2 Descriptive Statistics
5.3 Methodology
5.3.1 Stock Market Effects Methodology
5.3.1.1 Object Analyzed
5.3.1.2 Returns
5.3.1.3 Expected Returns
5.3.1.4 Abnormal Returns
5.3.1.5 Statistical Tests for Significance
5.3.2 Operating Performance and Price Multiples Effects Methodology
5.3.2.1 Object Analyzed
5.3.2.2 Measures of Operating Performance and Price Multiples
5.3.2.3 Expected Operating Performance and Price Multiples
5.3.2.4 Abnormal Operating Performance and Price Multiples
5.3.2.5 Statistical Tests for Significance
5.4 Announcement Effect
5.4.1 Type of Transaction: Spin-offs vs. Carve-outs
5.4.2 Place of Transaction: European vs. US Transactions
5.4.3 Robustness
5.4.3.1 Methodology
5.4.3.2 Expected Returns
5.4.3.3 Event Windows
5.4.3.4 Outliers
5.4.3.5 Year by Year
5.4.4 Industrial Focus
5.4.5 Geographical Focus
5.4.6 Independence of Subsidiary
5.4.7 Relative Size of Transaction
5.4.8 Timing
5.4.8.1 Stock Market Timing
5.4.8.2 Relative Valuation Timing
5.4.8.3 Operating Performance Timing
5.4.8.4 Financing Needs
5.4.9 Cross Sectional Regressions
5.4.9.1 Univariate Regressions
5.4.9.2 Multivariate Regressions
5.4.10 Summary and Appraisal of Results
5.5 Long-term Stock Market Effects
5.5.1 Type of Transaction: Spin-offs vs. Carve-outs
5.5.2 Place of Transaction: European vs. US Transactions
5.5.3 Robustness
5.5.3.1 Methodology
5.5.3.2 Expected Returns
5.5.3.3 Outliers
5.5.3.4 Year by Year
5.5.4 Industrial Focus
5.5.5 Geographical Focus
5.5.6 Incentive Alignment
5.5.7 Independence of Subsidiary
5.5.8 Relative Size of Transaction
5.5.9 Timing
5.5.10 Cross Sectional Regressions
5.5.10.1 Univariate Regressions on All Transactions
5.5.10.2 Univariate Regressions on Spin-offs
5.5.10.3 Univariate Regressions on Carve-outs
5.5.10.4 Multivariate Regressions on Spin-offs
5.5.10.5 Multivariate Regressions on Carve-outs
5.5.11 Summary and Appraisal of Results
5.6 Price Multiples Effects
5.6.1 Type of Transaction: Spin-offs vs. Carve-outs
5.6.2 Place of Transaction: European vs. US Transactions
5.6.3 Robustness
5.6.4 Industrial Focus
5.6.5 Geographical Focus
5.6.6 Incentive Alignment
5.6.7 Independence of Subsidiary
5.6.8 Timing
5.6.9 Summary and Appraisal of Results
5.7 Operating Performance Effects
5.7.1 Type of Transaction: Spin-offs vs. Carve-outs
5.7.1.1 Profitability
5.7.1.2 Leverage
5.7.1.3 Growth Rates
5.7.2 Place of Transaction: European vs. US Transactions
5.7.2.1 Profitability
5.7.2.2 Leverage
5.7.2.3 Growth Rates
5.7.3 Industrial Focus
5.7.3.1 Profitability
5.7.3.2 Leverage
5.7.3.3 Growth Rates
5.7.4 Geographical Focus
5.7.4.1 Profitability
5.7.4.2 Leverage
5.7.4.3 Growth Rates
5.7.5 Incentive Alignment
5.7.5.1 Profitability
5.7.5.2 Leverage
5.7.5.3 Growth Rates
5.7.6 Independence of Subsidiary
5.7.6.1 Profitability
5.7.6.2 Leverage
5.7.6.3 Growth Rates
5.7.7 Timing
5.7.7.1 Profitability
5.7.7.2 Leverage
5.7.7.3 Growth Rates
5.7.8 Summary and Appraisal of Results

6 Conclusion
6.1 Summary of Results
6.2 Consequences for Managers’ Decisions on Spin-offs and Carve-outs
6.3 Outlook

Abbreviations

Used Laws and Regulations

References

Appendix

Curriculum vitae

List of Figures

Figure 1: Alternative Types of Corporate Restructuring

Figure 2: Spin-off Formation

Figure 3: Carve-out Formation

Figure 4: Models on Spin-offs and Carve-outs

Figure 5: Overview on Existing Empirical Studies

Figure 6: Hypotheses To Be Tested

Figure 7: Number of Transactions Year by Year

Figure 8: Timeline in Event Time

Figure 9: Announcement: Total Return Index

Figure 10: Announcement: Histogram of CARs

Figure 11: Announcement: Overview on Hypotheses Tested

Figure 12: Long-term Stock Market: Abnormal Returns

Figure 13: Long-term Stock Market: Histogram of BHARs

Figure 14: Long-term Stock Market: Abnormal Returns of European and US Spin-offs and Carve-outs

Figure 15: Long-term Stock Market: Overview on Hypotheses Tested

Figure 16: Price Multiples: Overview on Hypotheses Tested

Figure 17: Operating Performance: Overview on Hypotheses Tested

Figure 18: Value Creation of Spin-offs and Carve-outs

Figure 19: Overview on Hypotheses Tested

List of Tables

Table 1: Tax Neutrality of Spin-offs and Carve-outs

Table 2: Announcement: Literature on US Spin-offs

Table 3: Announcement: Literature on European Spin-offs and Carve-outs

Table 4: Announcement: Literature on US Carve-outs

Table 5: Initial Day of Trading: Literature on US Spin-offs and Carve-outs

Table 6: Long-term Stock Market Performance: Literature on US Spin-offs

Table 7: Long-term Stock Market Performance: Literature on European Spin-offs

Table 8: Long-term Stock Market Performance: Literature on US Carve-outs

Table 9: Overall Hypotheses

Table 10: Pillars of Rationales and Associated Hypotheses

Table 11: Data Sample: Number of Transactions

Table 12: Data Sample: Deal Size

Table 13: Data Sample: 30 Largest Transactions

Table 14: Announcement: ACARs of Spin-offs and Carve-outs

Table 15: Announcement: MCARs of Spin-offs and Carve-outs

Table 16: Announcement: ACARs in European Countries

Table 17: Announcement: Level of Shareholder Protection and Origin of Law

Table 18: Announcement: Alternative Methodologies

Table 19: Announcement: Alternative Expected Returns

Table 20: Announcement: Alternative Event Windows

Table 21: Announcement: ACARs of Spin-offs and Carve-outs without Outliers

Table 22: Announcement: Year by Year

Table 23: Announcement: Number of Focus Increasing Transactions

Table 24: Announcement: Industrial Focus

Table 25: Announcement: Geographical Focus

Table 26: Announcement: Trajectory of Carve-out Subsidiary

Table 27: Announcement: Independence of Subsidiary

Table 28: Announcement: Relative Size of Transaction

Table 29: Announcement: ACARs Depending on Returns

Table 30: Announcement: ACARs Depending on Price Multiples

Table 31: Announcement: ACARs Depending on Profitability and Leverage

Table 32: Announcement: ACARs Depending on Earnings and Revenues CAGRs

Table 33: Announcement: Explanatory Variables for Cross Sectional Analysis

Table 34: Announcement: Univariate Analysis on CARs

Table 35: Announcement: Multivariate Analysis on CARs

Table 36: Long-term Stock Market: Average BHARs of Spin-offs and Carve-outs

Table 37: Long-term Stock Market: Median BHARs of Spin-offs and Carve-outs

Table 38: Long-term Stock Market: Average BHARs in European Countries

Table 39: Long-term Stock Market: Shareholder Protection Level

Table 40: Long-term Stock Market: Origin of Law

Table 41: Long-term Stock Market: ABHAR, ACAR and CAAR

Table 42: Long-term Stock Market: Alternative Expected Returns

Table 43: Long-term Stock Market: Fama-French Three Factor Model: Average

Table 44: Long-term Stock Market: Fama-French Three Factor Model: Median

Table 45: Long-term Stock Market: Fama-French Three Factor Model: Differences .

Table 46: Long-term Stock Market: Average BHARs of Spin-offs and Carve-outs without Outliers

Table 47: Long-term Stock Market: Year by Year

Table 48: Long-term Stock Market: Industrial Focus

Table 49: Long-term Stock Market: Geographical Focus

Table 50: Long-term Stock Market: Parents vs. Subsidiaries

Table 51: Long-term Stock Market: Trajectory of Carve-out Subsidiary

Table 52: Long-term Stock Market: Independence of Subsidiary

Table 53: Long-term Stock Market: Relative Size of Transaction

Table 54: Long-term Stock Market: Raw Returns

Table 55: Long-term Stock Market: Explanatory Variables

Table 56: Long-term Stock Market: Univariate Analysis on BHARs

Table 57: Long-term Stock Market: Univariate Analysis on BHARs of Spin-offs

Table 58: Long-term Stock Market: Univariate Analysis on BHARs of Carve-outs

Table 59: Long-term Stock Market: Multivariate Analysis on BHARs of Spin-offs

Table 60: Long-term Stock Market: Multivariate Analysis on BHARs of Carve-outs . 197 Table 61: Price Multiples: Spin-offs and Carve-outs

Table 62: Price Multiples: Differences between Spin-offs and Carve-outs

Table 63: Price Multiples: Industrial Focus

Table 64: Price Multiples: Geographical Focus

Table 65: Price Multiples: Trajectory of Carve-out Subsidiary

Table 66: Price Multiples: Independence of Subsidiary

Table 67: Profitability and Leverage: Spin-offs and Carve-outs

Table 68: Profitability and Leverage: Differences among Spin-offs and Carve-outs ... 217 Table 69: CAGRs: Spin-offs and Carve-outs

Table 70: CAGRs: Differences between Spin-offs and Carve-outs

Table 71: Profitability and Leverage: Industrial Focus

Table 72: CAGRs: Industrial Focus

Table 73: Profitability and Leverage: Geographical Focus

Table 74: CAGRs: Geographical Focus

Table 75: Profitability and Leverage: Trajectory of Carve-out Subsidiary

Table 76: Profitability and Leverage: Independence of Subsidiary

Table 77: CAGRs: Trajectory of Carve-out Subsidiary

Table 78: CAGRs: Independence of Subsidiary

Table 79: Data Sources

Table 80: Bloomberg Items Definition

Table 81: Price Multiples from T-5 to T+5

Table 82: Profitability and Leverage from T-5 to T+5

Abstract

This study investigates whether 1074 spin-offs and 803 carve-outs occurring in Europe and the USA between 1990 and 2003 create value. There is a robust positive market revaluation of roughly 1.0% to 3.0% for firms announcing a spin-off or carve-out of a subsidiary. This effect is similar for carve-outs and spin-offs, despite their different na- tures. Hence, the analysis on the long-term implications of spin-offs and carve-outs con- sequently unveils substantial differences: While the average spin-off firm outperforms the market, carve-outs considerably underperform. Over time it becomes obvious that spin-offs improve the business itself thanks to the increased independence and the focus on the core business, whereas managers time carve-outs and use them primarily as a cheap mean of funding, one that does not improve the business.

Abstract in German

Diese Studie untersucht, ob 1074 Spin-offs und 803 Carve-outs, die zwischen 1990 und 2003 in Europa und den USA durchgeführt wurden, Wert generierten. Dabei wurde fest- gestellt, dass sowohl Unternehmungen, welche einen Spin-off, als auch Firmen, welche einen Carve-out einer Tochtergesellschaft bekannt geben, aufgrund dieser Ankündigung am Aktienmarkt zwischen 1,0 % und 3,0 % höher bewertet werden. Damit scheint der Markt diese zwei Transaktionstypen ähnlich einzuschätzen, obwohl sie sich in ihrem Wesen substanziell unterscheiden. Die Analyse der langfristigen Auswirkungen von Spin-offs und Carve-outs zeigt tatsächlich beträchtliche Unterschiede auf. Die durch- schnittliche Spin-off-Unternehmung übertrifft die Erwartungen des Aktienmarktes, wäh- rend Carve-out-Firmen wesentlich schlechter abschneiden. Im Laufe der Zeit wird er- sichtlich, dass Spin-offs durch die gesteigerte Unabhängigkeit und die Konzentration auf das Kerngeschäft das eigentliche Geschäft verbessern, während Carve-outs von Mana- gern zu einem günstigen Zeitpunkt primär als günstiges Finanzierungsinstrument ver- wendet werden und das Geschäft an sich nicht verbessern.

1 Introduction

“Smart apple farmers routinely saw off dead and weakened branches to keep their trees healthy. Every year, they also cut back a number of vigorous limbs - those that are blocking light from the rest of the tree or otherwise hampering its growth. And, as the growing season progresses, they pick and discard some perfectly good apples, ensuring that the remaining fruit gets the energy needed to reach its full size and ripeness. Only through such careful, systematic priming does an orchard produce its highest possible yield.”

Dranikoff, Koller and Schneider (2002)

1.1 Motivation

What can managers, investors, academics and the press learn from apple farmers? At first glance, ownership restructurings are, for the press and investors, much less exciting than mergers and acquisitions (M&A). As their empires shrink, managers have few in- centives for ownership restructurings and hence companies have a strong bias against it. Additionally, there is little academic research on the benefits of such restructuring. It is thus not surprising that companies often restructure the ownership of their businesses both too little and too late. In my view, companies have many similarities to orchards – like smart apple farmers, managers should focus on prudent, systematic pruning that means following a regular, proactive program of restructuring. The measures of the management should be directed to expand the crop in the coming seasons, thus enabling them to harvest more than the average and exceed the expected crop.

An overview of the different types of ownership restructuring is given in this paper as well as the value creation of spin-offs and carve-outs. ^[1] Analyzing spin-offs and carveouts is particularly interesting, as they are similar, though there are differences: Spin- offs are pure ownership restructurings, undertaken for value purposes only, whereas carve-outs contain besides the ownership restructuring element also a financing element.

1.2 Research Question and Objectives

The overall research question of this paper is:

Do companies create value for their shareholders by conducting spin-offs and carve- outs?

In order to be able to give a thorough answer to this question this paper has three objec- tives:

1. To present an overview of the strategic, operating, legal, governance, accounting and tax implications of spin-offs and carve-outs in the USA, Germany and Switzerland.
2. To embed spin-offs and carve-outs into the existing principal-agent models and based on this and prior empirical evidence, build hypotheses on the rationales of the value creation of spin-offs and carve-outs.
3. To test the hypotheses by measuring which ownership structure maximizes the value of the business at the announcement and in the long run, and which ownership struc- ture improves the operating performance and the relative valuation of the firm.

1.3 Contribution

A review of the literature shows that as in other areas of finance, most empirical work on this topic as well uses US data, whereas European evidence is scarce. This paper also tests the effects of European transactions. The empirical findings of this paper are based on an extensive data sample of 1,074 spin-offs and 803 carve-outs occurring between 1990 and 2003, a time period that has not yet been broadly investigated in the USA or in Europe. Most of the existing research so far focuses on the announcement effect. This paper measures the value creation of transactions, not only around the announcement, but also analyzes the long-term effects on the stock market, on price multiples and on operating performance of firms involved in spin-offs and carve-outs. For practitioners, the value of this paper is a better understanding of spin-offs and carve-outs, the key dif- ferences between them and the various implications in the USA, Germany and Switzer- land. This research also intends to unveil the key rationales and drivers for the value creation of spin-offs and carve-outs occurring between 1990 and 2003, thereby enabling practitioners to better assess the stock market and operating consequences of spin-offs and carve-outs.

1.4 Demarcation

This paper aims to give an overview of implications of spin-offs and carve-outs. How- ever, for managers conducting a transaction, the support of experienced, local lawyers, tax consultants and auditors or accountants is indispensable. The empirical measure- ment of the value creation in this paper is done only for US and European spin-offs and carve-outs, as the data sample on the other types of public ownership restructuring (split- offs and tracking stocks) is too small. It is not the purpose of this paper to be a “cook- book” for successful spin-offs and carve-outs for managers nor is it an investment guide. This paper neither aspires to make a judgment on the efficiency of the stock markets overall, as the long-term stock market effect analysis in this study suffers (as well as any other study on long-term stock market effects) from the joint hypothesis problem.

1.5 Structure

This paper is structured as follows:

- Chapter 2 describes the fundamentals of ownership restructuring transactions. First, the different types of transactions are defined. Subsequently, an overview on the strategic, operational, legal, governance, accounting and tax implications of spin-offs and carve-outs in the USA, Germany and Switzerland is given. This will provide a better understanding of constraints and implications manager face when planning and conducting spin-offs and carve-outs.
- Chapter 3 presents an overview on models on spin-offs and carve-outs and on the existing research measuring the value creation of that kind of transactions.
- Chapter 4 develops based on the foundation in Chapter 2 and Chapter 3 testable hy- potheses. First the two overall hypotheses that (1) spin-offs create more value than carve-outs and that (2) the value creation of spin-offs and carve-outs is similar in Europe or in the USA are derived. The three pillars of rationales for the value crea- tion of spin-offs and carve-outs, “Strategic Business Portfolio Restructuring”, “Tim- ing & Financing Needs“ and “Outsiders’ Information Asymmetry Reduction” are subsequently presented.
- Chapter 5 focuses on empirical tests of the value creation of spin-offs and carve- outs. It first describes the data and the methodology used and then estimates the value creation effects. It empirically tests the announcement effect, the long-term stock market effects, the effects on price multiples and the effects on the operating performance.
- Chapter 6 concludes by summarizing the results, outlining consequences for manag- ers deciding about spin-offs and carve-outs, and giving an outlook.

2 Fundamentals of Spin-offs and Carve-outs

Chapter 2 intends to describe the fundamentals of spin-offs and carve-outs. First the alternative restructuring transaction types are defined and subsequently strategic, opera- tional, legal, governance, accounting and tax implications arising from spin-offs and carve-outs are discussed.

2.1 Type of Restructuring Transactions

An ongoing task of managers is to monitor, improve and hence restructure their busi- nesses.^[2] Rationales for restructurings are manifold: Lehn and Poulsen (1989) see sig- nificant operating underperformance as rationale while Kaplan (1991) stresses the trig- gering role of stock market underperformance. Mitchell and Mulherin (1986) put em- phasis on fundamental economic shocks in the industry and Jensen (1991 and 1993) argues that the intensifying global competition and changes in technology, input prices, or regulation are main rationales for restructurings.^[3] No matter the rationale for the re- structuring, once managers have ascertained the need for it they have to decide whether businesses require fundamental restructuring to address the value creation shortfall or whether this can be done within the current organizational and management structure. Most restructuring is done internally without changing the ownership structure for in- stance by changing the organizational set-up or reorganizing tasks, processes and/or re- sponsibilities.^[4] If outsiders have a more specialized management, higher synergies with other businesses, or funding is cheaper or available quicker for outsiders, firms may de- cide to facilitate the restructuring by an ownership change.^[5] As depicted in Figure 1, this can be done either by private or public transactions.

illustration not visible in this excerpt

There are three kinds of private transactions: a joint venture with a partner with specific expertise, selling part of the businesses in a trade sale to an outside buyer, or selling it to investors or the management team in a leveraged buy-out (LBO) or a management buy out (MBO).^[6] If there is a clear best owner identifiable and this best owner is not finan- cially constrained, private transactions are probably preferable to public transactions, as the current parent company can then capture a large portion of the future synergy and improvement potential by a takeover premium.

Public ownership restructuring transactions are carried out via the stock market, thus providing publicly available data about the transaction and therefore enable objective empirical tests on the value creation. A split-off is a mechanism that allows shareholders of a parent company to exchange their shares for shares in a subsidiary that is normally majority-owned by the parent firm. A split-off is defined as the redemption of shares in an existing company in exchange for shares in a newly created one.^[7] This method is usually applied as the second step after a carve-out, but has also been used independ- ently to take a private subsidiary public. The split-off of Sara Lee Corporation and Coach Corporation in 2001 is an example of a US split-off. After the transaction, Sara Lee focused on consumer-packaged goods and Coach focused on their production and sales of luxury leather goods.

Tracking stock is a form of common equity that intends to track the performance of a particular line of business within the firm (Billett and Mauer, 2000). Issuing tracking stocks does not create a new legal entity. From a legal point of view, tracking stocks are merely a class of shares with different economic interest such as dividend rights. All other rights and liabilities regarding the parent and the subsidiary company are identical for common and tracking stockholders. Tracking stock is sometimes referred to as “al- phabet stock”, “letter stock”, or “targeted stock”. The names “alphabet stock” and “let- ter stock” arose out of General Motor’s acquisitions of Electronic Data Systems and Hughes Aircraft in the 1980s. Lehman Brothers coined the term “targeted stock” when they assisted USX Corporation with their tracking stock equity restructuring in the early 1990s. Tracking stocks can be distributed through a pro-rata distribution of shares to existing parent shareholders through a spin-off, or to new shareholders through a carve out by an IPO (Chemmanur and Paeglis, 2000; Blanton, Perrett and Taino, 2000).^[8] In October 2000, the French company Alcatel was the first and only European firm issuing tracking stocks for its optimal elements business. Today, only five tracking stocks are still running worldwide.^[9]

This paper focuses on spin-offs and carve-outs. The popular press often does not differ- entiate between spin-offs and carve-outs and labels both kinds of transactions as “spin- offs”. The findings of this paper make it clear that existing and potential investors should carefully analyze the characteristics and structure of “spin-offs”.

2.1.1 Spin-offs

A spin-off is defined as a pro-rata distribution of a majority, (often 80% or more) of shares of the subsidiary to the parent's shareholders.^[10] As a result of a 100% spin-off, the subsidiary^[11] becomes a totally independent company, with initially the same share- holder base as the parent company. Following the transaction, the former parent share- holders own two securities: The shares from the parent company and the shares from the spun-off subsidiary. Hence a spin-off leaves the portfolio decision (of whether to be shareholder of the parent and the subsidiary company or not) up to the shareholders. Unlike carve-outs, a spin-off does not involve exchange of any cash. Thus, a spin-off is not motivated by the company's desire to generate immediate cash, while carve-outs (and trade sales) often become a source of liquidity for financially distressed firms.

In this paper, the term “spin-off” is denoted to mean the divestment of mature busi- nesses, not embryonic venture firms (Roberts, 1991) or university spin-off firms (Autio, 1997). A well-known example of a firm resulting from a spin-off is Syngenta AG, re- sulting from the spin-off and merger of the agrochemical divisions of Novartis and As- traZeneca. Other Swiss examples of spin-offs are Givaudan SA the flavors and fra- grances division out of the Roche Holding Ltd or Ciba Specialty Chemicals Holding AG, which was spun-off by Sandoz in 1997.

A split-up is an alternative type of spin-off in which a company separates into several parts, distributes stock of each part to its shareholders, and ceases to exist. The most well known example is the split-up of AT&T Corporation into three companies in 1996. AT&T Corporation was split-up in AT&T Corporation (national telephone network and cellular services), Lucent Technologies Inc. (communications hardware business and Bell Laboratories) and NCR Corp. (computer manufacturing).

2.1.2 Carve-outs

In an equity carve-out, “a portion of a wholly owned subsidiary’s common stock is of- fered for sale to the public” (Schipper and Smith, 1986) or to say it differently, a carve- out is the sale of shares in a non-listed subsidiary to the markets through an initial public offering (IPO). The shares offered that are sold to new shareholders could be either in a secondary carve-out existing shares owned by the parent company, or in a primary carve-out newly-issued shares sold by the subsidiary itself (Schipper and Smith, 1986).^[12]

In Switzerland Valora Holding 1997 carved-out Selecta AG, its snacks and refreshments vending machines business. In 1999 the Roche Holding AG carved-out in one of the largest IPO ever, 19% of the Biotechnology firm Genentech. Nestle S.A. announced in 2001 and completed in 2002 the carve-out of 23% of the stocks of its eyecare division Alcon. Sulzer AG carved-out in a first step 1997 Sulzer Medica before the remaining 74% of the stocks were given to the shareholders in 2001 in a spin-off. In Germany well-known examples of carve-outs are the carve-out of Infineon Technologies AG out of Siemens AG and of T-Online International AG out of Deutsche Telekom AG. In most of the cases only a minority stake of the subsidiary is carved-out, as this brings along tax and accounting benefits.^[13] However, as in the carve-out of Converium out of Zurich Financial Services in 2001, there exist also 100% carve-outs.

2.2 Strategic Implications

As companies regularly review their portfolios they develop new strategic directions and based on this, decide to carve-out or spin-off subsidiaries.^[14] Sections 2.2.1 and 2.2.2 show that spin-offs and carve-outs are embedded into well-known discussions such as diversification (discount), restructuring and refocusing. As there are many barriers for restructuring transactions, Section 2.2.3 has a focus on this topic.

2.2.1 Diversification

The studies of diversification at the corporate level can be grouped into studies of the link between corporate diversification and firm value that means the diversification dis- count and studies of patterns in corporate diversification over time.^[15] From the 1950s to the 1970s, expansive diversification strategies were pursued, resulting in conglomerates that were active in various business areas.^[16] These growth strategies based on diversifi- cation were mainly influenced by the ideas of Ansoff (1965).^[17] The perception of the capital markets later changed; with the result that throughout much of the last decade, the common wisdom among financial economists has been that diversified firms sell at a discount relative to single-segment firms.^[18]

Three key explanations for this diversification discount can be found. First, it could be that diversification itself destroys value as the drawbacks of diversification overcompen- sate the benefits.^[19] Benefits of diversification include:

1. Managerial economies of scale as multidivisional firms create a level of management coordinating the specialized divisions (Chandler, 1977).
2. Economies of scope, meaning that firm specific assets could be exploited in other industries (Panzar and Willig, 1981; Teece, 1980; Teece, 1982).
3. Coinsurance effects from combining businesses with imperfectly correlated earnings. As a result conglomerates have a greater debt capacity due to this portfolio effect (Lewellen, 1971; Hennessy, 2000).
4. Alleviating adverse selection problems when issuing equity (Hadlock, Ryngaert and Thomas, 2001)

Possible disadvantages of diversified firms are:

1. The opportunities for managers of firms with free cash flow to inefficiently use the excess cash for empire building (Jensen, 1986; Matsusaka and Nanda, 2002).
2. Limited know-how and experience of conglomerates’ managers active in various businesses (Cornell, 1998).
3. Information asymmetries between managers and outside market participants such as analysts as managers have information not available to market participants (Krish- naswami and Subramaniam, 1999). In addition, outside market participants show a lack of understanding for diversified firms; as for example equity analysts are spe- cialized in one industry (Gilson et al., 2001).
4. Information asymmetries between central management and divisional managers add complexity and lead to high costs of coordination (Harris, Kriebel and Raviv, 1982). They also make it difficult to motivate divisional managers by giving them equity participation in the diversified firm (Aron, 1991).

One of the key questions regarding the benefits and drawbacks of diversification is whether internal or external capital markets are more efficient in allocating resources to businesses with good investment opportunities.^[20] Scharfstein and Stein (2000) ascribe the diversification discount to agency problems that are exacerbated within the multidi- visional structure. They show that in diversified firms, divisional managers have an in- creased incentive for rent seeking and subsequently subvert the internal capital alloca- tion decisions. Gertner, Powers, and Scharfstein (2000) examine the investment behav- ior of subsidiary firms before and after they are spun-off. They show that investments after the spin-off are significantly more sensitive to measures of investment opportunities (such as the industry’s Tobin's Q^[21]) than before the transaction. Their findings suggest that spin-offs improve the allocation of capital.

The second explanation for the diversification discount is that the lower value of diversi- fied firms is not causally related, but merely reflects a selection bias. Firms that choose to diversify differ from not diversifying firms in a number of characteristics.^[22] If less valuable firms tend to cluster together into conglomerates, then the fact that the average conglomerate is worth less than a comparable portfolio of single segment firms does not necessarily imply value destruction, as diversified firms were already trading at a dis- count prior to diversifying (Chevalier, 1999; Lang and Stulz, 1994; Servaes, 1996).

A third explanation for the diversification discount are measurement errors such as er- rors in measuring Tobin’s Q (Whited, 2001). Burch and Nanda (2003) and Lamont and Polk (2002) test the three possible explanations for the diversification discount and con- clude that the diversification discounts at least partially reflect a value loss due to the diversified nature of the firm itself, rather than only due to the selection bias or meas- urement errors.

2.2.2 Restructuring and Refocusing

Although the debate whether there is a diversification discount or not goes on, it is obvi- ous that it is demanding to manage a conglomerate due to its complexities, inefficiencies and administrative burdens. Even today, many multi-business groups own assets, which are under-exploited, strategically constrained or for which they are not the best owner. ^[23] Moreover, multi-business groups often face focused competitors with diverging business models, each of which requires different skills and success factors, as they are at differ- ent stages of the lifetime cycle.^[24] This situation, often combined with a performance or a growth issue, triggers a systematic review of company portfolios. Hill and Jones (1998) differentiate between two approaches to review a company’s existing portfolio of busi ness activities: It can either be done with portfolio planning matrices^[25] or by reviewing the company’s core competencies (Hamel and Prahalad, 1990). A more focused strategy is often the result of these corporate portfolio-reviewing processes.^[26] Activities and business lines that do not belong to the core business and hence do not have the required strategic fit get prepared for divestment (Kaplan and Weisbach, 1992). A frequent find- ing is that refocusing raises firm value (Berger and Ofek, 1999).^[27] Public ownership restructuring transactions such as carve-outs and spin-offs can be used to speed up and implement the intended focus (Schipper and Smith, 1983). Hence, that kind of transac- tion has gone from being a technique to eliminate poor performers and has become a mean of unlocking value (Cornell, 1998).

The interdependencies between diversifying M&As and focus improving divestitures have been the topic of many papers. One broadly supported explanation is that firms that had previously diversified with M&As conduct spin-offs and carve-outs.^[28] This might be after acquisitions, where from the beginning, the acquirer was exclusively in- terested in a specific part of the target’s businesses; hence they spin-off the other part. It might also be that the expected synergies do not materialize and the acquirer corrects a former mistake or that the parent company realizes that it does not want to provide the funds required for investments.^[29]

There is also another perspective on the interdependence between M&As and divesti- tures: Dranikoff, Koller, and Schneider (2002) document that companies actively man- aging their business portfolios through both acquisitions and divestitures create substan- tially more shareholder value than companies passively sticking to their existing busi- nesses. Corporations that balance divestitures and acquisitions perform better than com- panies focusing on one or the other. In their view, regularly divesting businesses with missing strategic fit, no matter how good they are, ensures that the remaining units reach their potential and that the overall company grows stronger. They also argue that execu- tives spend too much time on acquiring businesses and not dedicating adequate attention to divesting them.^[30]

2.2.3 Barriers for Restructuring Transactions

One can differentiate between voluntary and mandatory public ownership restructuring transactions, whereas voluntary are much more frequent than mandatory transactions (Achleitner and Wahl, 2003). Barriers for restructuring transactions are only relevant to voluntary transactions.^[31] In mandatory transactions, the firm is obliged to act due to legal or regulatory reasons such as anti-trust laws (Kudla and McInish, 1983). Quasi- mandatory transactions are those where management intends to free up a parent or a sub- sidiary from the other’s regulatory or legal burden (McKenna, 2000). For example if a subsidiary faces significant legal problems, a divestiture may remove the legal uncertain- ties from the parent firm. Additionally, a business or subsidiary may also be divested to prevent the threat of anti-trust accusations.^[32] Krishnaswami and Subramaniam (1999) investigate on the impact of the regulatory status of spin-offs on the announcement effect and find no significant influence. Schipper and Smith (1983) on the other hand show that the announcement effect is slightly bigger for spin-offs associated with regulatory or tax advantages. They conclude that relaxing regulatory or tax constraints can hence be a source of shareholder gains in spin-offs.

More than 75% of divestitures are reactive and often extrinsically motivated (Achleitner and Wahl, 2003; Dranikoff, Koller, and Schneider, 2002). This may be a result from the fact that many firms have a strong bias against divestitures. They divest businesses only reactive to: (1) pressure from the capital markets (Berger and Ofek, 1999) especially takeover threats, negative analysts reports, pressure from blockholders (Bethel and Lie- beskind, 1993), or poor stock market performance (Jain, 1985); (2) poor operating per- formance such as heavy losses; or (3) a parent company's large debt burden (Berger and Ofek, 1999). Boards may also try to circumvent divestitures and keep on holding busi- nesses long after the divestiture is appropriate, in an attempt to avoid creating an image of failure or weakness (Caytas and Mahari, 1988). Therefore it is not surprising that Dranikoff, Koller, and Schneider (2002), Ravenscraft and Scherer (1991), and Markides (1992) show that a recent change in management increases the probability of divesti- tures. Divestitures are also much more probable after takeovers than without corporate control changes (Bhide, 1989; Bhagat, Shleifer, Vishny, 1990). New management often has fewer barriers to undo previously done acquisitions. This is consistent with the ar- guments of Boot (1992) and Cho and Cohen (1997), showing that the new managers can unveil the mistakes of their predecessors. An additional factor against divestitures such as spin-offs is that they reduce the managers’ empires. The result of these different kinds of barriers against divestitures is that companies often sell businesses too late and hence at too low prices.^[33]

2.3 Operational Implications

Spin-offs and carve-outs differ substantially in terms of their operational implications. Spun-off subsidiaries are fully independent of their parents and hence have clear goals and decision processes. As an independent company, they lose potential synergies with the parent company. However, as parents and subsidiary firms often are active in dispa- rate lines of businesses with different business environments, the synergy potential is limited and parents and subsidiaries’ managers face different operational and strategic challenges (Kudla and McInish, 1983). Thus the benefits of independence often out- weigh the disadvantages: Both firms involved in spin-offs can focus on their business and no longer have to concern themselves with the others’ business. As there are no conflicts of interest with the parent, spun-off subsidiaries can approach competitors of their former parent as customers, suppliers or partners more easily. They also benefit from full operational and strategic freedom. On the one hand, spun-off subsidiaries lose access to the internal capital market of their former parent firm. On the other hand, they can use external financing opportunities that are tailored to their needs. Additionally, their listed stock is an attractive currency for acquisitive growth.

The day-to-day business of carve-out subsidiaries, in contrast, is still heavily influenced by the strong, existing link to the parent firm. The fact that carve-outs enable employee stock option plans that improve management incentives and that the synergies with the parent company can be exploited further, are two advantages of this transaction type. However, there are many disadvantages of carve-outs if only a minority stake is carved- out. The major weakness of carve-outs is the potential for operating conflicts between the two companies. The problem is created because the managers of the carved-out sub- sidiary firm have a new group of financial stakeholders who have different goals, re- quirements and interests than the original stakeholder (McKenna, 2000). This conflict can lead to sub-optimal decision-making and may hinder the performance of either firm. Additionally, the parent company still owning the majority of shares in the subsidiary cannot fully focus on its own business, as they are still concerned about the operational performance and strategic moves of the subsidiary. Subsidiary’s management has to fulfill the expectations of their strongest shareholder and therefore has not the full free- dom to act. Potential customers, suppliers and partners are aware of this and hesitate to set-up long-term contracts with the carved-out subsidiary. Thus, carve-outs bring along conflicts of interest, limited strategic flexibility, an unattractive acquisition currency and limited access to suppliers and customers. As a consequence, the lack of separation between the two entities prevents the subsidiary as well as the parent firm from fully reach- ing its potential.

2.4 Legal Implications

The process of a spin-off or a carve-out starts with organizational restructuring that means preparing the internal separation such as business processes, reporting lines etc. (Blanton, Perrett and Taino, 2000). The process depends on the pre-transaction struc- ture of the parent firm; whether there is a group structure with separate legal entities, or whether there is only one legal entity organized according to Strategic Business Units (SBUs).

2.4.1 Spin-offs

Figure 2 gives an overview of the situation before and after a spin-off. If the parent firm is organized in a group structure before the transaction, the spin-off consists mainly of the distribution of shares in the spun-off subsidiary to its own shareholders and the con- current listing of the subsidiary shares on a stock exchange. If the parent firm has a SBU structure before the transaction, the parent firms can create a legal entity for its subsidi- ary and distribute the shares of this subsidiary to its own shareholders in Germany and Switzerland in one step. In the USA in contrast, parent firms first have to create a sepa- rate legal entity for the subsidiary, before the shares of this subsidiary can be distributed to the parent company shareholders.

Figure 2: Spin-off Formation

illustration not visible in this excerpt

2.4.1.1 USA

Suchan (2004) points out that spin-offs are a two-step process in the USA, if the subsidi- ary is not a separate legal entity yet. In the first step, the parent company founds a new company and transfers the subsidiary’s business to this new legal entity in exchange for all of the new entity’s outstanding stock. The corporate law requirements for this trans- fer are identical with those for any formation of a corporation. The second step of a spin-off in the USA is the distribution of the subsidiary shares to the parent shareholders through a pro-rata dividend so that the parent shareholders own two securities - the shares of the parent company as well as the shares of the subsidiary company (Blanton, Perrett and Taino, 2000). To this dividend the same corporate law limitations as to any other dividend apply (Suchan, 2004).

According to Glover (2002) and the Bulletin No. 4 of the SEC, a subsidiary company does not need to register the shares of the spin-off with the SEC if it meets the following conditions of the Securities Act of 1933: (1) The parent shareholders do not provide consideration for the spun-off shares; (2) the spin-off is pro-rata to the parent sharehold- ers; (3) the parent company provides adequate information about the parent and the sub- sidiary company to its shareholders and to the stock markets; (4) the parent has a valid business purpose for the spin-off; and (5) the spun-off shares are not restricted securities. If the parent spins-off restricted securities, it must have held those securities for at least two years, unless it formed the subsidiary being spun-off. When the parent is a public company, though, the subsidiary's securities must be registered under the Securities Ex- change Act of 1934. The parent must distribute an information statement describing the spun-off company and the transaction to its stockholders and must also include pro- forma financials.^[34] Moreover, the parent company has to provide an audited financial statement of the subsidiary company on a standalone basis. The subsidiary company itself has to file a form 10 with the SEC. This includes a description of the risk factors, capitalization table, business description, management section and selected financials.

At the same time as the spin-off takes place, the subsidiary company’s stocks usually will become listed at a stock exchange in order to ensure a liquid and efficient secondary market. The parent company and the subsidiary company may also choose to trade on different exchanges. Under the Securities Act of 1933, the subsidiary company must disclose, as in any public offering of securities, a registration statement on form S-1^[35] to the SEC. A company making a public offering is exempted from filing an S-1 form only if it has been filing annual (10-K) and quarterly (10-Q) reports with the SEC for at least three years and meets additional criteria.

As stated in Glover (2002), spin-off parent and subsidiary firms often enter into a spin- off agreement defining the spin-off dividend. This agreement may also assign the assets to the company to be spun-off and liabilities between the parent and the subsidiary. As- sets and liabilities have to be assigned in a way that ensures that both firms involved have all the assets they need to carry on their businesses and that they will bear primary responsibility for the liabilities associated with their businesses. The agreement may also include arrangements under which the parent or the subsidiary makes payments or provides guarantees and indemnities to the other company. The parent and the subsidi- ary to be spun-off may also enter into supply, distribution and marketing arrangements and technology licensing agreements. In addition, they may enter into agreements under which the parent will continue to provide the subsidiary with administrative services— such as accounting, legal and other similar services—for a specified period following the completion of the transaction. The parent and the subsidiary to be spun-off may enter into tax sharing agreements. Finally, they may enter into covenants not to compete un- der which the parent and spun-off company set forth the limits on their freedom to com- pete.

2.4.1.2 Germany

There are two different approaches to conduct a spin-off in Germany. Prior to January 1st 1995, the only possibility to conduct a spin-off was the spin-off with transfer of a singular title (“Spaltung mit Einzelrechtsübertragung ^[36]”). That means a two-step ap- proach, by first transferring assets into an existing or new wholly owned subsidiary and then distributing the stock of this subsidiary to the parent company’s shareholders.^[37] The German Corporate Reorganization Act (“Umwandlungsgesetz”), which will be the focus of this section, provides a second new method. The German Corporate Reorgani- zation Act’s goal is to reduce formalities when a legal structure is changed. Hence, UmwG permits the process of reorganization to take place by way of universal succes- sion (“Gesamtrechtsnachfolge”). The Corporate Reorganization Act offers three possi- bilities: “Aufspaltung”, “Abspaltung” or “Ausgliederung”. An “Aufspaltung”, accord- ing to section 123 (1) UmwG, refers to a split-up, where the initial company ceases to exist. An “Ausgliederung” is the transfer of part of the assets of the entity to a new or existing other corporation in exchange for stock in this corporation. An “Abspaltung”, according to section 123 (2) UmwG, is equivalent in economic terminology to a spin-off or split-off. The Corporate Reorganization Act differentiates between symmetric and asymmetric distribution of rights to parent company shareholders. Symmetrically (as in spin-offs) means that shareholders of the parent firm receive shares in the subsidiary firm proportional to their previous participation, while in an asymmetrical allocation (as in split-offs), the rights are not distributed proportionally to the participation in the par- ent company before the transaction.

Achleitner and Wahl (2003) show that transactions according to the Corporate Reor- ganization Act consist of three key steps:

1. Preparatory phase
- Spin-off plan and spin-off contract (sections 4, 6 and 7 UmwG)
- Spin-off report
- Spin-off audit (sections 9 to 12 UmwG)

2. Decision phase
- Spin-off decision (sections 13 to 15 UmwG)
- Special rules

3. Execution phase
- Application for registration of the spin-off (sections 16, 17 and 19 UmwG)
- Registration of the spin-off (sections 21 UmwG)
- Disclosure of the spin-off (sections 22, 23, 25 and 26 UmwG)

Once the transaction becomes effective, the parent company no longer has legal liability, as the rights, duties, assets and liabilities are transferred to the subsidiary company to- gether with the subsidiary company’s equity. However, the parent company remains jointly liable with the subsidiary company for the first five years for any transferred li- ability. According to Achleitner and Wahl (2003), a capital reduction is usually required when equity is transferred to the subsidiary company. This can be done in a simplified manner, as detailed in section 145 (1) UmwG. One can conclude that the Corporate Reorganization Act enables spin-offs in Germany to be conducted in a simplified man- ner. The spin-off of Takkt AG out of Gehe AG and Celanese AG out of Hoechst AG (the first spin-offs according to the new law) gave objective evidence for this assump- tion.^[38]

In terms of disclosure, it is required to register the spin-off in the Commercial Registers of the parent as well as the subsidiary company (sections 130, 125 and 20 UmwG). A mandatory report on the transaction must detail legal and commercial information and justification of the transaction (sections 4, 6, 7 and 127 UmwG). Also required is an external auditor who prepares a report (sections 9 to 12 UmwG). As in other countries, the subsidiary company’s stocks generally will be listed at a stock exchange. The listing requirements are the same as for any IPO and are specific to the selected stock ex- change. Three key documents defining conditions for a listing at a German stock ex- change are the Prospectus Ordinance, the Stock Exchange Admission Regulation and the Exchange Act.^[39] The listing regulations of exchanges all over Europe (including Swit- zerland) are heavily dependent on the relevant directives of the European Union of which the Admission Directive, the Prospectus Directive and the Interim Reports Direc- tive.^[40]

2.4.1.3 Switzerland

Since the end of the 1990s, there were several spin-off transactions in Switzerland for instance Sandoz spun-off Ciba SC, Novartis spun-off Syngenta, Algroup spun-off Lonza and Roche spun-off Givaudan. The legal situation at that time was ambiguous. The commentary on the Swiss Merger Act (BEFusG 2000) states that spin-offs were not foreseen in Swiss legislation and were therefore illegitimate. As of July 1, 2004, the formation of spin-offs, split-ups, split-offs and the first step of carve-outs were regulated in the Swiss Merger Act (“Fusionsgesetz”).

The Merger Act differentiates between “Abspaltung” and “Aufspaltung”.^[41] According to section 29b FusG, an “Abspaltung” is when the parent company transfers part of its assets and liabilities to other companies (Riedweg, 1998). The shareholders of the par- ent company then receive shares of the corresponding subsidiary company. Since not all assets and liabilities are disposed of, the parent company continues to exist and is left with some of its original assets and liabilities. This characterization corresponds to the definition of a spin-off or a split-off given in Section 2.1.1. According to section 29a FusG, an “Aufspaltung” (which is, according to the definition given in section 2.1.1 a split-up) is when the parent company divides all of its assets and liabilities into two or more parts. They may transfer these to other companies in which the shareholders of the parent company then receive a corresponding share (Reich, 2000). At this stage, the parent company is dissolved and deleted from the Commercial Register.

The regulation of these two types in the Swiss Merger Act is very similar. This paper focuses on the more relevant area of „Abspaltung“, as there are many more spin-offs and split-offs than split-ups.^[42] As in the German Corporate Reorganization Act, the Swiss Merger Act also differentiates between symmetric (i.e., spin-offs) and asymmetric (i.e., split-offs) allocation of participation and voting rights to parent company share- holders (section 31 (2) lit. a and b FusG; ESTV, 2004).

According to Von der Crone et. al (2004a), the procedure of a spin-off or split-off re- quires the following documents and decrees:^[43]

- The executive bodies of the involved companies shall establish in writing a spin-off contract (section 36 (1) FusG).
- A spin-off plan has to be prepared by the executive bodies of the involved compa- nies if the parent company intends to transfer parts of its assets and liabilities to companies that will be newly established (section 36 (2) FusG).
- The assets and liabilities to be transferred with the spin-offs shall be listed in an inventory and the employment contracts shall be specified (section 37 lit b FusG).
- In either a commonly or separately edited and written spin-off report, the executive bodies of the involved companies shall explain and clearly state the reasons for the planned transaction (section 39 FusG).
- A qualified auditor must examine the balance sheet, the spin-off agreement and the spin-off report. These documents, together with the corresponding final reports, shall be subsequently disclosed (section 40 FusG).
- Upon consent of the general meeting and its required quorum, the spin-off takes effect with the entry into the Commercial Register and all assets and liabilities are transferred to the subsidiary company (“partielle Universalsukzession” Sections 43, 51 and 52 FusG).

Watter and Reutter (2002) show that there are different possibilities to transfer shares of the subsidiary company from the parent company to the its shareholders in Switzerland:

- Through a capital increase of the subsidiary company and a transfer of the rights issue from the parent company to its shareholders (as it was done in the spin-offs of Ciba SC and Lonza).
- Through the issue of new subsidiary company shares (Givaudan).
- Through the issue of new subsidiary company shares linked with a capital reduction of the parent company (Sulzer Medica).
- Through the issue of rights issues to the parent company shareholders, enabling them to buy subsidiary company shares at nominal value from the parent company (Syn- genta).

As the transaction takes place, the subsidiary company’s stocks simultaneously will be listed at a stock exchange, accomplishing the normal legal requirements of a listing.^[44] The respective regulation in Switzerland, such as the duty to publish a prospectus and the prospectus liability, is covered in the sections 652a, 1156 and 752 of the Swiss Code of Obligations (CO) and the section 32 of the Listing Rules of the SWX Swiss Stock Exchange (SWX).^[45] A stock exchange listing involves a number of far-reaching obliga- tions for issuers.^[46] Spin-off subsidiary companies usually qualify as an exception to the listing requirement that an issuer must have been in existence for three years (section 7 LR and Directive on Exemptions from the “Three-Year Rule” of the SWX). Another issue, which is more severe for spin-offs than for other IPOs, is the flow-back pressure.^[47]

2.4.2 Carve-outs

Elsas and Löffler (2001) document that carve-outs, in comparison to trade sales and spin-offs, are a specific type of asset sales with distinguishing features. New sharehold- ers are public ones and dispersed as opposed to a single buyer in a trade sale. In addi- tion, carve-outs always generate cash, either for the parent or the subsidiary company. While a trade sale also raises funds, this does not hold true for spin-offs. An important legal difference between carve-outs, as compared to trade sales and spin-offs, is the re- quired constitution of a separate legal entity before the transaction, even if the parent firm has a SBU structure (Figure 3).

Figure 3: Carve-out Formation

illustration not visible in this excerpt

As pointed out by Allen and McConnell (1998), although the parent often still holds significant stakes in the subsidiary after the IPO, management of the parent company has lost significant control rights. The subsidiary has its own management, is subject to dis- closure requirements and underlies the mechanisms of the market for corporate control.

According to Rossetto, Perotti, and Kranenburg (2002), carve-outs seem to be especially transitory and part of a dynamic strategy. Within two to six years after the transaction, most of the carved-out subsidiary firms have ceased to exist.^[48] Carve-outs can hence be seen as a real options; either as a ”call option to reacquire” or a ”put option to sell or spin-off” (Rossetto, Perotti, and Kranenburg, 2002). The “dynamic strategies” of Euro- pean incumbent telecommunication companies regarding their Internet Service Providers divisions are good examples showing the optionality of carve-outs: Deutsche Telekom, France Télécom and Telefónica first issued the options by carving-out minority stakes in their T-Online, Wanadoo and Terra Lycos divisions during the tech boom in the end of the 1990s, when these businesses were very aggressively valued. After the subsequent decline in stock market prices particularly in these businesses, they are exercising their call options by reintegrating these divisions (i.e., buying back the shares) in 2003 and 2004 for much lower prices.

2.4.2.1 USA

In carve-outs, the particular line of business is first consolidated into one subsidiary by transferring the assets and liabilities related to this line of business to a separate, eventu- ally newly-founded legal entity. Parts of the shares of the subsidiary company are then sold to public investors in an IPO.

Primary Carve-out vs. Secondary Carve-out As depicted in Figure 3, in a primary carve-out, the subsidiary sells newly issued sub- sidiary company stocks to outside investors via an IPO. The parent is not a direct party of the offering, although its fractional ownership in the subsidiary company decreases. The proceeds of the IPO go to the subsidiary, and can be used (1) to pay off loans espe- cially those owed to the parent, (2) to retire debt incurred to finance a special cash divi- dend previously paid to the parent or (3) to finance its own development.

In a secondary-share offering, the parent company sells shares in the subsidiary in an IPO to new shareholders. Hence the proceeds of the IPO go to the parent firm (Blanton, Perrett and Taino, 2000). However, in many cases a combination occurs, that means the parent sells part of its holdings and the subsidiary raises new equity. After the carve-out, the parent shareholders continue to own their share in the parent company and indirectly a reduced part of the subsidiary. Such a partial carve-out may allow the parent company to keep the benefits of tax pooling and could be used as a first step towards a tax-free spin-off or split-off.

Carve-out followed by a spin-off

As described in Low (2002) and Blanton, Perrett and Taino (2000), there has been a noticeable trend in the USA towards two-step spin-off transactions. Parent firms first sell up to 20% of the shares in the subsidiary in a carve-out and after a seasoning period, the parent company distributes the remaining ownership stake in the subsidiary company (pro-rata in a spin-off to parent company shareholders).^[49] A recent example of such a two-step spin-off is the carve-out by Motorola in mid of 2004 of less than 10% of its semiconductor unit Freescale and the subsequent spin-off of the remaining stake in De- cember 2004. After the spin-off, Motorola will no longer own any shares of Freescale Semiconductor and Freescale will be a fully independent, publicly traded company. The 20% limit is usually observed in the first step in order to preserve the tax-free status of the transaction (according to section 355 IRC).^[50] The advantage of this two-step spin- off is that using the carve-out as the first step enables dedicated equity analyst coverage of the subsidiary company before the full spin-off. Additionally, market making sup- ports the subsidiary company shares and this procedure limits the flow-back pressure by creating a natural investor base.^[51] On the contrary, a one-step spin-off is a more simple transaction for the parent company that guarantees a quick execution and is less depend- ent on the capital markets environment, as the parent company does not cash-out on any stake in the subsidiary company. Hence a two-step spin-off will typically be a more complex and a longer process, as it is a combination of two transactions; however, it may help better prepare for the ultimate separation.

2.4.2.2 Germany

The first step for German carve-outs is the transfer of assets and liabilities (“Ausglied- erung” based on Section 123 (3) UmwG). The second step is a public sale in an IPO.^[52] As stated in Semler and Stengel (2003), companies can, by one single act, transfer all or part of their assets and liabilities to another legal entity. This transfer does not formally affect the shareholders of the parent company, as the shareholders keep their positions in the parent company without becoming shareholders in the subsidiary company. As stated in section 123 (3) UmwG, the assets and liabilities can be transferred to an exist- ing or a new company. According to Semler and Stengel (2003), the main difference of an “Ausgliederung”, as compared to an “Aufspaltung” or an “Abspaltung”, is that there is no capital reduction in the parent company and that there is no external audit required (section 125 UmwG).^[53]

The factors to be taken into account for the second step of a carve-out will generally be those relating to a listing of any company (see 2.4.1.2). The rights issues of the parent company shareholders to subscribe for the subsidiary company equity issue must first be removed. As in any IPO, there is the mandatory publication of an IPO prospectus. The board of the parent company must disclose its decision for the transaction as soon as the decision is made. The listing and registration requirements are usually specific to the selected stock exchange.

2.4.2.3 Switzerland

As in the USA and in Germany, equity carve-outs in Switzerland involve a two-step le- gal process. The first step is the transfer of assets and liabilities (“Vermögensübertra-gung”, according to Section 68 FusG) and the second step is the public sale in an IPO. As stated in Von der Crone et al. (2004b), the newly instituted transfer of assets and li- abilities allows a company registered in the Commercial Register to transfer, by one sin- gle act, the so called ”universal succession”, transferring all or part of its assets and li- abilities to another legal entity. The transfer of assets and liabilities does not formally affect the shareholders of the parent company; the shareholders keep their positions in the parent company without becoming shareholders in the subsidiary company. A trans- fer of assets and liabilities is based on the transfer contract (section 70 and 71 FusG), and the assets and liabilities to be transferred must be inventoried. The inventory is not only the basis of the transfer of assets, but also defines its scope and extent. The transfer becomes legally binding upon entry in the Commercial Register. To protect creditors and employees, the transferring company is jointly and severally liable with the absorb- ing company for the transferred liabilities for three years (section 75 FusG). The re- quirements regarding disclosure are limited (section 74 FusG): The parent company shareholders must be informed about the transfer of assets and liabilities, including its conditions. If the transferred assets and liabilities account to less than 5% of the parent company’s total in the balance sheet, there is no duty of disclosure.^[54] The second step of a Swiss carve-out is then a normal IPO. As in the USA and Germany, either the parent or the subsidiary company can sell the shares at the IPO.

2.5 Governance Implications

In order to better understand the specific governance implications of spin-offs and carve- outs, first an overview of the leading governance principles in the USA, Germany and Switzerland is presented.^[55]

In Switzerland, the board of directors (as required in the Code of Obligations) is a uni- tary board. It is therefore similar to the one-tier system of Anglo-Saxon law and differs from the two-tier system embodied in German law. In Switzerland, the division of func- tions between the executive and supervisory board reduces the tasks of the latter to es- sentially a monitoring role.^[56] On the other hand, the US system is significantly more flexible and leaves the company considerable freedom to apportion powers between the board and the management.^[57] The Swiss Code of Obligations also leaves considerable organizational discretion to the board. Only the responsibility for key areas of the board of directors (listed in section 716a Code of Obligations) cannot be delegated upwards, that means to the annual general assembly, or downwards, to the executive management. In Germany, a dual board system is legally prescribed for stock corporations: the man- agement board is responsible for managing the enterprise.^[58] Its members are jointly ac- countable for the management of the company. The supervisory board appoints, super- vises and advises the members of the management board and is directly involved in de- cisions of fundamental importance to the company. Specific to Germany is the co- determination of the supervisory board; half of the members of the supervisory board must be labor representative.^[59] Through co-determination, employees are thus guaran- teed a significant voice in the process of corporate decision-making in Germany.^[60]

The key point regarding governance implications of spin-offs and carve-outs is whether the transaction requires shareholder approval or not.

2.5.1 Spin-offs

2.5.1.1 USA

According to the SEC (2004) and Blanton, Perrett and Taino (2000), shareholder ap- proval is not a formal requirement in the USA for spin-offs since a spin-off is a dividend distribution; only the approval of board of directors is needed. However some state laws require shareholders vote if all or most of the assets of the parent company are distrib- uted. Glover (2002) states that in making its decision, the board must fulfill its fiduciary duties of good faith and due care in designing and effecting the transaction. If it satisfies this requirement, it will ordinarily enjoy the protections of the business judgment rule. As said by Blanton, Perrett and Taino (2000), the parent company installs a board of directors for the subsidiary company in US spin-offs prior to the transaction. The sub- sidiary company board is subject to the normal shareholder approval and confirmation after the transaction. The board members of the subsidiary company are appointed at discretion of the parent company. However, to benefit from tax exemption, none of par- ent company’s directors or officers may serve as director or officer of the subsidiary company.

2.5.1.2 Germany

The Corporate Reorganization Act explicitly regulates that both the parent and the sub- sidiary firms’ shareholders must approve a spin-off, split-off or a split-up by a three- quarters majority of the share capital represented at the respective shareholders’ meet- ings (sections 125 (1), 13 (1) and 65 (1) UmwG). Having this approval, the parent com- pany, as the sole shareholder of subsidiary company prior to the spin-off, can appoint new shareholder representatives to the supervisory board of the subsidiary company. These members will only be appointed until the next annual general meeting of the sub- sidiary company, at which subsidiary company shareholders can appoint new supervi- sory board members. The composition of the supervisory board under the German Co- Determination Act must be confirmed in a special proceeding in accordance with section 97 of the Stock Corporation Act. The subsidiary company employees in Germany, in accordance with the provisions of the Co-Determination Act, elect the employee repre- sentatives to the subsidiary company supervisory board.

2.5.1.3 Switzerland

In terms of decision making (according to sections 36 (3) and 43 FusG and Watter and Reutter, 2002) for Swiss spin-offs, split-offs and split-ups, the general assembly shall resolve all issues regarding the transaction i.e., the general assembly has to approve the contract and plan. An asymmetrical split-off or split-up requires the consent of at least 90% of all shareholders (section 43 (3) FusG). Upon consent by the general meeting, with the required quorum, the spin-off takes effect with the entry into the Commercial Register. In case of a split-up, the parent company is simultaneously deleted. The new Swiss Merger Act does not comment on the board composition, so the normal rules ap- ply, hence the general assembly elects the supervisory board members.

2.5.2 Carve-outs

2.5.2.1 USA

According to Blanton, Perrett and Taino (2000), the factors to be taken into account for carve-outs will generally be those relating to the listing of any company. That means there is no formal requirement for shareholder approval, unless the shares sold represent all or almost all of the parent company shares. The parent company installs or confirms the board of directors of the subsidiary company prior to the listing.^[61] As stated in Blanton, Perrett and Taino (2000), nomination of independent non-executive directors to represent interests of minority shareholders is required. The subsidiary company board members are then formally appointed at the discretion of the parent company as the par- ent company usually still has the majority of votes. Practically, however, the composi- tion should reflect the new shareholding structure.

2.5.2.2 Germany

The general assembly of the parent as well as of the subsidiary company must approve the first step of a carve-out, the transfer of assets and liabilities by a three-quarters ma- jority of the share capital represented at the respective shareholders’ meetings (Sections 125 (1), 13 (1) and 65 (1) UmwG).^[62] For the second step of the transaction, the IPO, the general assembly of the parent company must agree if the carve-out reflects a consider- able share of the parent company (Trapp and Schick, 2001). The definition of consider- able share is not clear; according to Achleitner and Wahl (2003), it is in the range of 8.5% to 25% of the revenues, equity or the assets or liabilities. If the carve-out is con- ducted as a secondary carve-out, the shareholders of the parent company must get rights issues. The suspension of rights issues by the general assembly is possible but requires specific factual justification. Trapp and Schick (2001) state that there are no other addi- tional rights for the shareholders of the parent company in an IPO of a subsidiary com- pany. The supervisory board election of the subsidiary company takes place according to the normal German process including co-determination of employees (according to the German Co-Determination Act); the listing requirements are the same as for any IPO and specific to the selected stock exchange.

2.5.2.3 Switzerland

A transfer of assets and liabilities is based on the transfer contract to be concluded by the executive body of the involved legal entity (section 70 FusG and Von der Crone et al., 2004b). The transfer of assets and liabilities does not require approval by the sharehold- ers of the parent company. Regarding the IPO, the second step of a carve-out the gov- ernance requirements depend on whether it is a primary or a secondary carve-out. As already stated in section 2.5.1.3, the Swiss Merger Act does not comment on the board composition. Therefore, the normal rules apply that the general assembly elects the su- pervisory board members.

2.6 Accounting Implications

National and international accounting standards may have significant implications on the choice of divestiture methods. One of the key issues is that if more than half of a sub- sidiary company shares are carved-out or given to the initial shareholders in a spin-off, the subsidiary company no longer can be consolidated (Anslinger et al., 1997).

2.6.1 US GAAP

In determining the annual profit, the US Generally Accepted Accounting Principles (US GAAP) differentiate between continuing and discontinuing operations.^[63] A subgroup of the discontinuing operations are the discontinued operations, which cover business areas of the parent company that were already given up or for which a concrete, formal plan exists to give it up (APB, 1973b; and Boadnarine, 1995). Business areas for which an equity carve-out, spin–off, split-off or a split-up is planned, therefore have to be classi- fied in the books of the parent company as discontinued operations. As such, the par- ent's current and prior financial statements are recast so that the income or loss from the operations of the discontinued segment is reported (net of tax) on the face of the income statement as a component of income before extraordinary items.^[64] The deadline for changing the accounting for businesses that are planned for public ownership restructur- ing transactions is the point of time when the management decides the restructuring measure (Bertschinger, Haag, Marty, 1997). Starting from this point, US GAAP defines detailed, specific valuations methods and other instructions.^[65]

2.6.2 IFRS

International Financial Reporting Standards (IFRS) formerly known as International Accounting Standards (IAS) classifies business areas foreseen for public ownership re- structuring transactions as “discontinuing operations”.^[66] Section 35 IAS is a presenta- tion and disclosure standard (PWC, 2004). It aims to establish a basis for separate in- formation about a major operation that the firm is discontinuing from information about its continuing operations and (2) to specify minimum disclosures about the discontinuing operation. It focuses on how to present a discontinuing operation in the parent com- pany’s financial statements and what information to disclose. Contrary to US GAAP, IFRS does not establish any new principles on how to recognize and measure the in- come, expenses, cash flows, and changes in assets and liabilities relating to discontinu- ing operations. It instead requires from the companies to follow the general principles of IFRS (PWC, 2004). Under section 35 IAS, initial disclosures about a discontinuing operation must be included in the financial report in the period in which the initial dis- closure event for that discontinuing operation occurs. Those disclosures must then be updated in subsequent reporting periods (PWC, 2004). Further impairment may become evident in the course of carrying out the plan. The entity should re-estimate the recover- able amount of the assets and recognize any additional impairment loss or where appro- priate any reversal.

2.6.3 German Commercial Code and German GAAP

In contrary to US GAAP and IFRS, the German Commercial Code (“Handelsgesetz- buch”) and German Generally Accepted Accounting Principles (German GAAP) do not have regulations about disclosure before and during the transaction. Only the reporting after the transaction is regulated to acknowledge the method and the circumstances of the transaction. According to section 17 (2) UmwG, the parent company is obliged to generate a closing balance sheet and eventually an intermediate balance sheet in order to get an entry into the Commercial Registry. The subsidiary company has two options for the valuation of assets and liabilities: Either with book value as in the closing balance sheet of the parent company or with the purchasing cost including a premium (section 253 (1) HGB).^[67] Details of the German Commercial Code are not discussed in this pa- per as the EU regulation 1606/2002 issued on July 19, 2002 requires listed companies throughout the European Union to use IFRS by 2005.^[68]

2.6.4 Swiss GAAP ARR

Similar consequences as the EU regulation for EU-listed companies have instructions of the SWX for companies listed in Switzerland. In 2002 to make the financial statements of these companies more easily comparable, the SWX required that financial statements of companies (listed on the main trading segment of the SWX) must be prepared in ac- cordance with IFRS or US GAAP in order to be admitted to listing from 2005 on- wards.^[69] Therefore this paper does not comment on the implications of public ownership restructuring transactions in Swiss Generally Accepted Accounting Princi- ples/Accounting and Reporting Recommendations (Swiss GAAP ARR).

2.6.5 Spin-offs

2.6.5.1 US GAAP

Blanton, Perrett and Taino (2000) and Maydew, Schipper and Vincent (1999) show that the accounting impact associated with a distribution of shares are not onerous to either the parent or the subsidiary. The parent will record the spin-off at book value adjusted for any impairment of value and will not recognize a gain or loss. Stockholders’ equity will decrease by the net amount recorded on the parent’s balance sheet for the assets and liabilities of the subsidiary. The subsidiary company itself is then required to prepare its own financial statements, including all required disclosures. The spun-off subsidiary company’s accounts remain at historical cost amounts. The spin-off does not trigger the need for adjustments to fair values; hence no goodwill is created (Blanton, Perrett and Taino, 2000).

2.6.5.2 IFRS

Spin-off transactions, where ownership of the discontinuing operation is transferred to the entity's existing shareholders, could be viewed as a different form of a sale of opera- tions or abandonment (PWC, 2004). These transactions should be accounted for as business reorganizations. According to section 27 IAS, a subsidiary is no longer con- solidated from the date when the parent no longer has control. Gains or losses on the disposal of a subsidiary are calculated by comparing the proceeds received to the carry- ing amount of the parent's share of the subsidiary's net assets, including any goodwill (PWC, 2004). However, as there are no proceeds in a spin-off, there is by using IFRS as by using US GAAP no goodwill created.

2.6.6 Carve-outs

2.6.6.1 US GAAP

If the public offering price of the subsidiary stock is greater (less) than the book value in the parent books, the financial statement of the parent company will reflect a gain (loss) net of direct transaction costs (Blanton, Perrett and Taino, 2000). The parent company can elect to record such a gain (loss) in its income statement or directly to the sharehold- ers' equity. Hand and Skantz (1999a) find that the majority of the parent firms book the gain on their income statement, which leads that parents’ net income in the year of the transaction will likely overstate the operating performance. If reported on the income statement, the gain (loss) should be presented as a separate line item in the income statement and be clearly designated as non-operating income. The accounting does not change if a cash dividend is paid to the parent prior to the carve-out by the subsidiary. Such a dividend could affect the size of the gain or loss reported by reducing the par- ent’s carrying value in the subsidiary shares. The parent will also be required to provide for income taxes that are immediately payable and perhaps record deferred taxes on any gain depending on its future plans. As stated in Anslinger et al. (1997), selling more than 50% of the voting interest in the subsidiary company results in deconsolidation for financial reporting purposes. If the parent company’s interest were between 20% to 50%, the parent would account for its holding under the equity method and for less than 20%, the parent would use the cost method of accounting for the carved-out subsidiary company.

2.6.6.2 IFRS

According to PWC (2004), carve-outs, where parents retain control, can be treated as disposal of a partial interest. This requires the elimination of an appropriate proportion of not amortized goodwill and those fair value adjustments that have not yet been con- sumed or amortized, together with an appropriate change in the minority interest. When a parent company disposes of an interest in a subsidiary such that it no longer retains control, significant influence or joint control, the interest becomes an investment and is subject to the guidance in section 39 IAS (PWC, 2004). Generally, such investments would be part of available-for-sale assets and recorded at fair value. The gain or loss on a partial disposal is the difference between the proceeds received and the carrying amount of the parent's share of the net assets sold, plus or minus any differences between the remaining carrying value and the fair value of the investment. Subsidiaries are in- cluded in the consolidated financial statements, more specifically the income and cash flow statements, up until the date when consolidation is no longer appropriate, generally the date of disposal (sections 27 and 31 IAS).

2.7 Tax Implications

This chapter intends to give an overview on tax implications of spin-offs and carve-outs in the USA, Germany and Switzerland. Differentiations need to be made between the tax implications for the parent company, the subsidiary company and the shareholders of the parent company. Spin-offs and carve-outs are complex and in all cases, it is vital to cooperate with local, specialized tax experts and lawyers. Key questions regarding the tax implications are: (1) whether hidden reserves will be disclosed due to the transac- tion; (2) whether the transaction itself generates a taxable capital gain; and (3) whether the parent and the subsidiary companies remain a tax group after the transaction (Achleitner and Wahl, 2003).

Table 1 summarizes the conditions for tax-neutral spin-offs and carve-outs in the USA, Germany and Switzerland as subsequently derived in Section 2.7.1 and 2.7.2. The tax environment is most favorable for spin-offs in the United States and Switzerland and for carve-outs since 2001 in Germany.

Table 1: Tax Neutrality of Spin-offs and Carve-outs

illustration not visible in this excerpt

Not all transactions meet the requirements for being tax-free. Krishnaswami and Subra- maniam (1999) and Copeland, Lemgruber, and Mayers (1987) show empirically that taxable spin-offs in the USA are associated with lower positive abnormal returns than non-taxable spin-offs. They interpret these results as evidence that taxes impose like a penalty on shareholder gains.

2.7.1 Spin-offs

As common drawback of spin-offs in all three countries, is that after the completion of the transaction parent and subsidiary company cannot build a tax group anymore and that they hence are not treated as a single unit for tax purposes.

2.7.1.1 USA

One of the key elements of spin-offs in the USA is that they can be conducted tax- neutral on the level of the parent and the subsidiary company as well as on shareholder level. Most US companies planning spin-offs seek to clarify the tax situation by tax rul- ings from the Internal Revenue Service (IRS) before the transaction.^[70] In specific situa- tions tax benefits may even be the primary motivation for spin-offs (Kudla and McInish, 1983). The Internal Revenue Code (IRC) of 1954 and 1986 provides in section 355 and 368 (a) special rules for the distribution of stock and securities of a controlled corpora- tion.^[71] If the requirements of these sections are met, the Code allows tax-free treatment on corporate as well as shareholder level. According to Suchan (2004) the basic idea behind these provisions is to prevent tax avoidance schemes. In the context of section 355 IRC two principal concerns might be the driving forces: Spin-offs could be used (1) to convert ordinary dividend income at the shareholder level into capital gain, and (2) to transfer appreciated property out of the corporation without triggering tax on the corpo- rate level. The starting point in evaluating tax implications and the first condition for a tax neutral spin-off is that the parent company controls the subsidiary company before the transaction (Kudla and McInish, 1983):

1. According to section 368c IRC, the parent must own at least 80% of the total com- bined voting power of all classes of stock entitled to vote and at least 80% of the to- tal number of shares of all other classes of stock of the corporation. Section 355 IRC specifies the other requirements for a spin-off to qualify as a non- taxable spin-off:
2. The transaction must have a valid business purpose; according to section 355a IRC, “The transaction was not used principally as a device for the distribution of the earn- ings and profits of the distributing corporation or the controlled corporation or both“.
3. The parent must distribute at least 80% of its stock in the subsidiary. According to section 355a IRC, „The distributing corporation distributes all of the stock and secu- rities in the controlled corporation held by it immediately before the distribution, or an amount of stock in the controlled corporation constituting control within the meaning of section 368c“.
4. The parent as well as the subsidiary company has to continue the business; according to section 355b IRC, “The distributing corporation, and the controlled corporation (...) is engaged immediately after the distribution in the active conduct of a trade or business“.
5. Both the parent and the subsidiary companies must have actively operated the busi- nesses (directly or indirectly) for at least five years; according to section 355b IRC, „Such trade or business must have been actively conducted throughout the 5-year pe- riod ending on the date of the distribution“.
6. The subsidiary must not have been acquired in a taxable transaction during the pre- ceding five years. According to section 355b IRC, „Such trade or business must not have been acquired within the period described in subparagraph (B) in a transaction in which gain or loss was recognized in whole or in part, and control of a corporation which (at the time of acquisition of control) was conducting such trade or business”.
As stated in Schnee, Knight, and Knight (1998) the continuity of interest is an additional condition for tax-neutral spin-offs:
7. Parent company shareholders must generally retain at least 50% of both parent com- pany and subsidiary company shares for two years. Otherwise, contingent tax liabil- ity will be triggered.

If these requirements are met, the parent company’s capital gain on the subsidiary com- pany share disposal is tax-exempt. The fact that there were many tax-free spin-offs in the USA over the last 30 years shows that these conditions can be met.

Glover (2002) states that if the spin-off does not qualify as tax-free, the parent share- holders will pay tax on the value of the spun-off company's shares that they receive in the distribution. This tax will be assessed at normal income tax rates to the extent the parent has current or accumulated earnings and profits. The stockholders' basis in the spun-off company's stock will equal its value at the time of the distribution and the dis- tributing corporation will recognize gain inherent in the stock of the controlled corpora- tion.

2.7.1.2 Germany

With the introduction of the Corporate Reorganization Act on January 1st 1995, the re- lated tax law the Corporate Reorganization Tax Act (“Umwandlungssteuergesetz”) was also adapted and some barriers to spin-offs were removed.^[72] Although the requirements are similar to those of section 355 IRC in the USA they differ in part. Particularly sec- tion 15 (3) UmwStG, which contains a provision disallowing the transfer of stock of corporations taking part in the spin-off to third parties, is very demanding. That means that if within five years following the transaction more than 20% of one of the involved companies is sold, belated taxes for the transaction must be paid. The key issue in my view is that investors do not know the tax consequences at the announcement nor at the completion date. Consequently, Achleitner and Wahl (2003) speak about a “ban on spin-offs”.^[73] Additionally, under German law in the typical case of a spin-off to a newly formed subsidiary no outside ownership in the stock distributed is allowed (Suchan, 2004). The same 100% ownership is required for the parent to spin off an existing sub- sidiary. The transaction qualifies for tax-free treatment only, if the parent corporation has owned the subsidiary 100% for the three years prior to the spin-off.^[74] Capital gain taxes, value-added taxes and real estate transfer taxes are other examples of taxes result- ing from spin-off transactions for the parent company.

If the opening tax balance sheet of the subsidiary company shows the assets at the same values as those shown in the parent company tax transfer balance sheet (s ections 15 (1), 12 (1) and 4 (1) UmwG), the transfer of assets is tax neutral for the subsidiary company. That means that there will be no taxable acquisition gain or taxable revaluation gain. While the conditions for a tax neutral transaction for the parent company are very de- manding, transactions generally do not generate taxable income to parent company shareholders.^[75] For Germans holding that kind of share as a business asset (“steuer- liches Betriebsvermögen”), shareholders will be required to apportion their tax basis in parent company shares held immediately prior to the transaction between these shares held after the transaction and the subsidiary company shares received in the transaction. To the extent that parent company shares are held as non-business assets (“steuerliches Privatvermögen”) and the substantial participation condition of section 17 and the minimum holding period for short-term capital gains condition of section 23 of the Ger- man Income Tax Act are fulfilled, shareholders will be required to apportion their acqui- sition costs in the parent company shares. To the extent that any parent company shares are tainted by a blocking amount (within the meaning of section 50c of the German In- come Tax Act), a portion of this amount will be allocated to the subsidiary company shares (section 13 (4) UmwStG). That kind of spin-off is also tax-neutral for US and UK citizens, assuming the spin-off qualifies as a tax-free transaction (section 355 IRC) and a scheme of reconstruction or amalgamation (section 136 of the British Taxation of Chargeable Gains Act of 1992).

2.7.1.3 Switzerland

The key objective of the Merger Act was to facilitate mergers and restructuring transac- tions. This implies that these transactions can be conducted in a tax-neutral way.^[76] As most of these transactions did not trigger income and profit taxes already in the old law, there were few changes required in the tax laws (Kumschick, 2001, ESTV, 2004). As stated in Von der Crone et. al (2004c) and ESTV (2004) there are four key requirements to avoid income and profit-taxes (section 8 (3) and section 24 (3) StHG as well as sec- tion 19 (1) and section 61 (1) DBG):

- The tax liability of the companies involved must continue after the restructuring in Switzerland.77
- The past book values of assets and liabilities must be transferred.
- The hidden reserves must not be realized.
- The assets must reflect as a whole a business that means the hidden reserves should be objectively linked with its business environment (section 24 (3) lit. b StHG and section 61 (1) lit. b DBG).

Unlike the old regulation, there is for spin-offs no blocking period condition anymore (ESTV, 2004). As stated in Von der Crone et. al (2004c), Neuhaus and Brauchli-Rohrer (2002) and Swiss-American Chamber of Commerce (2003), spin-offs and transfer of assets and liabilities are subject to specific conditions exempted from dividend withholding tax (section 5 (1) VstG), stamp duties and share issuance taxes (section 6 (1), 13 (2) and 14 (1) lit. b StG), and transfer duties on real estate. But according to Von der Crone et. al (2004c) and Neuhaus and Brauchli-Rohrer (2002), companies are required to pay VAT (section 47 (3) MWStG together with section 9 (3) MWStG). In Switzerland there is no capital gain tax for private individuals. However there may be tax implications for shareholders of the parent company, depending on whether there are compensation pay- ments or other cash benefits such as an increase in nominal value (section 7 (1) StHG, section 20 (1) c DBG; Watter and Reutter, 2002; ESTV, 2004).

2.7.2 Carve-outs

Assessing tax consequence of carve-outs in the USA, Germany and Switzerland, one must differentiate first between the two steps of carve-outs and second between primary and secondary carve-outs.

2.7.2.1 USA

As outlined in Myers (2002) the tax implications of the first step of carve-outs; the crea- tion of a new legal entity and the consequent transfer of assets and liabilities into the new legal entity, are not onerous.^[78] For federal tax reporting purposes, U.S. companies can continue to file a consolidated return for parents and subsidiaries in which they own at least an 80% stake. There might even exist benefits in terms of taxes of the new struc- ture at the state and/or international levels.^[79] The key point in evaluating tax implica- tions of US carve-outs is rather the difference between primary and secondary carve-outs (Anslinger et al., 1997). In a secondary carve-out, the parent company sells some of its subsidiary company stock to outside investors via an IPO. To the parent company, the subsidiary company shares it owns are assets and like any asset, its sale triggers recogni- tion of a gain or loss for tax purposes. Since stock is a capital asset, the gain or loss on sale is a capital gain or loss and will be taxed at the corporate capital gains tax rate. The amount of taxable gain or loss is the difference between the proceeds from the carve-out and the parent company’s tax basis in the stock of the subsidiary company. The tax rules that govern a parent’s basis in the stock of its subsidiary company work in much the same way as the financial accounting rules for equity method investments. Thus, the parent’s tax basis in the subsidiary stock increases when the subsidiary reports taxable income and decreases when the subsidiary pays dividends to the parent.

Unlike a secondary carve-out, a primary carve-out triggers no gain or loss for tax pur- poses, because a corporation cannot recognize a taxable gain or loss in its own stock. Since the subsidiary company, not the parent company, sells the subsidiary stock to in- vestors, there is no gain or loss recognition for tax purposes. A primary carve-out has no effect on the parent company’s tax basis in the stock of the subsidiary that it owns. However, the parent company in a primary carve-out may wish for some or all of the proceeds to reside at the parent level, as they do in a secondary carve-out. This can be achieved by having the subsidiary company pay the parent a dividend before the carve- out equal to the expected net proceeds. According to Blanton, Perrett, and Taino (2000), there are no tax consequences to the parent unless the dividend is greater than the aggregate tax basis in the subsidiary.

If the amount of stock sold causes the parent’s voting or economic interest in the sub- sidiary not to fall below 80%, the parent can continue to consolidate its subsidiary own- ership for tax purposes.^[80] As a consequence, dividend payments from the subsidiary company to the parent company are non-taxable and losses of one group member can be used to offset income of profitable members of the affiliated group (Suchan, 2004). With this in mind, it is astonishing that 37% of all carve-outs in the USA are secondary carve-outs although they appear to be tax-disadvantaged as they trigger sizable capital gain taxes for parent companies that could be avoided if primary shares were issued instead.^[81] Once the transaction is completed, consolidation for tax purposes is only possi- ble if the parent company controls at least 80% of the subsidiary company based on vot- ing rights and capital (Anslinger et al., 1997). With at least 80% ownership, the parent company can distribute the remaining shares in a tax-free distribution such as a spin-off (section 355 IRC).

2.7.2.2 Germany

Assessing tax consequence of German carve-outs, one must also differentiate between the two steps of a carve-out. The tax-neutral implementation of the first step the transfer of assets and liabilities of the subsidiary company out of the parent company (according to the Corporate Reorganization Act) has two requirements: First (according to section 20 (2) UmwStG) the subsidiary company must continue to account for the assets and liabilities with the same book value as in the parents books and secondly (according to section 20 (4) UmwStG) the parent company must record the received subsidiary shares with the same book value as the transferred assets.

As in the USA, one has to differentiate in the second step between a primary and a sec- ondary carve-out. As in the USA, primary carve-outs do not lead to any taxes while with secondary carve-outs; if the proceeds of the IPO are bigger than the book value in the parent company, capital gains arise that used to be subject to capital gain taxes. In De- cember 1999, Germany’s government made a surprise announcement that it would lower the corporate capital gains tax rate from 50% to zero on sales of German equity invest- ments (crossholdings). According to Achleitner and Wahl (2003), thanks to this German tax reform in 2001, capital gains from selling stakes in other companies are tax-free un- der certain conditions. The conclusion is that the tax environment for carve-outs is more attractive in Germany than in the USA (and in Switzerland).

According to Suchan (2004) there are no tax groups foreseen in the German tax law. Nevertheless, the tax treatment of the so-called “Organschaft” provides similar relief. Under these rules income or loss of a controlled company is attributed to the controlling company and the controlled company is only taxed on payments to minority sharehold- ers. To qualify for “Organschaft”, a profit and loss pooling agreement must be in place, and the controlling company must hold the majority of voting stock of the controlled corporation.

2.7.2.3 Switzerland

As in Germany and the USA, one has to delineate the two steps of carve-outs in Switzer- land as well. The tax neutrality of the first step, the transfer of assets and liabilities (ac- cording to section 69 (1) FusG) of the subsidiary company out of the parent company, is subject to five key requirements (Von der Crone et. al, 2004c; ESTV, 2004):

- The tax liability of the companies involved must continue in Switzerland, after the restructuring (section 61 (1) DBG).
- The past book values of assets and liabilities must be transferred and the hidden re- serves must not be realized (section 61 (1) DBG).
- The assets and liabilities must reflect as a whole a business and the hidden reserves should be objectively linked with its business environment (section 61 (1) lit. d. DBG).
- The parent company must retain a minimum of 20% of the subsidiary company (Swiss-American Chamber of Commerce (2003) and section 61 (1) lit. d. DBG).
- The assets and liabilities must not be directly or indirectly sold for a price higher than the book values within the blocking period of five years, otherwise this leads to belated taxation of the transferred hidden reserves (section 61 (2) DBG).

The second step of the carve-out process is then the sale of shares of the subsidiary in an IPO. As in other countries, it matters whether it is a secondary carve-out, where the par- ent company sells some of its subsidiary company stocks to outside investors or a pri- mary carve-out, in which the subsidiary sells newly issued stock to investors. Usually the carve-out cannot be conducted tax neutral as the IPO takes place within the blocking period and the share price is higher than the book value. The tax differences between primary and secondary offerings are not as obvious in Switzerland as in the USA and Germany. While primary offerings cause share issuance taxes of 1%, the tax implica- tions of secondary offerings depend on the tax situation of the shareholders.^[82] For natural persons holding the stocks for private purposes there is no capital gains tax in Swit- zerland (Von der Crone et. al, 2004c). However, even for such shareholders, there may be tax implications depending on whether compensation payments or other cash benefits such as an increase in nominal value are granted (section 7-(1) StHG und section 20-(1) c DBG).

2.8 Other Implications

Apart from the implications described above, spin-offs and carve-outs also influence the composition of stock market indexes and the terms and conditions of existing derivatives with the parent firm as underlying.

If the parent company is included in stock market indexes, spin-offs and carve-outs lead to changes in the composition of these indexes. The subsidiary company must meet cer- tain criteria to be included in the index for example in terms of size, industry representa- tion or liquidity. If the subsidiary meets these criteria, it will be added to the index on the distribution date of the subsidiary shares. According to Blanton, Perrett and Taino (2000), this occurred in the spin-off of Palm out of 3Com. 3Com moved to the S&P Midcap 400 index, while its subsidiary Palm replaced it in the S&P 500. If subsidiary companies are included in an index, other companies usually will become excluded from the specific index. Goetzman and Garry (1986) show that there is a persistent negative price effect for six companies, which were removed from the S&P 500 due to the inclu- sion of the subsidiary companies resulting from the AT&T split-up in 1984.^[83] On the other hand, if the parent company is compromised in an index and the subsidiary does not meet the criteria for inclusion, then index funds that receive the pro-rata distribution will not hold on to the subsidiary shares. This may cause downward pressure on the subsidiary’s stock price.^[84] Recirculation of subsidiary shares may also occur if the valuation characteristics such as “growth” versus “value” of the subsidiary and parent are different and they will attract different types of investors. Brown and Brook (1993) document that the initial flow back pressure for spin-offs is mainly caused by institutions that divest subsidiary stocks and that this price pressure is a function of parent and sub- sidiary firm characteristics. Abarbanell, Bushee, and Raedy (2001) confirm that spin- offs create new firms with characteristics markedly different from the original firm; insti- tutional investors that are committed to certain investment styles or subject to fiduciary restrictions thus have incentives to rebalance their portfolios at the time of the spin-off.

Spin-offs and carve-outs usually also lead to adaptations in the terms of derivatives with the parent company as underlying (Kudla and McInish, 1983). For example, due to the spin-off of Lonza out of Algroup, the conditions (i.e., the underlying and the strike) of all warrants, options and structured products had to be adapted.^[85] The conditions of employee stock option plans must also be modified (Gaughan, 1999).

2.9 Appraisal of Implications

Although there are many parallels among spin-offs and carve-outs, there are also five key differences: the extent and type of external financing involved, the tax implications of the transaction, the degree of subsequent control retained by the parent company, the change in the shareholder base and the typical trajectory. While spin-offs do not gener- ate cash proceeds nor cause taxes in general, carve-outs do. Hence, managers planning to carry out a carve-out have an incentive to conduct the transaction when such financing is cheap, exploiting a window of opportunity. Additionally, following a spin-off, the parent company completely loses its influence on the subsidiary, whereas parent compa- nies following carve-out transactions retain a controlling interest in the subsidiary com- panies. This exasperates potential conflict of interests, complicates decision-making and reduces the strategic flexibility. A new shareholder base in the subsidiary firm results from carve-outs, whereas initially there are the same shareholders in spun-off compa- nies. In terms of typical trajectory, carve-outs often are an intermediate step, leading to consequent transactions, while the subsidiary companies resulting from spin-offs are on a stable basis as independent companies.

3 Models and Empirical Studies on Spin-offs and Carve- outs

After having laid the foundation in Chapter 2, Chapter 3 gives an overview about the existing models (Section 3.1) and the empirical literature on the value creation of spin- offs and carve-outs (Section 3.2).

3.1 Models on Spin-offs and Carve-outs

The focus throughout Section 3.1 is on intuitive arguments and the key messages of models on spin-offs and carve-outs. Mathematical proofs can be found in the literature mentioned. After describing the general problems arising from principal agent settings, the implications of moral hazard (Section 3.1.1) and the ones from adverse selection (Section 3.1.2) are described as well as how one can generally dissolve them. Section 3.1.3 presents existing models on spin-offs, while in 3.1.4 the same is done on carve- outs.

Attempts to explain real world phenomena with tools developed for perfect market world conditions as outlined for example in Modigliani and Miller (1958) are not fully satisfactory as in reality, the very demanding assumptions are not fulfilled.^[86] One of the key deviations is asymmetric information, meaning that not all parties involved have the same information set. In principal-agent relationships, an informed agent acts on behalf of an uninformed principal and the information of the informed party is relevant for the common welfare.^[87] On the one hand, the specialized knowledge and know-how of the agent is an advantage for the principal. On the other hand, due to asymmetric informa- tion, there is also the risk for the principal that the agent’s self-interested behavior is not in his best interest. Hence the key challenge for the principal is to define mechanisms that ensure that the agent best protects his self-interests (Salanié, 2002).

Jensen and Meckling (1976) were the first who applied the principal agent theory to capital structure and organizational problems. They analyze problems arising from the separation of ownership and management. In such principal-agent relationships agency costs arise. As stated in Jensen and Meckling (1976), one can differentiate three ele- ments of agency costs:

- Monitoring and search costs that incur to the principal in the process of tracking and evaluating actions of the agent. Formal control systems, information collection, budget mechanisms and the establishment of incentive compensation systems are ex- amples causing that kind of costs.
- Signaling and bonding costs are borne by the agent to ensure that his behavior is in the principal’s best interest. Signaling must be costly, as good types of agents prove themselves by undertaking an action costly enough to deter mimicking by bad types (Spence, 1973). Hence signaling costs must be (at least relatively) higher for bad types than for good types. Bonding costs arise from actions to guarantee that the agent will act in favor of the principal or at least not act against the interests of the principal. For example, the agent would want to employ external auditors to certify that he has acted in the best interest of the principal.
- Residual losses are the difference between the first best and the realized solution. They arise among others in situations where rational players achieve only the sec- ond-best solution; for example in a situation where a contract that would be benefi- cial for both parties, cannot be closed due to the rational mistrust of the parties in- volved.

3.1.1 Moral Hazard

Moral hazard refers to the problem when a principal hires an agent and the effort of the agent is unobservable. The agent’s output is random; it depends partially on his efforts and partially on chance. Usually if the output is low, the agent will say: “My output is only low because of chance - I actually worked hard.” But the principal can merely base wages on what is observable. There is a tension here that is important in these models. The principal would like to make wages to vary with output; the more output the more wages in order to get the agent to put in more effort. However this adds uncertainty to the agent’s pay-offs and in case the principal is risk neutral and the agent risk averse, this makes the wage the principal has to pay higher.^[88] Jensen and Meckling (1976) applied this model in a setting with an inside manager and outside shareholders. The specific cost for outside equity is low effort of the manager, as the incentives to devote high ef- forts to value creating activities such as searching new profitable projects falls, the more equity-financed the firm is. The specific costs for debt is risk shifting.^[89] Jensen and Meckling (1976) conclude that the optimal financing choice and hence the optimal capi- tal structure is often a mix between equity and debt as this minimizes agency costs.

3.1.1.1 Shareholders vs. Management

The moral hazard agency theory can reveal motives for empire building such as diversi- fication in unrelated businesses. The managers’ motivations for unrelated acquisitions, for example, might be the maximization of own self-interests. Unrelated acquisitions that satisfy managerial self-interests, all else being equal, are expected to be retained more frequently than unrelated acquisitions that do not satisfy those interests (Bergh, 1997). The theory of free cash flows^[90] may be another explanation why many compa- nies have invested outside of their core business. In these models the manager controls the resources inside the firm (Jensen, 1986). As the manager gets private benefits increasing in free cash flows, he could misallocate resources. Aron (1988), on the other hand, shows that diversification is valuable because it diminishes the incentive problem firms face with respect to the CEO, as diversification reduces the amount of risk the manager must bear for incentive purposes. Diversification allows the principal more accurately to infer the manager’s behavior.^[91]

Overall, one can classify three general mechanisms to prevent moral hazard: Incentive mechanisms, control mechanisms and mechanisms that improve the information of the principal.

Incentive Mechanisms

The idea of incentive mechanisms is to align shareholders and managers interest and in that way ensure that the manager acts in the best interest of the shareholders. The most well known example is to link the salary of the manager to the performance of the com- pany for instance by using Employee Stock Ownership Plans (ESOP). Employee own- ership potentially can align the interests of owners and workers in much the same way that stock options give managers a greater stake in the firm’s performance.^[92] A potential trap in diversified companies is to link compensation of the manager of a small division to the performance of the whole group. This is not a strong incentive for him as the out- come is heavily dependent on factors not in his hands (Aron, 1991). Another way to ensure a proper use of the company’s resources such as free cash flows in the Jensen (1986) framework, is an incentive optimal capital structure. Abuse of free cash flows can be prevented with a mix of short-term and long-term debt.^[93] Jensen (1993) further claims that an adaptation of the organizational form can also be an optimal response to agency problems.

Control Mechanisms

Key control mechanisms are monitoring by shareholders or by stock market institutions and the market for managers. Monitoring systems are defined as systems that make it possible for the firm's principal to gather and analyze information about the firm and hence about the manager (Myers, 2003). Basic assumption of many monitoring models such as the one of Grossmann and Hart (1980) is that there is one manager, dispersed shareholders and a weak board of directors. This setting empirically mainly applies to the USA. As monitoring is a public good the problem of free riding arises.^[94] Ways to mitigate the free riding problem of monitoring are shareholder blocks.^[95] According to Burkart and Panunzi (2000), shareholder blocks and better legal protection are substi- tutes. In the model of Burkart, Panunzi, and Shleifer (2003), monitoring is more expen- sive than legal protection. Hence, based on the high legal protection in the USA, share- holders are mainly dispersed, whereas in Europe due to the lower legal protection, blockholders monitor the management. In Asia, where legal protection is even lower, family firms, which do not separate management and ownership, are in this model often better off. Apart from the direct costs resulting from monitoring, there might also be the cost associated from excessive monitoring by shifting management initiative. According to Burkart, Gromb, and Panunzi (1997), an ex-ante monitoring expropriation threat can reduce management’s efforts. In their model, limited ownership concentration can be seen as a commitment of shareholders to management to minimal intervention.

[...]

---

^[1] In a spin-off, a parent firm distributes shares of a subsidiary to the parent shareholders; in a carve-out, a portion of shares of a subsidiary is sold through an IPO to new public investors. In order to be able to differentiate between “spin-offs” and “carve-outs”, an anonymous reader constructed a memory hook: Spin- offs starts with “S”, as the parent shareholders get “stocks” of the subsidiary company. In contrast, carve- outs start with “C”, as the parent or the subsidiary company gets “cash” due to transaction.

^[2] Rappaport (1992) stresses this, claiming that: “What has happened, is that the pace of innovation and change in the environment has become so rapid and the magnitudes of the change so great, that CEOs today are literally spending a large proportion of their time monitoring change and trying to understand what the next restructuring activity is.”

^[3] For a good overview on the alternative rationales for restructuring, see Seisreiner and Wurster (2002).

^[4] Due to its incremental nature, and, as disclosure rules do not require to inform investors as comprehensively as in ownership restructuring, organizational restructuring does not receive the detailed external monitoring given to ownership restructuring (Bowman and Singh, 1990).

^[5] Another argument for ownership restructuring is that the value creation can possibly be captured immedi- ately for example in a trade sale. However, in all ownership restructuring types, the transaction itself does not “solve” the issues. Hence, subsequently organizational restructuring is required in the new ownership set-up.

^[6] For more details on joint ventures, trade sales, LBOs and MBOs, see for example Bowman and Singh (1990).

^[7] Split-offs are closely related to spin-offs – the end result of the transaction is that the public stockholders of a parent company own stock in two enterprises, the parent and a split-off subsidiary. The main difference between the two types of transactions is that after the completion of a split-off, the stock of the subsidiary is held by the parent’s stockholders on a non-pro rata basis. Some shareholders may hold only parent stock, while others may hold only subsidiary stock, and still others may hold both.

^[8] See also Billett and Mauer (2000) and Logue, Seward, and Walsh (1996).

^[9] The four remaining US tracking stocks consist of University of Phoenix Online (which follows Apollo Group Internet-based education business) Carolina Group (which is tied to the performance of the cigarette unit of Loews), Celera Genomics Group (a biotechnology arm of Applera Corp), and CombiMatrix Group (a division of Acacia Research Corp). The only tracking stock still trading outside the USA is Sony’s tracking stock for its Internet-access business.

^[10] See Miles and Rosenfeld (1983); Schipper and Smith (1983); Woo, Willard, and Daellenbach (1992); Cu- satis, Miles and Woolridge (1993); and Veld and Veld-Merkoulova (2004). If a shareholder in the parent company owns a number of shares, such that he has a fractional entitlement to shares in the subsidiary company, he can either sell such entitlements or buy the required fractional entitlements to achieve entitle- ment to one share. For details, see Hoechst-Celanese (1999).

^[11] As in most of the literature as for instance in Daley, Mehrotra, and Sivakumar (1997), the pre-transaction existing and continuing entity is called the “parent”, “parent firm” or the “parent company”, and the spun- off or carved-out unit is denoted as the “subsidiary”, “subsidiary firm” or the “subsidiary company” (even though there is no parent-subsidiary relation following the transaction anymore).

^[12] See also Vijh (1999 and 2002).

^[13] For more details on accounting and tax implications, see Sections 2.6 and 2.7.

^[14] See for instance Rechsteiner (1994) and Gaughan (1999).

^[15] For a good overview about the literature on the diversification discount, see Martin and Sayrak (2003).

^[16] In 1950, only 38.1% of the Fortune 500 US companies generated more the 25% of their revenues from diversified activities. By 1974, this figure had risen to 63%. In 1950, more than 60% of the largest For- tune 500 companies were either single businesses or dominant business firms. By 1974, this had dropped to 37% (Rumelt, 1974).

^[17] Ansoff (1965) was the first to show how to apply a formal approach of strategic decision-making. In his growth vector components matrix, diversification is the strategy that intends to sell new products based on a new mission. For an overview about the motives and incentives of diversification, see Hitt, Ireland and Hoskisson (1999). They differentiate between motives to enhance strategic competitiveness (economies of

scope, market power and financial economics), incentives and resources (e.g., antitrust regulation, tax laws, and low performance) and managerial motives (diversifying managerial employment risk and increasing managerial compensation).

^[18] Berger and Ofek (1995) find based on sample from 1986 to 1991 that the sum of the stand-alone values to the firm’s actual value implies on average a 13% to 15% value loss from diversification. See also Werner- felt and Montgomery (1988); Lang and Stulz (1994); Servaes (1996); and Maksimovic and Phillips (2002).

^[19] For a more detailed description of pros and cons of diversification, see Campa and Kedia (2002).

^[20] Stein (1997) makes the case that internal capital markets are more efficient than external markets, as corpo- rate headquarters are likely to be better informed than external suppliers of capital about investment oppor- tunities within the firm. Stulz (1990) argues that larger internal capital markets help diversified firms re- duce the underinvestment problem described by Myers (1977). Matsusaka and Nanda (2002) stress that diversified firms are more valuable as their real option to avoid costly external capital markets is valid in more states of the world than the one of single segment firms. On the contrary, several studies suggest that conglomerates tend to misallocate their investment funds by cross subsidizing poorly performing divisions (Shin and Stulz, 1998; and Lamont, 1997). Berger and Ofek (1995), for example, find that diversified firms tend to invest too much in segments with poor investment opportunities and that this kind of overin- vestment is associated with lower firm value. Rajan, Servaes, and Zingales (2000) model the presence of power struggles among the firm's divisions and show that diversification causes resources to be used for inefficient investments.

^[21] Tobin’s Q is the present value of future cash flows divided by the replacement cost of tangible assets, see e.g., Lang and Stulz (1994).

^[22] See Campa and Kedia (2002); Villalonga (1999); and Graham, Lemmon, and Wolf (2002). Villalonga (2004) even finds based on an alternative data sample a diversification premium.

^[23] Caytas and Mahari (1988) compare restructurings with the history of Koh-i-Noor (mountain of light), the largest diamond ever found (793 carats). They stress that before the recut, the Koh-i-Noor was just a huge impressive stone. Only thanks to the recutting, reducing the Koh-i-Noor to 109 carats, the gem got so bril- liant and attractive and became hence the center stone of the crown of Queen Mary.

^[24] See Achleitner and Wahl (2003) for more details on divestitures of businesses that are at the end of their lifetime cycle.

^[25] Initially often proposed by management consultants. For example, Boston Consulting Group’s four cells matrix based on relative market share and industry growth rate resulting in cash cows, dogs, questions marks and stars or McKinsey’s nine cells matrix based on competitive position and industry attractiveness.

^[26] In the 1960s and 1970s, this was primarily an answer to the disappointing performance of the former diver- sification strategies. Other reasons for the increased restructuring activities include according to Hill and Jones (1998) (1) innovations in management processes that have diminished the advantages of diversifica- tion, (2) new ways to cooperate, such as strategic outsourcing, strategic alliances or virtual corporations, (3) shorter product life cycles that privileged smaller, more dynamic and innovative companies and (4) many diversified companies found their core business areas under attack from new competitors and there- fore management wanted to devote more time and attention to the challenged core business.

^[27] Berger and Ofek (1999) come to the conclusion that firms with the greatest value loss due to diversification are the most likely to have divestitures. See also Comment and Jarrell (1995), Markides (1995), and John and Ofek (1995).

^[28] Porter (1987) finds that more than 50% of the acquisitions made by 33 firms in unrelated industries were subsequently divested. Ravenscraft and Scherer (1987) report that 33% of acquisitions in the 1960s and 1970s were later divested and Kaplan and Weisbach (1992), who study a sample of large acquisitions com- pleted between 1971 and 1982, notice that by the end of 1989, the acquirers have divested almost 44% of the target companies.

^[29] See for instance Allen et al. (1995).

^[30] This might be one of the reasons why acquisitions are more common than divestitures. Fluck and Lynch (1999) find another explanation: According to their model, the motivation for mergers stems from the in- ability to finance marginally profitable projects as standalone firm due to agency problems. Hence a con- glomerate merger is a way that allows these projects to survive a period of distress. However, if profitabil- ity improves, the financing synergy ends and the acquirer divests these assets.

^[31] For more details on barriers for restructuring transactions, see Rechsteiner (1994).

^[32] The spin-off of Liberty Media out of AT&T is such an example. AT&T wanted to overcome potential regu- latory issues and conflict of interests resulting from owning cable networks and television channels (NZZ, 2001).

^[33] There are additional elements of cost in holding on too long to a unit. Companies with subsidiaries that produce regular but not growing revenues can become complacent, hence ignoring the corporate need to build new, higher-growth units. This supports risk-averse corporate cultures, which stifles innovation and diverts management time and capital to slow-growing businesses (Dranikoff, Koller, and Schneider, 2002).

^[34] The parent company has to hand in a form 8-K. 8-K is a report of unscheduled material events or corporate changes which could be of importance to the shareholders or to the SEC. Examples include acquisition, bankruptcy, resignation of directors, or a change in the fiscal year.

^[35] Companies often file S-1's with the SEC long before they make printed prospectuses (i.e., the final prospec- tus, form 424B filing) available to the public. That means S-1 is the pre-effective registration statement submitted when a company decides to go public. S-1 generally consists of the following sections: front section, cover/inside cover, prospectus summary, risk factors, use of proceeds, dividend policy, capitaliza- tion, dilution, selected financial data, management's discussion and analysis, business, management, cer- tain transactions, principal shareholders and description of capital stock, underwriting, legal mat- ters/experts/additional information, financial statements and other documents.

^[36] To ensure a consistent understanding of legal terms, the respective German term is given in brackets. This is especially important, as there are no German terms for spin-offs, split-offs and carve-outs as defined in this paper.

^[37] Suchan (2004) stresses that the tax treatment will be different, although the economic effect of the two-step approach is the same as in a “Abspaltung” as the shareholders of the parent company in the end own stock of the parent as well as of the subsidiary company.

^[38] For more details, see Mehring-Schlegel and Zimmermann (2001).

^[39] Fore details on the requirements of the listing prospectus, see Wiesmann, von Gossler, and von Harder (2001).

^[40] Directive 79/279/EEC coordinates the conditions for the admission of securities to official stock exchange listing; Directive 80/390/EEC coordinates the requirements for the drawing up, scrutiny and distribution of the listing particulars to be published for the admission of securities; and Directive 82/121/EEC lists in- formation to be published on a regular basis by companies whose shares are admitted to official stock ex- change listing.

^[41] According to the Swiss American Chamber of Commerce (2003), an “Abspaltung” as well as an “Aufspal- tung” must always be vertical, meaning that the business will be divided vertically. The horizontal “demerger” (where the business to be divided will be contributed to a subsidiary) must be realized by the way of transfer of assets and liabilities (See Section 2.4.2.3 on Swiss carve-outs).

^[42] Consequently, in this section the term spin-off also meant to include split-offs and split-ups.

^[43] The Merger Act provides the possibility of a simplified process for small and medium-sized enterprises: They may opt to neither prepare a demerger report, appoint an auditor nor grant a right of document in- spection. This dispensation, however, is conditional on the approval of all members (section 39 (2), section 40 based on section 15 (2) and section 41 (2) FusG.)

^[44] Hodel (2002) gives a good overview of legal implications arising from a listing at the SWX.

^[45] For more details on the prospectus and the prospectus liability, see Lenoir (2004).

^[46] Foremost among these are transparency requirements (such as disclosure requirements), the obligation to present a true and fair view of the financials, the obligation to provide information on technical and admin- istrative matters, corporate governance requirements and the regulations concerning disclosure of price- sensitive facts.

^[47] Watter and Reutter (2002) discuss the legal implications of the measures e.g., share repurchasing programs against the potential flow-back pressure.

^[48] Schipper and Smith (1986) find that more than 60% of the carved-out subsidiaries were later reacquired by the parent, completely divested, spun-off, or liquidated. Klein, Rosenfeld, and Beranek (1991) show that 56% of all carve-outs are reacquired and 38% are sold. Hand and Skantz (1999b) document that 42,7% of the carved-out subsidiaries are sold, 17.4% are reacquired, and 13.2% are spun-off.

^[49] Split-offs can also be used as back-end transactions for the second step. Blanton, Perrett and Taino (2000) conclude that a split-off distributes the subsidiary company shares to those shareholders who prefer sub- sidiary company shares and therefore implies no flow-back pressure. The disadvantage of split-offs, as compared to spin-offs, is that they are more complex in terms of filing requirements and handling than spin-offs.

^[50] For details on section 355 IRC, see Section 2.7.

^[51] This initial stock price decline is usually associated with the portfolio rebalancing activities of large institu- tional investors who may not wish to hold the shares of the subsidiary given away by the parent in a spin- off transaction. The results of Low (2002) give some indication that two-step spin-offs perform better in the short term than pure spin-offs following the transaction.

^[52] Before the introduction of the Corporate Reorganization Act, carve-outs in Germany had to be conducted with transfers of singular title as for example in the first carve-out in Germany, the carve-out of Kolben- schmidt AG as a subsidiary of Metallgesellschaft in 1984 (Nick, 1994). For detail on the process with transfer of singular title, see Heidkamp (2003).

^[53] For other regulations such as the three key steps and its components (Achleitner and Wahl, 2003), see Sec- tion 2.4.1.2.

^[54] There are more demanding requirements if the transfer of assets and liabilities makes it impossible for the parent company to follow the company’s purpose as stated in the bylaws. If this is the case, the transfer of assets and liabilities requires an amendment of the bylaws and thus the consent of shareholders in a general meeting.

^[55] Hofstetter (2002) or Giger (2003) provide a more detailed overview on the Swiss corporate governance regulation and the differences compared to other countries. Despite fundamentals differences between cor- porate governance in USA, Germany and Switzerland, “good” corporate governance results in all three countries in a higher valuation (Drobetz, Schillhofer, and Zimmermann, 2003; Beiner et al., 2004; McKinsey & Company, 2000).

^[56] The sources for corporate governance in Switzerland are primarily the relevant laws and regulations. These include corporate law embodied in the CO, stock market law (SESTA and pertaining ordinances) and the listing rules of the SWX. Attention must also be given to the legal reality in Swiss companies, including the articles of incorporation, the regulations and prevailing usages. In 2002 the “Swiss Code of Best Prac- tice for Corporate Governance” and the “SWX Swiss Exchange Directive on Information relating to Corpo- rate Governance” were established. The purpose of the former is to set out guidelines and recommenda- tions, but not force Swiss companies into a straightjacket, while the directive is intended to encourage issu- ers to make certain key information relating to corporate governance available to investors (Giger, 2003).

^[57] In the USA, the discussion of corporate governance became particularly lively in the 1980s and 1990s, leading ultimately to the “Blue Ribbon Report” on the independence of the audit function and on the audit committee. Key requirements in the USA are based on the corporate governance standards of the respec- tive stock exchange and the Sarbanes-Oxley Act, which was one of the measures used to rebuild tarnished confidence of investors following corporate scandals such as Enron and Worldcom.

^[58] Details on the German terms on corporate governance are based on the law of control and transparency in corporate matters (KonTraG) and the German Corporate Governance Code.

^[59] Co-determination laws apply to all corporations in Germany with at least 500 employees. Additionally, there is another kind of co-determination in Germany in the works councils.

^[60] Zugehör (2001a) shows that there are significant differences in the extent labor representative are involved. He mentions on the one hand, the restructuring of VEBA AG with a high involvement of labor representa- tives. On the other hand, Siemens’s presentation of its demanding 10-point corporate restructuring pro- gram to the supervisory board without any prior discussion with workforce representatives is an example of low level of co-determination. The value added of the employee determination is challenged by Gorton and Schmid (2000); companies with equal representation of employees and shareholder representatives on the supervisory board trade at a 31% stock market discount, compared with companies where the subsidiary board composes only one-third of employee representatives.

^[61] Schipper and Smith (1986) find that in 34 out of 48 carve-outs the president or CEO of the subsidiary firm used to be manager in the parent firm and that in 56 out of 57 carve-outs the board of directors of the sub- sidiary includes at least one member that is also a director or officer in the parent firm. Boone (2002) shows based on a sample of 220 equity carve-outs that the subsidiary board composition is affected by product market relationships with the parent firm as there is greater executive and board overlap in cases with product market relationships between the firms.

^[62] For governance implications of German carve-out using the transfer of singular title approach, see Heid- kamp (2003).

^[63] For details on US GAAP, see Delaney et al. (2004) or Grünberger (2003).

^[64] Though reclassification is only permitted if the spin-off occurs in connection with the initial registration of a company under the Securities Act or Securities Exchange Act and the parent and the subsidiary are (1) in dissimilar businesses, (2) have been managed and financed historically as if they were autonomous, (3) have no more than incidental common facilities and costs, (4) will be operated and financed autonomously after the spin-off and (5) will not have material financial commitment, guarantees or contingent liabilities to each other after the spin-off (Schnee, Knight, and Knight, 1998; and APB, 1971).

^[65] APB (1973a) provides instructions on the accounting for spin-offs by the parent company. It says that spin-offs are nonreciprocal transfers to owners that “should be based on the recorded amount of the non- monetary assets distributed.” Thus, the distributing corporation treats the distribution as a dividend (Schnee, Knight, and Knight, 1998). For details on the valuation methods, see Kudla and McInish (1983); Delaney et al. (2004) or http://www.fasb.org/.

^[66] Section 35 Par. 2 IAS: „A discontinuing operation is a component of an enterprise (a) that the enterprise, pursuant to a single plan, is disposing of in its entirely (...) disposing of piecemeal (...) or terminating through abandonment; (b) that represents a separate major line of business or geographical area of opera- tions: and (c) can be distinguished operationally and for financial reporting purposes“.

^[67] For details on the accounting implications of „Ausgliederungen“ see Linssen (2001).

^[68] The EU Commission argued that in order to contribute to a better functioning of the internal market, pub- licly traded companies must be required to apply a single set of high quality international accounting stan- dards for the preparation of their consolidated financial statements. Unlike directives, EU regulations have the force of law without requiring transposition into national legislation. Member states have the option of extending the requirements of this regulation to unlisted companies and to the production of individual ac- counts. European companies applying US GAAP to date received an extension and have a January 1, 2007 deadline of applying IFRS (sections 4 and 9 EU regulation).

^[69] Swiss GAAP ARR will continue to be recognized for smaller companies, which have no international shareholder base and are listed in the SWX Local Caps segment. These recommendations are based on IFRS principles, but their scope and disclosure regulations are far less complex and extensive than IFRS or US GAAP. They do, however, observe the fundamental principles of international financial reporting, ac- cording to the tenet of a true and fair view. Unlike the EU, the Admission Board of the SWX will continue to accept US GAAP as a reporting standard after 2005. By doing so, it relieves all companies with a dual listing in Zurich and New York and of their obligation to include transitional accounts from IAS to US GAAP in their financial statements. Several organizations such as the International Accounting Standards Board and the International Organization of Securities Commissions would like to go yet a step further and eliminate all significant differences between IFRS and US GAAP by the end of 2004.

^[70] However, in 2003 the IRS changed their attitude regarding tax rulings and said that it won't issue rulings on three of the most important aspects of spin-offs, including whether there is sufficient business purpose to the spin-off for the IRS to treat it as tax free anymore (See Forbes, 2003).

^[71] For details, see Bittker and Eustice (1996).

^[72] For details on the conditions for tax-neutral spin-offs in Germany, see Schultze (1997); Achleitner and Wahl (2003); and Suchan (2004).

^[73] In Hoechst-Celanese (1999), the conclusion is drawn that, “as the requisite criteria cannot be met by a publicly-listed company”. The resulting income tax to Hoechst AG was consequently estimated to be somewhere between 170 and 250 million Euros. In Hoecht-Celanese (1999) there were no capital gains taxes and no value-added tax, but real estate transfer taxes of approximately 21 million Euros.

^[74] In the USA and in Switzerland, in contrast a tax-free distribution may be achieved without owning 100% of the subsidiary the stock of which is distributed.

^[75] Based on Hoechst-Celanese (1999) and Hoereth, Schiegle, and Zipfel (2001).

^[76] For details on the tax implication of spin-offs, split-offs and split-ups, see Neuhaus and Brauchli-Rohrer (2002) and ESTV (2004).

^[77] According to Swiss American Chamber of Commerce (2003), cross-border reorganizations are income tax neutral to the extent that a taxable presence at least in the form of a permanent establishment is maintained in Switzerland.

^[78] A broad discussion of alternatives for tax-efficient divestitures of subsidiary companies such as carve outs, can be found in Willens and Zhu (1999).

^[79] Myers (2002) explains that many states tax companies on all of their income, regardless of where it was generated. But some, such as Pennsylvania and Michigan, allow subsidiaries to file returns that tax only the earnings generated within the state’s borders, not those generated in other locations. Companies that oper- ate internationally can also set up foreign businesses as separate subsidiaries. Typically, the profits of those subsidiaries will then be taxed abroad where the subsidiary is incorporated and will not be subject to U.S. taxes.

^[80] According to section 351a IRC carve-outs can be conducted tax neutral as long as the parent company is in control and it is a primary carve-out. Control means (according to section 368c IRC) that the ownership of stock possesses at least 80% of the total combined voting power of all classes of stock and is entitled to vote and holds at least 80% of the total number of shares of all other classes of stock of the corporation.

^[81] Corporate capital gains tax rates of parent companies that are measured on a marginal basis and that take into account the extent to which the carve-out gain would have otherwise been deferred, are on average only one-fifth of the statutory capital gains tax rate (Hand and Skantz , 1999a).

^[82] The stockholding of natural persons in Switzerland is classified as (1) for private purposes, (2) for profes- sional purposes or (3) for business purposes. Corporate bodies are classified as “normal corporate body” or as a “holding company” (Neuhaus and Brauchli-Rohrer, 2002, section 5(1) together with 8 (1) StG). The tax implications for both, natural persons and corporate bodies are dependent on these classifications.

^[83] AT&T Corp. over its long history has gone from a small business built around a revolutionary invention to a corporate giant that then conducted various ownership restructurings. In 1984 it split-up into a national telephone company and seven regional telephone companies (“baby bells“).

^[84] Practitioners are aware of the influence of spin-offs on index constitution. Goldman Sachs (2003) docu- ments (based on a study of 131 spin-offs between 1992 and 2003) that spin-off subsidiaries (which are in building. Long-term debt thus reduces firm’s access to outside financing by using up the firms’ debt ca- pacity.cluded in the S&P 500) tend to benefit from speculative trading and outperform the index by 2.4%, on av- erage, during the four business days prior to inclusion in the index.

^[85] The underlying of the warrant “ALUVO” before the spin-off was 1 ALUN with a strike of CHF 1750. This was adapted due to the spin-off to 1 ALUN + 1 LONN with a strike of CHF 1761.00. For more details, see SWX (1999).

^[86] The assumptions in Modigliani and Miller (1958) are: (1) frictionless capital markets meaning no transac- tion costs and no institutional restrictions, (2) competitive markets meaning that individuals as well as firms are price-takers, (3) all agents have the same information, (4) investors borrow or lend on same terms as firms, (4) taxes are neutral that means there is the same tax rate on all sources of income, (5) firm’s fi- nancing and operating decisions are independent and (6) absence of bankruptcy risk meaning the firms can meet their debt obligations in every state of the world.

^[87] The Principal Agent Theory as well as the Transaction Cost Economics and the Property Rights Theory belong to the New Institutional Economics. Coase (1937) laid the foundations of the New Institutional Economics with its explicit introduction of transaction costs into economic analysis.

^[88] That the principal is risk neutral is justified usually by assuming that the principal faces many independent risks and thus can diversify the risks associated to the relationship with the agent. On the contrary, the agent exhibits risk-aversion as he is “small” and hence it is more difficult for him to diversify his risks (Salanié, 2002).

^[89] See Section 3.1.1.2.

^[90] Free cash flows are defined in Jensen (1986) as leftover cash after all NPV positive projects are financed.

^[91] In the Aron (1988) model there is, for a given firm size, a trade-off between increasing diversification of the firm, thereby reducing agency costs, and increasing the size of each product line, thereby reducing produc- tion costs. In equilibrium, optimal firm size, product line size, and diversification are positively related.

^[92] As described in Pugh, Jahera, and Oswald (1999), the view that ESOPs provide benefits to both sharehold- ers and employees has been challenged because ESOPs can serve to disrupt the market for corporate con- trol by making a takeover more costly and difficult. Thus, rather than serving to align the interests, ESOPs may do existing shareholders more harm than good.

^[93] As stated in Jensen (1986) short-term debt is a measure to reduce that kind of agency conflict as short-term debt reduces the resources under control by the manager by pumping them out of the firm. An optimal level of short-term debt gives investors control over free cash flows and the manager controls the remaining funds, which are required to finance NPV positive projects. In the model of Hart and Moore (1995) the manager controls the company’s access to outside financing. He might raise excessive funds for empire

^[94] See Grossmann and Hart (1980) on the free rider problem, Grossman and Hart (1988) on the best security voting structure and Burkart, Gromb and Panunzi (1997) on endogenous private benefits.

^[95] The advantage of blockholders is that they enjoy control and hence mitigate the free rider problem. On the other hand they may use this control for their own goals and private benefits, which may result finally in a conflict between blockholders and dispersed shareholders. For more details on implications of blockhold- ers see Bebchuk (1994), and Burkart, Gromb, and Panunzi (1997).