Corporate Control Contests and the Disciplining Effect of Spin-Offs: A Theory of Performance and Value Improvements in Spin-Offs

Abstract

We develop a new rationale for the performance and value improvements of firms following corporate spin-offs. We consider a situation of a firm with multiple divisions, where incumbent management may have differing abilities for managing various divisions. Giving up control to a rival with better ability in managing the firm, while it benefits equity holders (including incumbent management) by increasing the firm's equity market value, also involves losing the incumbent's benefits from control. Due to this trade-off, the incumbent, while willing to relinquish control to extremely high ability rivals, may not wish to do so for rivals who have only moderately higher management ability relative to him. Spin-offs increase the chance of loss of control to potential rivals in two ways: First, it reduces the ability of the incumbent to use firm size strategically against the rival in a control contest (after the spin-off, the rival can invest to the full extent of his wealth in the equity of the firm more vulnerable to a takeover). Second, it increases the probability that passive investors will vote with the rival in a contest for control for at least one division (in a joint firm, the superior management ability of any rival with respect to one division may be neutralized by inferior ability with respect to another one). This increased chance of loss of control following a spin-off, in turn, motivates the incumbent to work harder (despite his disutility for effort) in equilibrium in an attempt to maintain control. Thus, the increase in equity market value of the firm upon spin-off announcements arises not only from market participants incorporating in their valuations the increased probability of a takeover by a more able rival for control, but also from their anticipating the increase in managerial efficiency arising from the disciplining effect of the spin-off on firm management. Our analysis predicts that, in addition to positive announcement effects, the equity of a sample of spun-off firms will also exhibit long-term positive abnormal returns under certain conditions. Our model also explains a wide variety of other recently documented empirical regularities, and provides hypotheses for further empirical work.