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Information asymmetry, valuation, and the corporate spin-off decision
I analyze the information hypothesis to explain why firms divest divisions through spin-offs. A spin-off is a pro-rata distribution of shares of a subsidiary of a firm to the shareholders of the firm. The operations and management of the subsidiary are then separated from those of the parent. The information hypothesis argues that a spin-off improves market valuation of the separated divisions by reducing the information asymmetry about the firm. I construct a theoretical model of information asymmetry between the managers and the outside investors of a multi-division firm, where the investors use a signal extraction rule to estimate the cost and efficiency of the individual divisions from the total cost of the combined firm. I show that the securities issued by the firm, to finance new investments of its high- growth division are undervalued. This undervaluation can be mitigated by dissociating the divisions through a spin-off. Thus, even in the absence of negative synergies, information asymmetry about a firm's operating costs and efficiency is by itself a sufficient motive for firms to engage in spin-offs. Using analysts' earnings forecast errors, the standard deviation of the forecasts, and the fraction of intangible assets of a firm as measures of information asymmetry, I find that sample firms have higher information dissemination problems than their industry and size matched controls. I also find that information problems decrease after the spin-off. The gains around spin-offs are positively related to earnings forecast errors. This relation is more pronounced for firms which spin-off related subsidiaries, i.e., for firms that should have lower negative synergies between divisions. This finding is consistent with the notion that while negative synergies may play a role in explaining spin-off gains, Litigation of information problems is also an important factor. The results are robust to other measures of information asymmetry. Finally, consistent with the predictions of the model, I find that firms that have larger growth opportunities, but are cash-constrained (firms that have a pressing need for external capital), show a higher propensity to engage in spin-offs.
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Includes bibliographical references: pages 63-65.