Equity Carve-Outs: A New Spin on the Corporate Structure

Abstract

The purpose of a corporate center is to do for the subsidiaries what they cannot do effectively for themselves. Many structures serve this purpose: operating companies, multibusiness companies, holding companies, conglomerates, and even investment firms such as Berkshire Hathaway - all are different ways for a single, central parent to deliver value to its business units. The newcomer to the list is the equity carve-out. Like its predecessors, the carve-out enables a subsidiary to draw on the wisdom, experience, and practical assistance of the executive center. But it also offers something new: a degree of independence that appears to foster innovation and growth. An equity carve-out is the sale by a public company of a portion of one of its subsidiaries' common stock through an initial public offering (IPO). Each carved-out subsidiary has its own board, operating CEO, and financial statements, while the parent provides strategic direction and central resources. As in any other corporate structure, the parent can provide executive management skills, industry and government relationships, and employee plans, and perform time-consuming administrative functions, freeing the subsidiary's CEO to concentrate on products and markets. What is different is the way in which the role of the corporate center is clearly spelt out in contractual agreements. A number of companies have chosen to spin off a single subsidiary in this manner. A smaller group, including Thermo Electron, Enron, Genzyme, Safeguard Scientifics and, more recently, The Limited, have chosen the carve-out as their basic organizing structure, repeatedly selling stakes in their business units. The results are striking. We examined the performance of US equity carve-out subsidiaries from 1985 to 1995, in cases where 50 percent or more of each subsidiary's shares were retained by the parent. (We were interested only in those companies where the parent remained an operating center, not a loosely affiliated holding company.) Over a three-year period, the subsidiaries in this sample showed average compound annual returns of 20.3 percent 9.6 percent better than the Russell 2000 Index [ILLUSTRATION FOR EXHIBIT 1 OMITTED]. Those companies that repeatedly sold stakes in subsidiaries fared even better. Three years after the carve-out, their subsidiaries showed annual returns of 36.8 percent. The parent companies themselves experienced average annual shareholder returns of 31.1 percent [ILLUSTRATION FOR EXHIBIT 2 OMITTED].(*) The results suggest that equity carve-outs are an effective way for companies to exploit growth opportunities and increase shareholder value. Safeguard Scientifics, for instance, has spawned six new companies since 1985, with revenue growing from $66 million then to $1.9 billion in 1996. So what is it about a carve-out that promotes such growth? The answer appears to lie in the changed relationship between the corporate center and the business unit, and the effect this has in three important areas: corporate governance, human resources, and finance. Corporate governance More value from the corporate center. Many corporate centers often do little more than shadow-manage business units; and frequently they suboptimize the plans of individual business units in the search for intra-company synergies. Carve-outs prevent these abuses. The agreements between parent and subsidiary are communicated to the subsidiary's shareholders through the offering prospectus. If the cost of the services the parent provides (typically 1 to 2 percent of revenue) is not deemed worth the benefits, then the subsidiary's board has a responsibility to minority shareholders to renegotiate the agreement or bring the services in house. The corporate center is therefore forced explicitly to add value by answering to an outside constituency of shareholders. No transaction will be tolerated, either between the subsidiary and its parent or the subsidiary and another business unit, that is not in the economic interests of all concerned. …