A new look into the effect of corporate governance on the decision of a corporate spin-off

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A new look into the effect of corporate governance on the decision of

a corporate spin-off

Master Thesis, MSc Accountancy

University of Groningen, Faculty of Economics and Business

Thesis supervisor: S.Rusanescu Field of study: Accountancy

Jari Feenstra S3181928 Oudesluis 9a, Lemmer

+31628451769 j.feenstra.5@student.rug.nl

2 Abstract

Word count: 9644

Keywords: spin-offs, corporate governance, managerial ownership, agency theory, managerial incentives, board effectiveness, board size, board

experience, board independence.

Spin-offs are major corporate events that have become more and more frequent in the last decades. Despite their importance, there is little research on the determinants of the spin-off decision, and

particularly on the role of corporate governance mechanisms. Taking into account the agency theory and the resource dependence theory, I study the effect of board effectiveness and managerial incentives on the likelihood of performing a corporate spin-off. A more effective board is more likely to approve the value-creating spin-off decision. The managerial incentives should align the interests of the manager with that of the shareholder, resulting in a bigger chance that the management will perform a spin-off. Board effectiveness is proxied by a compound measure obtained through a factor analysis based on board size, board independence and board experience. Using a sample of 97 spin-off firms and 97 control firms from the US in the period between 2000-2017, I find no evidence that corporate governance has an influence on the spin-off decision. These findings imply that my corporate governance variables do not variate much in the listed US firms after the multiple regulations were implemented at the start of century. Most of the listed US firms have good corporate governance, so this does not determine whether to engage in a spin-off or not.

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A new look into the effect of corporate governance on the decision of

a corporate spin-off

1. Introduction

A corporate spin-off is a transaction that spins-off a division and this division transforms in a separate legal new firm, which is independent of the old parent. The shares will be distributed to the parent’s shareholders, on a pro-rata basis. This means that the original shareholders of the parent receive equivalent shares in the new company in order to compensate for the loss of equity in the original parent, after this event the shareholders can divest the two firms separately (Feng, Debarshi and Yisong, 2015). A corporate spin-off can create value for the shareholders in multiple ways. Spinning-off a division increases the value for the parent firm if the spin-off decreases the firm’s industrial scope (Daley,

Mehrotra and Sivakumar, 1997). Schipper and Smith (1983) found that firms can also benefit from regulatory or tax benefits by spinning-off a segment. For example, spinning-off a royalty trust, separating an unregulated segment from a more regulated firm or spinning-off a foreign segment to prevent paying taxes on foreign earnings and to avoid restrictions between the two countries. As last, Chemmanur and Yan (2004) found that the management of the spun-off enjoys private benefits of control after the spin-off. For example, the management is no longer restricted to justify all their actions to the parent firm. These benefits can be lost if the new company gets taken over by another management team. This will result in the fact that the management of the spun-off will work harder, to prevent a take-over by another management team.. The increase in effort from the management results in an increase in operating performance and stock performance after the spin-off.

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Mike Niland, an US divestitures leader from PriceWaterhouseCoopers, said in an article from the 5th of December in 2017 that he expects the number of corporate spin-offs (S&P 500) to rise in the upcoming years (Niland, 2017). The article mentions that if the market is at a high point, that this results in an increase of the amount of spin-offs. After the dot-com bubble bust in 2000, the amount of spin-offs has reduced, which also meant that the academic research about spin-offs was less popular than at the end of the 20th century. This expected rise in corporate spin-offs, makes it interesting to take a look at the spin-off literature nowadays.

The board of directors, in short board, is a group of directors who together mainly supervise and advice the management of an organization. The agency theory argues that the board should perform a monitoring role and restrain the management from performing actions that are value-decreasing for the organization (Hart, 1995). The resource dependency theory states that the board has a more advisory and counselling role. The more diverse the board is, the more quality resources the board has at its disposal to advise management (Pfeffer and Salancik, 1978; Anderson, Reeb, Upadhyay, and Zhao, 2011; Aggarwal, Jindal, and Seth, 2019). As it is the task of the board to act in the best interests of the owners (shareholders) of the company and the fact that the board has to approve the decision of performing a spin-off, this is an important topic to research in the spin-off literature (Gibson Dunn, 2018). A effective board should create a culture that creates value for the company and prevents the company from the risk of value destruction (Gonzales and André. 2014). I expect that a more effective board recognizes this opportunity and this results in an higher likelihood of performing a corporate spin-off.

Another important factor for the decision to perform a spin-off or not are managerial incentives. The management has to make the decision whether to perform a spin-off or not. The agency theory states that organizations grant restricted stock and stock options to their CEO to make the interests of the shareholders and the manager more aligned. Shareholders want the CEO to perform conform their long-term interests, which does not automatically happen because of managerial short-termism. Like mentioned, performing a spin-off is often a good option for an

organization to create value for the shareholders. The increased effort of the spun-off’s management and the increased scope of the parent firm make a spin-off a very interesting option for shareholders, because they also receive shares of the spun-off firm after the separation. So, both the

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parent firm and the spun-off can benefit from the spin-off. This makes the effect of managerial incentives as a corporate governance mechanism interesting to research in the likelihood of performing a spin-off. I expect that more managerial incentives lead to more alignment with the shareholders, which will lead to an increased change of engaging in the value-creating spin-off transaction.

Feng et al. (2015) mention that both managerial incentives and effective corporate governance are important for the long-run success of a spin-off. They are in some way complementary for success. Like mentioned, a more effective board may be a good influence on corporate decisions (like spin-offs). However, it is not something that can replace managerial equity incentives permanently (Feng et al., 2015). The CEO can have personal reasons to maintain a spin-off, like the reduction of risks that multiple different segments provide (Aggarwal and Samwick, 2003; Amihud and Led, 1981). The fact that the CEO also owns stock of the firm is still necessary to let the CEO make choices that are more aligned with the shareholders, which means choosing strategies that improve the long-term stock performance of the company. This indicates that both an effective board and a good managerial incentives portfolio can be important for the likelihood of performing a spin-off and in general for implementing effective corporate governance.

In this research, I investigate the effects of an effective board of directors on the likelihood of performing a spin-off. I look at board size, board independence and board experience to compound a measure for board effectiveness that I obtain through a factor analysis. The reasons why I think these variables describe an effective board are found in prior literature and linked to either the agency theory or the resource dependency theory. First, a mitigation of the free-rider problem and the fact that in a larger board an open dialogue is more difficult are reasons that a smaller board is a more effective monitor than a larger board (Jensen, 1993; Yermack, 1996). Second, a board with a high level of independence is better able to enhance the value of a diversified firm (Anderson, Bates, Bizjak and Lemmon 2000). This is due to the fact that board members from inside the firm are seen as people for management entrenchment (Eisenberg, 1976; Millstein, 1993). Third, in line with the resource dependency theory, firms that have directors with more prior or current board experience are more experienced and this might imply that they have more knowledge about diversified firms and engaging in a corporate spin-off.

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I compare firms that performed a corporate spin-off with control firms that did not perform a corporate spin-off in the same year. I expect in line with previous papers that a more effective board leads to an increased chance of performing a spin-off (Ahn and Walker, 2007) Also, I expect that more managerial incentives lead to an increased likelihood in the company performing a spin-off (Feng et al, 2015). So, the research question that is guiding this research is:

To what extent do an effective board and managerial incentives influence the likelihood of a corporate spin-off decision?

Currently, the academic literature on the likelihood of performing spin-offs is scarce, especially in the recent decade. Prior study of Ahn and Walker (2007) looked at the effect of corporate governance on the likelihood of engaging in a corporate spin-off. This article together with the article of Feng et al. (2015) are the only articles that take a deeper look in to corporate governance to look at determinants of the corporate spin-off. Ahn and Walker (2007) found significant evidence that corporate governance variables have an influence on the likelihood of performing a spin-off. They mentioned that their results might not be generalizable, because that their results might be limited to a specific period (1981-1997). The study shows that the newer portion of their sample is more significant than the older portion. This means that their main findings were more significant during the 1990s than in the 1980s. They called for future research regarding a newer time period to look if this trend continues. Feng et al. (2015) researched the effect of managerial incentives on the likelihood of spin-offs. They found significant evidence that managerial incentives have a positive relation with the likelihood of performing a spin-off. Their sample reaches from 1993 until 2006, so the more recent years are not included in this research either.

Another study finds that the structure of boards changed in the period from 1997 until 2003 (Chhaochharia and Grinstein, 2007). The biggest effect of this changes was between 2000 and 2003, which could indicate that the corporate scandals (Worldcom, Enron) and the new governance rules (SOX in 2002) in this period had a big influence on the corporate governance changes. Chhaochharia and Grinstein (2007) document that

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boards became smaller and more independent, there were fewer situations of interlocked directorships and a decrease in multiple directorships was found. They also found changes in the personal background of directors. This are mostly board characteristics that indicate a more effective board. A more effective board is more likely to approve performing a value-increasing spin-off than a board with less effective characteristics (Ahn and Walker, 2007). So, there is a good reason to expect that after 2003 the corporate governance mechanisms changed which might affect the likelihood of performing a spin-off after the new regulations and the corporate scandals.

I expect that most US listed firms will have good corporate governance mechanisms nowadays, which might indicate that the mechanisms are not determinants of the likelihood of performing a corporate spin-off anymore. The study of Ahn and Walker (2007) was based on a sample from 1981 until 1997, which is before the findings of Chhaochhari and Grinstein (2007) regarding the changes in boards. Newer findings, in particular after the new corporate governance regulations of 2003, form a gap in the current research of spin-offs. Also, (Cohen, Dey and Lys, 2012) found evidence that after the implementation of SOX, the pay-performance and incentives of CEO’s have declined. This can mean that the managerial incentives are no longer a determinant of spin-offs nowadays, because most pay packages of CEO look quite the same. I question the previous evidence that corporate governance variables and managerial incentives can have an effect on the likelihood of performing a corporate spin-off.

I focus on US companies in the period of 2000 until 2017. The data has been collected by using SDC Platinum to obtain information about completed spinoffs. I excluded the spin-offs where the parent is operating in the financial and regulated industries (SIC 4900–4999, 6000– 6999)(Feng et al., 2015; Ahn and Walker, 2007). This data was merged with the data from Compustat and Boardex. This results in a total of 97 spin-off events from 88 different companies. For the Beffect variable, I combined multiple board characteristics with a factor analysis to have a single board strength variable (Gonzales and André, 2014). The following characteristics are used: board size, board independence and board experience. I measure the managerial incentives by looking at the managerial ownership that is obtained from Boardex and Compustat. The control variables that I use in this study are: firm size, market value, CEO turnover, CEO dual, ROA, leverage and loss.

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The results of my empirical tests indicate that Beffect and CEOown are not related with the likelihood of performing a spin-off in my period. In addition, I looked at the individual effect of the three board characteristics used to compute the compound measure I observed that only Bexp has a significant negative relation with the likelihood of engaging in a corporate spin-off. This indicates that the more experience is present on the board, the less the probability of performing a corporate spin-off. This is against the prediction that more experienced directors might have more experience about value-creating spin-offs and that this will increase the likelihood of one happening. My results could be explained by the corporate governance rules in the US, suggesting that most boards are effective and the composition of managerial incentives are mostly alike in listed US firms. This would indicate that the spinoff decision is driven by operational motives, instead of poor corporate governance.

This research adds to the literature on corporate governance. Specifically, my results show that Beffect and CEOown do not determine the choice whether to engage in a corporate spin-off or to maintain a diversified firm. Studies like Ahn and Walker (2007) and Feng et al. (2015)

documented that corporate governance can be a important factor to decide to engage in a corporate spin-off. Ahn and Walker (2007) found this effect for corporate governance variables and Feng et al. (2015) found the effect for managerial incentives on the likelihood of performing a corporate spin-off, while my findings suggest that they do not influence the spin-off decision. This suggests that, in my sample, the decision to spin-off is driven by other factors than poor corporate governance mechanisms. The possible explanation can be that most US listed firms have the same corporate governance mechanisms nowadays after the implementation of the SOX.

I also extend the literature on corporate spin-offs. Opposing to Ahn and Walker (2007) and Feng et al. (2015) I didn’t find a relation between corporate governance mechanisms and the likelihood of performing a corporate spin-off. This is a important finding, because this indicates that the effectiveness of the board and managerial incentives to not determine the likelihood of performing a corporate spin-off anymore. So, there might be different reasons that explains why some firms perform a spin-off and other firms maintain their diversified firm. The literature about the determinants of a corporate spin-off is quite limited, so this research gives a new insight that other determinants need to be researched to understand the determinants of engaging in a corporate spin-off.

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The rest of this paper is organized as follows: in the second section, I discuss the currently existing literature, theories and develop the

hypotheses. The third section consists of the research methodology. In the fourth section, I present my findings. In the last section, I discuss the findings of my research.

2. Theoretical Framework

Several studies state that a corporate spin-off can create value. Daley, Mehrotra, Sivakumar (1997) found that spinning off a division increases value if the decision decreases the firm’s industrial scope. Also, the share price reaction after the spin-off announcement significantly increases (Schipper and Smith, 1983). This confirms the hypothesis that eliminating unrelated segments makes it possible for the manager to focus on the core operations and that a more focused firm is better manageable. There can also be tax or regulatory benefits, these benefits can be achieved by escaping the external constraint of regulation or by spinning-off a subsidiary that is located abroad to avoid paying taxes in the domestic country (Schipper and Smith, 1983). Examples of these tax or regulatory benefits can be spinning-off a royalty trust or separating an unregulated segment from a more regulated firm.

Chemmanur and Yan (2004) mention the managerial discipline hypothesis as a possible reason to perform a spin-off. The management of the spun-off enjoys private benefits of control after the separation, but these can be lost if the company gets taken over by another management team. This means that the spin-off transaction disciplines the spun-off management to work harder, to not be taken over, which leads to an increase in operating performance and stock performance after the spin-off, even if the actual takeover might not appear. However, even if an actual takeover takes place, the effect of the new management might improve performance.

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There is evidence that an overdiversified firm can destroy value, for example by overinvestment, cross-subsidization and information asymmetry (Rajan, Servaes, Zingales, 2000, Berger and Ofek, 1995, Krishnaswami and Subramaniam, 1999). Overinvestment means that a firm invests more in one segment than they would invest as a single-firm. This indicates that multi-segment firms are more likely to overinvest in a division that might not be worth the money because the segment is under-performing. Investing in under-performing segments contribute to the value loss of diversification (Berger and Ofek, 1995). The company would invest the money in more value-generating operations when the

under-performing segments were spun-off into individual firms.

Cross-subsidization means that the well-performing segments of a company finance the poorly performing segments, leading to a loss of value of the company overall (Berger and Ofek, 1995, Rajan et al., 2000). An under-performing independent business is not able to have a value below zero. Most of the time the firm would go bankrupt or be abolished because the firm can’t make profits. However, these sort of business segments can have a negative value if it is part of an overdiversified firm that works with cross-subsidies (Meyer, Milgrom, Roberts, 1992). The well-performing segments can create value, while the under-well-performing segments lose value for the firm. Rajan et al. (2000) mention that CEOs give each division in the overdiversified firm a fair share, instead of looking which divisions have the most potential to do good business. The CEO can for example look at the amount of assets or sales to adjust a budget. With this argument, there are no divisions that feel like they are treated unfairly.

Krishnaswami and Subramaniam (1999) state that holding on to a overdiversified firm leads to more information asymmetry compared to when a division would be spun-off. The existence of information asymmetry often leads to undervaluation of segments in the market, which means that the whole overdiversified firm loses value (Hughes, Liu, Liu, 2007). Segments of a diversified firm have less external reporting duties compared to when they would be an independent business. This means that segments might keep internal information from the rest of the firm, which leads to more information asymmetry. Moreover, the internal battle between segments for capital often leads to increased information asymmetry. Other segments might benefit from the private information of another segment to convince the firm to give more capital to their segment, this

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problem increases the asymmetry in a firm. Information asymmetry also leads to a higher cost of capital from external parties, because these parties have less information available. This leads to an increase in controlling of the firm from the external parties to make sure the firm is able to pay its debt (Bhattacharya and Daouk, 2002). An increase in the controlling of debt providers results in higher costs of debt. Krishnaswami and Subramaniam (1999) show that these drawbacks of information asymmetry for a segment, and so the whole company, decreases when the segment is spun-off. This means that there is less information asymmetry when the segment is spun-off. However, some companies do not eliminate segments from their (over)diversified firm, possibly due to less effective corporate governance structures (Ahn and Walker, 2007).

The main theory for the question whether to perform a corporate spin-off or not is the agency theory. This theory consists of the conflict between the principal and agent. The principals in this case are the shareholders of a firm and the agent is the management of the firm. Shareholders are the owners of the firm and it is the responsibility of management to act in the best way to satisfy the shareholders. However, the interests of the management and shareholders can be different and this causes conflicts. The resource dependency theory explains how external resources can influence the firm. According to the agency theory and the resource dependency theory the board has a role to monitor and advise the daily business in the company (Hart, 1995; Pfeffer and Salancik, 1978; Anderson et al., 2011; Aggarwal et al., 2019). The agency theory says that the board of directors should monitor the management, while the resource dependency theory states that the board has a more advising role. The resource dependency theory states that if there are more quality board members, that they can advise management effectively. The board has the role to approve the decision whether to engage in a corporate spin-off or not and the management is responsible for deciding whether to perform a spin-off or not and the execution of the spin-off transaction.

12 2.1. Board effectiveness

Gonzales and André (2014) mention that an effective board creates a culture that is built around value creation and preventing the company from the risk of value destruction. Following the two theories, it can be argued that more effective board characteristics result in better monitoring and advising capabilities. A more effective board can recognize the value-decreasing firm and advise management to take actions. The board will have to approve the decision to perform a spin-off and a more effective board will approve this decision more often (Angel et al., 2018). As the shareholders do not have the option to approve the spin-off, the board has to act on their behalf and decide to approve the spin-off or not. Daley et al. (1997) and Schipper and Smith (1983) showed in their studies that a spin-off can create value due to decreasing an organization’s scope, tax benefits and increased productivity of the spun-off.

Following Gonzalez and André (2014) and Elsaid and Davidson (2009), I make a measure for board effectiveness by taking into account the following three characteristics: board size, board independence and board experience. I do not use every board characteristic independently because board characteristics are not independent of each other, which make them really hard to interpret (Gonzalez and André, 2014). So I use the term Beffect as the main part of discussion. Next, I explain the theory behind the chosen board variables in the Beffect variable.

2.1.1. Board Size

Yermack (1996) and Jensen (1993) found evidence that states that smaller boards are more effective monitors than larger boards, this is due to the mitigation of the free-rider problem and the fact that larger boards are not as useful as smaller boards for an open dialogue. An increase in the size of the board means that the coordination and processes run slower because more people have to decide or give their opinion. This indicates that the board may encounter problems in communication and decision-making which reduces the effectiveness. This would indicate that diversified firms with smaller boards would recognize the value-increasing opportunity of a spin-off faster than diversified firms with a large

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board and that the decision about the spin-off could be made more effectively. In line with this argument, Ahn and Walker (2007) and Nixon, Roenfeldt, Sicherman (2000) found significant evidence that a smaller board increases the likelihood of a spin-off.

However, in line with the resource dependency theory, Pfeffer (1972, 1973) states that a larger board brings more expertise and resources for the organization, so there might be better decision-making about performing a spin-off. If there are more directors, there is more knowledge on the board regarding (over)diversified firms. Moreover, Boone, Field, Karpoff, Raheja (2007) argue that large firms that operate in more than one industry should have more sophisticated boards that are familiar with all the daily businesses to monitor and advice management. This would indicate that a(n) (over)diversified firm should have a larger board, to have more expertise available to decide about the spin-off. The literature about this is inconclusive, so both effects are possible in my study.

2.1.2. Board independence

In line with the agency theory, boards with a high level of independence are more effective in monitoring decisions of managers and enhancing the diversified firm’s value (Anderson, Bates, Bizjak, Lemmon 2000). The reason for this is that independent board members are the only one who can strongly monitor management because inside board members are seen as a device for management entrenchment (Eisenberg, 1976, Millstein, 1993). As mentioned before the management can have several (personal) reasons to prevent a company from performing a spin-off. When the board consists of mostly inside directors, the management can have more influence on the board to prevent the board from approving a corporate spin-off. Landier, Sauvagnat, Sraer, Thesmar (2013) found that more independent board members from the CEO have a positive influence on the firm’s performance. They mention that independent board members give management more limitations than members who might own him their job. These limitations may prevent the CEO from making decisions that are inefficient and value-decreasing for the company. So, you could say that the personal desire of the CEO to possibly prevent a spin-off is more limited by independent board members than by inside directors. At last, Chen and Chen (2012) showed that a board with high independence is more effective in monitoring the allocation of capital in diversified firms because they do not have connections to one of the segments in the diversified firm. In the context of

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spin-offs, this argument would imply that independent board members would be more likely to advise and/or approve a spin-off of a segment when they acknowledge that the parent and the spun-off segment would function better independently. Thus, these findings would indicate a positive relationship between board independence and the likelihood of a spin-off.

2.1.3. Board experience

In line with the resource dependency theory, a director with more experience is better in advising the management. More experience means that a director has more knowledge than without experience because he experienced different events in other firms. This experience can help to advise the current management to make good choices. This indicates that having multiple directorships in companies increases your experience and this can be useful in helping the company you are a director of. Kroll, Walters, Wright (2008) provide evidence in line with this argument and show that firms that hire directors with prior or current board experience are experiencing higher returns than boards who do not. A board with more experienced directors might have more knowledge about diversified firms and performing offs, which implies that the likelihood of a spin-off in these companies is higher.

Contrary, there is also literature that documents the disadvantages of having board members with multiple directorships. Studies found evidence of a negative relationship between busy directors and firm performance (Ahn, Jiraporn and Young, 2010; Jich and Schivdasani, 2006). The main reason for this is that the directors have too many directorships and cannot put the desired effort in monitoring or advising a single firm. This literature is quite new and results show inconclusive results, so both effects are possible in this study.

Board size and board experience both have prior literature that indicates that there can be a positive or negative relation with the likelihood of performing a corporate spin-off. I follow the results of Ahn and Walker (2007) and Nixon et al. (2000) that board size has a positive influence on the spin-off decision. Board experience has not been related with the spin-off decision before, however, I think that more experience has a

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more experience on the board, this might result in directors who have experience with the transaction. They will acknowledge the possible value-creation and approve the spin-off decision. The measure of board effectiveness is made by compositing the three characteristics that I just mentioned and results in the following hypothesis:

H1: Board effectiveness positively affects the likelihood of a corporate spin-off

2.2.Managerial incentives

The agency theory explains two main reasons for managers to decide to diversify their firms. The first reason is that the manager has reasons to reduce the risk in their company. Managers who have (high) equity ownership face higher idiosyncratic risk and often decide to diversify the firm they manage to reduce this risk of losing value on the shares (Aggarwal and Samwick, 2003; Amihud and Led, 1981). Moreover, May (1995) found evidence that a CEO who has more wealth in the firm’s equity is more likely to perform more diversifying acquisitions. The second motive involves the private benefits that managers derive from managing a more diversified firm. Managing a diversified firm can result in better career prospects or an increase in the manager’s pay (Aggarwal and Samwick, 2003). A manager of a diversified firm is often considered to be

experienced in managing a company. According to the literature, there are even more reasons for managers to keep divisions like empire-building (Jensen, 1986), overconfidence (Roll, 1986), increasing the value of manager’s human capital (Schleifer and Vishny, 1989) and inertia (Bertrand and Mullainathan, 2003). These arguments can be a reason for a firm to maintain its diversified focus, although increasing their focus on specific divisions would add value to the shareholders. Shareholders want the CEO to perform conform their long-term interest, which does not automatically happen because of managerial short-termism

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Managerial incentives are performance-based rewards for the CEO to align the interests of the shareholders and the CEO. Management has to make the decision whether to engage in a spin-off or not and after that execute the transaction, so it is interesting to look what the effect of managerial incentives are on this decision. Denis et al (1997), Lins and Servaes (1999), Anderson et al. (2000) and Singh, Marthur, Gleason (2004) found evidence that the effect of insider ownership is relevant in the case of diversified firms, the management makes better decision for the long-term shareholders when his managerial ownership is higher. So, a firm is more likely to perform a spin-off when managerial incentives are higher. This would make sense because hurting the shareholders would also result in a loss for the manager itself and performing a spin-off is often value-creating action for a firm. Managerial incentives should motivate the manager of the parent to make a spin-off decision whenever this is likely to benefit the shareholders (Feng et al., 2015). They also mention that the CEO is responsible for the execution of the spin-off, so having the manager motivated in the right way by using managerial incentives leads to a better restructuring of the company.

Higher managerial incentives should prevent the manager to act in his own interests, however does this also mean that it has an effect on the likelihood of performing a corporate spin-off? Feng et al. (2015) looked at the pay-performance sensitivity and found a positive significant relation with the likelihood of performing a corporate spin-off. I decide to look at the amount of shares that the CEO owns. So, I do not look at a specific managerial incentive, but at the amount of shares that the CEO owns from the used managerial incentives. This has never been done before in relation with the likelihood of performing a corporate spin-off. In line with Feng et al. (2015) I expect to find a positive relationship between managerial equity incentives and the likelihood of a corporate spin-off and this leads to the following hypothesis:

17 3. Research Methodology

3.l Data and sample selection

I use SDC Platinum to obtain information about completed spinoffs undertaken by listed US firms during the period from 2000 until 2017 for US-firms. Following previous spin-off studies I exclude the spin-offs where the parent firm is operating in the financial and regulated industries (SIC 4900–4999, 6000–6999)(Feng et al., 2015; Ahn and Walker, 2007). I use the Compustat database for financial data and Boardex for the

Beffect variable and the CEOown variable. Since this study investigates the effect of board effectiveness and managerial ownership on the

propensity to undertake a spinoff, I collect the necessary data in the year prior to the spin-off announcement. In this year the decision to perform a corporate spin-off has often been made. These exclusion criteria result in a total of 97 spin-offs from 88 different firms. The most spin-offs took place in the business service sector (SIC-code: 73, 13 firms spin-offs in the sample).

3.2 Dependent variable: spin-off decision

The dependent variable is a dummy variable, which equals 1 if the firm performed a spin-off in the following year and 0 if the firm did not perform a spin-off in the following year.

3.3 Independent variable: board effectiveness

Corporate governance is a broad and complex concept which is used to control how the decision-making and performance of firms is managed. Especially, looking at corporate governance variables individually makes research more difficult, because most of these variables are correlated (Adams, Hermalin, Weisbach, 2010; Hardwick, Adams, Zou, 2011). Following Gonzalez and André (2014), I combine multiple board

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characteristics with a factor analysis to obtain one board strength variable. I compute a single board variable and call it Beffect. Using indices avoids several problems in comparison with single board variables. The classification of some variables like board independence would be challenging, for example, classifying an independent board as one with 51% independent directors and a dependent board as one with 49% independent directors is odd (Gonzalez and André, 2014). Moreover, I do not have to use ‘arbitrary’ weights for the variables that are used in the construction of the board variable: Beffect. The last benefit is that the problems of using highly correlated variables in a regression are prevented (Gonzalez and André, 2014). The variables that I use in the factor analysis for the Beffect variable are:

Bsize: the number of directors on the board.

Bind: the number of independent non-executive directors (NED) divided by board size.

Bexp: the total number of other boards that directors are currently sitting on.

All my variables for the Beffect variable are retrieved from BoardEx. The factor analysis loads for one factor. The factor is mainly determined by

Bsize and Bexp and explains a variation of 47,68%. The Kaiser-Meyer-Oklin (KMO) measure gives a score of 0.51. Variables suitable for a

factor analysis should a KMO score of more than 0.5, so my Beffect variable is suitable for this analysis.

3.4 Independent variable: managerial incentives

I measure managerial incentives by looking at the ownership of the CEO. CEOown is defined as the percentage of total shares owned by the CEO. For the spin-off firms, I look at the shares owned by the CEO in the year prior to the spin-off announcement. For the control firms, I look at the shares owned by the CEO in the year for which the company is used as a control (i.e. one year before the spin-off announcement of the firm to which it is linked).

19 3.5 Control Firms

In my empirical analysis, I compare the sample of spin-off firms with similar firms that did not perform a corporate spin-off. I look at the year before the spin-off announcement, because most of the time this is the year in which the company decides to be performing a spin-off. Similar to Feng et al. (2015), I match these firms on firm size and industry. I do not include the Herfindahl Index (HHI) because I have little data available for this measure, which would result in a big loss of observations. Instead, I look at similar firms that have at least two business segments. For each spin-off firm, I select a control firm prior to the year of the spin-off announcement. I first select firms that have the same 2-digit SIC code as the spin-off firm and then match the firm closest to the firm size of the spin-off firm, provided that this firm has data available at the BoardEx and Compustat databases (Feng et al., 2015). At last, I check whether the firm has multiple segments in the CompuStat database for segments. The firm with the closest amount of business segments compared to the spin-off firm is chosen. Firms have to fulfill all these requirements to be able to act as a control firm (Feng et al, 2015).

3.6 Control variables

I use seven different control variables in my research model. These are Fsize, MV, CEOturn, CEOdual, ROA, leverage and loss. ROA is defined as the return of total assets and controls for firm performance. Ahn and Walker (2007) also controlled for the ROA variable and found that spin-off firms have significantly higher sales than control firms. This might indicate that there are losses in the control firms, which can motivate the firm to look at spinning-off a (loss-making) segment. That is why I include a dummy variable for loss. Loss equals 1 if the company had a loss and 0 if the company didn’t have a loss in the year before the spin-off announcement. Losses have not been related to the likelihood of

performing a spin-off before in literature. Leverage looks at the ratio in which the firm is financed with debt. Ahn and Walker (2007) didn’t find a significant effect for leverage on the likelihood of performing a spin-off. Following Ahn and Walker (2007) and Feng et al. (2015), I look at

cross-20

subsidization and information asymmetry (Rajan et al., 2000; Berger and Ofek, 1995; Krishnaswami and Subramaniam, 1999). A larger firm has therefore multiple reasons to perform a spin-off, to avoid having these kind of problems. Following Feng et al. (2015) I control for whether there was a change of CEO in the year prior of the spin-off. A new CEO can bring new ideas in a company, for example that it is better to spin-off a division. I also control if the CEO is also the chairman of the board. Brickley, Coles, Jarrell (1997) state: ‘when the CEO is also chairman, management has de facto control, yet the board is supposed to be in charge of management. Checks and balances have been thrown to the wind.’ Having the CEO as a chairman can give troubles regarding the decision of performing a spin-off or not. If the board has a different opinion compared to the CEO, the CEO has more power on the board to make sure his decision is being executed. I control for CEOturn and CEOdual with dummy variables (Bhagat and Bolton, 2008; Zhang and Rajagopalan, 2010).

3.7 Model

I examine whether Beffect and CEOown are linked with the likelihood of performing a spin-off. To reduce the impact of outliers, I winsorized all the continuous variables at the 1% and 99% levels (Feng et al, 2015). I use the ordinary least squares (OLS) regression. All the variables are calculated for the parent-firm the year prior to the spin-off announcement. I expect positive signs for both Beffect and CEOown on the likelihood of performing a corporate spin-off. The model looks as followed:

Spint = β0 + β1 x Beffectit + β2 x CEOownit + β3 x Fsizeit + β4 x MVit + β5 x CEOturnit + β6 x CEOdualit + β7 x ROAit + β8 x Leverageit + β9 x Lossit + εit

(1)

21 4. Results

4.1 Summary statistics

Table 1 shows the descriptive statistics of the variables used in the model. I show the statistics for spin-off firms and control firms separately and then I perform tests for the differences in means, medians and proportions between the two sub-samples.The T-test compares the mean of the two subsamples and gives the chance that the mean is significantly different. The Kruskal Wallis test compares the medians of both sub-samples and gives the chance whether this is significantly different. For the three dummy variables I used a proportion test to test

the differences between the sub-samples.

The mean (median) of Beffect is -0.05 (0.08) in the sub-sample of spin-off firms and 0.05 (-0.03) in the control sample, but the difference is not statistically significant. Bexp gives a mean (median) of 0.57 (0) for spin-off firms and 0.86 (1) for control firms. The difference is statistically significant at the 5% (10%) level, so spin-off firms and control firms do not have the same experience on the board. Control firms have more experience on the board than spin-off firms have. The control variables do not have a significant difference between spin-off firms and their control firms. Overall, the means of spin-off firms and control firms are quite small, especially in the variables Beffect and CEOown. This indicates that these variables do not explain why half the firms chose to engage in a spin-off, while the other half decided not to perform one.

In table 2 I report on the correlations between the variables. The likelihood to engage in a spinoff is not significantly correlated with Beffect and

CEOown, suggesting that the decision to go through the divestiture is not influenced by board characteristics nor managerial incentives.

The correlations of the dependent and control variables are not significant, suggesting that the decision to engage in a spin-off is not influenced by variables like Fsize, MV, ROA and Loss. I do further not expect problems regarding multicollinearity in my multivariate analyses, because there is no correlation above the value of 0.7

22 Table 1: descriptive statistics

Variable definitions are in Appendix A. All the variables are obtained in the year prior to the spin-off. The T-test, Kruskal Wallis test and the Proportion test state p-values that indicate a 10% significance.

Spin-off firms Control firms Spin-off vs controlfirms

VARIABLES N mean median sd N mean median sd T-test Kruskal Wallis Proportion

Beffect 97 -0.05 0.08 0.88 97 0.05 -0.03 1.11 0.47 0.99 - Bsize 97 10.01 10 2.23 97 10.01 10.00 2.79 1.00 0.68 - Bind 97 0.85 0.89 0.09 97 0.84 0.88 0.09 0.25 0.07 - Bexp 97 0.57 0 0.72 97 0.86 1.00 1.03 0.02 0.06 - CEOown 97 0.02 0 0.07 97 0.02 0 0.04 0.94 0.02 - Fsize 97 3.90 3.94 0.73 97 3.86 3.92 0.74 0.73 0.78 - MV 97 3.92 3.92 0.71 97 3.92 3.89 0.81 0.48 0.90 - CEOturn 97 0.23 0 0.42 97 0.23 0 0.42 - - 1.00 CEOdual 97 0.48 0 0.50 97 0.47 0 0.50 - - 0.89 ROA 97 0.03 0.06 0.14 97 0.05 0.05 0.23 0.56 0.89 - Leverage 97 0.23 0.23 0.16 97 0.89 0.23 4.78 0.18 0.63 - Loss 97 0.22 0 0.41 97 0.18 0 0.38 - - 0.47

23 Table 2: correlation matrix

Variable definitions are in Appendix A. All the variables are obtained in the year prior to the spin-off. *, **, *** are for the significance at respectively the 10%,5% and 1% level. I used 194 observations for this matrix, so both the spin-off firms and the control firms.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (1) Spin 1 (2) Beffect -0.053 1 (3) CEOown 0.005 -0.044 1 (4) Fsize 0.025 0.380*** -0.062 1 (5) MV -0.051 0.288*** _{0.023 0.627}*** ₁ (6) CEOturn -0.062 -0.128 -0.044 -0.071 -0.051 1 (7) CEOdual 0.010 0.080 0.043 0.161* 0.097 -0.115 1 (8) ROA -0.043 0.080 0.008 0.036 0.276*** -0.054 -0.072 1 (9) Leverage -0.097 -0.020 0.007 -0.053 0.020 -0.036 -0.094 0.281*** 1 (10) Loss 0.052 -0.159* _{-0.034 -0.162}* _-0.235*** _{0.045 -0.136 -0.486}*** _{-0.040 1}

24 4.2 Regression analysis

Table 3 shows the results of the regression analysis. The first model tests the effect of Beffect and the control variables on the likelihood of performing a spin-off. Model 2 takes CEOown and all the control variables in consideration. Model 3 looks at the effect of both main

independent variables on the likelihood of performing a spin-off. In model 4 from the regression table I split the Beffect variable back into the three individual variables to see if this gives the same results as by using a factor analysis.

My first prediction is that a more effective board is positively associated with the likelihood of performing a corporate spin-off. The coefficient of Beffect is not statistically significant, suggesting that effective boards are not determinants of the spin-off decision. This result does not support H1 at the 1%, 5% or 10% level, which means that there is no proof that a more effective board results in an increased likelihood of a spin-off in this sample.

This second hypothesis states that managerial ownership would have a positive effect on the likelihood of a firm to engage in a corporate spin-off. The coefficient of CEOown is not significant at conventional levels. This means that the managerial incentives do not influence the spin-off decision. The regression results are consistent with the descriptive statistics and correlations matrix suggesting that Beffect and do not influence the spin-off decision. Moreover, there is also no significant evidence that one of the control variables has an effect on the likelihood of a firm engaging in a corporate spin-off.

Model 4 shows that Bsize, Bind and CEOown are still not significantly related to the decision to engage in a corporate spin-off. They are all still positively related to the dependent variable, but not significant. Bexp on the other hand is showing a significant negative coefficient on the likelihood of engaging in a spin-off. This means that the more experience on the board, which means that directors are also involved at boards in other firms, the lower the chance of a firm engaging in a corporate spin-off. This is against my prediction that a more effective board will have a

25

positive influence on the likelihood of performing a spin-off. This result confirms the view of Jich and Schivdasani (2006) who said that the board members who have other directorships cannot put the desired effort in monitoring or advising a single firm. The mean of the control firms (0.86) is higher than the mean of spin-off firms (0.57), this could mean that board members of the spin-off firms have more time to acknowledge the value-creating opportunity of a spin-off than the control firm’s board members.

26 Table 3: Regression models

(1) (2) (3) (4)

VARIABLES Spinoff Spinoff Spinoff Spinoff

Beffect -0.036 -0.036 (0.040) (0.040) CEOown 0.108 0.088 0.489 (0.607) (0.607) (0.623) Bsize 0.008 (0.017) Bind 0.466 (0.435) Bexp -0.113** (0.047) Fsize 0.000 0.000 0.000 0.000 (0.000) (0.000) (0.000) (0.000) MV 0.000 0.000 0.000 0.000 (0.000) (0.000) (0.000) (0.000) Turn -0.048 -0.043 -0.047 -0.046 (0.049) (0.049) (0.049) (0.049) Dual -0.000 -0.001 -0.001 -0.026 (0.076) (0.076) (0.076) (0.076) ROA 0.098 0.098 0.099 -0.050 (0.244) (0.244) (0.245) (0.250) Leverage -0.0151 -0.015 -0.015 -0.013 (0.011) (0.011) (0.011) (0.011) Loss 0.066 0.074 0.066 0.040 (0.108) (0.108) (0.109) (0.108) Constant 0.502*** 0.504*** 0.500*** 0.114 (0.067) (0.068) (0.069) (0.380) Observations 194 194 194 194 R-squared 0.027 0.023 0.027 0.058

Variable definitions are in Appendix A. All the variables are obtained in the year prior to the spin-off. *, **, *** are for the significance at respectively the 10%,5% and 1% level. Model 1 explains the effect of board effectiveness on the likelihood to engage in a spin-off. Model 2 looks at the effect of managerial ownership on the likelihood to engage in a spin-off. Model 3 looks at the effect of both board effectiveness and managerial ownership on the dependent variable. Model 4 only looks at the individual board characteristics that are used in the board effectiveness measure and the effect on the dependent variable.

27 5. Discussion and conclusion

The frequency of corporate spin-offs is expected to rise, due to companies getting back to their core, more activism from shareholders and tax benefits (Niland, 2017). Daley, Mehrotra, Sivakumar (1997) and Schipper and Smith, (1983) documented that corporate spin-offs can increase a firm’s value. The firm’s industrial scope will be decreased, which makes the firm have more corporate focus. In addition, Krishnaswami and Subramaniam (1999) found that there is also less information asymmetry after the spin-off in the parent firm. So, in general the shareholders often benefit from a firm engaging a corporate spin-off. Corporate governance mechanisms may be important determinants of corporate

transactions like spinoffs, because there can be reasons for managers to prevent the firm to engage in a spin-off and the managers are the one who should make the decision to engage in a spin-off or not.

In this regard, Ahn and Walker (2007) documented a positive effect between multiple effective corporate governance characteristics and the likelihood of performing a corporate spin-off in the period from 1981 until 1997 (Ahn and Walker, 2007). However, the paper mentioned that their results might be limited to the specific time period. The study says that the newer portion of their sample is more significant than the older portion. Moreover, Chhaochharia and Grinstein (2007) found that boards and ownership structure changed in the period from 1997 until 2003, probably because of the corporate scandals (Worldcom, Enron) and the new governance rules (SOX in 2002). Feng et al. (2015) used the pay-performance sensitivity to measure the effect of managerial incentives on the likelihood of performing a spin-off and found a significant positive result. Their study had a time period from 1996 until 2006. These studies make it interesting to take a look into the effect of these two corporate governance mechanisms in a newer time period.

This study takes a new look at the effect of the two corporate governance mechanisms on the decision to perform a corporate spin-off using a more recent time period. My research expected that effective corporate governance mechanisms would have a positive influence on the likelihood of a spin-off, because these mechanisms can prevent agency problems between shareholders and management. Specifically, I

28

investigate the effect of board effectiveness and managerial incentiveson the spin-off decision. The board has the role to advise and monitor the actions of the managers and prevent the company of from the risks of value destruction (Hart, 1995)(Gonzales and André, 2014). The board has to approve the decision for a spin-off. A more effective board should result in better monitoring and advising capabilities, which make the board approve that a spin-off is a good option. A spin-off transaction can be value-creating for the shareholders and it’s the task of the board to act in the best interests of the shareholders.

The board effectiveness variable in this study consists of three board characteristics, namely board size, board independence and board experience. Yermack (1996) and Jensen (1993) found evidence that documented that smaller boards are more effective monitors than larger boards, because of less free-rider problems and the fact that smaller boards are more suitable for an open dialogue. That’s why I predict that a smaller board will increase the likelihood of a corporate spin-off, because the board is more effective when there are less board members. Independent boards are more effective in monitoring decisions of managers and enhancing the diversified firm’s value (Anderson, et al., 2000). This is because inside board members are seen as a device for management entrenchment (Eisenberg, 1976, Millstein, 1993). A more

independent board is expected to acknowledge the value-creating effect of a spin-off event, which will lead to an increase in the likelihood of a spin-off. As last, a board with more experience is better in advising the management, according to the resource dependency theory. The board can have more experience about (over)diversified firms and offs, which will result in an advise to management and the approval of the off decision. These arguments indicate that a more effective board would have a positive effect on the likelihood of performing a corporate spin-off.

There are multiple reasons for managers to maintain a diversified firm and prevent a firm to engage in a corporate spin-off. Managerial incentives should motivate managers to make decisions that are more in the best interests of the shareholders (Feng et al, 2015). Managerial incentives are incentives that grant restricted stock and stock options to their CEO to make the interests of the shareholders and the manager more aligned. Managers can (over)diversify their firm to reduce the risk of only focussing on one business segment (Aggarwal and Samwick, 2003; Amihud

29

and Led, 1981). Besides that, managers can also achieve personal benefits while managing a diversified firm. Things like: inertia (Bertrand and Mullainathan, 2003), overconfidence (Roll, 1986) and empire-building can make the manager reluctant to perform a spin-off.

If the managers will have more shares of the firm they manage, the managers might hurt their own compensation when they maintain a value-decreasing diversified firm. So, for managers there is a trade-off between personal benefits when making the choice about a spin-off. I expect that managerial incentives will make the manager more aware of the value-creating opportunity of a spin-off, so the managerial incentives will have a positive effect on the likelihood of performing a corporate spin-off. I take a look at the amount of shares that the CEO owns of the company he manages.

I compared firms that did perform a spin-off in the period between 2000 and 2017 with comparable firms that did not perform a spin-off in this period. My results do not support the hypothesis about the positive effect of board effectiveness on the likelihood of engaging in a spin-off. Also, the second hypothesis about the positive effect of managerial incentives on the likelihood of a spin-off is not supported. In particular, my results suggest that the spin-off decision is not affected by board effectiveness nor managerial incentives. This contradicts the results of Ahn and Walker (2007) and Feng et al. (2015) and is not in line with my expectations. However, when I divide the board effectiveness variable in the individual characteristics of board size, board independence and board experience and also add the managerial ownership variable there is a small

difference. Board experience shows a significant negative coefficient on the likelihood of engaging in a spin-off. This means that the more experience on the board, the lower the chance of a firm engaging in a corporate spin-off. This result confirms the view of Jich and Schivdasani (2006) who said that directors who also have other directorships cannot put the desired effort in monitoring or advising a single firm.

So, why did I not found the same positive effect that Ahn and Walker (2007) and Feng et al. (2015) did? Chhaochharia and Grinstein (2007) argue that board and ownership structures changed in the period after 1997, with the biggest changes in the period of the corporate scandals of Worldcom and Enron (2000-2002). After these scandals the SOX was implemented in 2002 with multiple regulations regarding corporate governance. Moreover, US specific organizations like the Institutional Shareholders Services, Inc. and the Council of Instutional Investors

30

recommended US corporations to have a smaller and more independent board (Boone et al., 2007). This could indicate that listed US firms nowadays have similar corporate governance mechanisms, which can explain the lack of evidence of these variables on the likelihood of performing a spin-off. This is consistent with my findings regarding the difference of board effectiveness and managerial ownership between spinoff and non-spinoff firms in my sample. This implies that both corporate governance mechanisms are effective, which would mean that the spinoff decision is driven by operational motives, instead of poor corporate governance. Besides that, the board’s task is not to make the decision of engaging in a corporate spin-off or not. Their task is to approve the decision when the management wants to perform a corporate spin-off. This influence of the board on the spin-off transaction might be too limited to find an effect of a more effective board on the likelihood of engaging in spin-off.

My study contributes to the literature on the effect of corporate governance mechanisms and the determinants of corporate spin-offs. Specifically, I use a recent sample of corporate spin-offs to investigate the effect of corporate governance mechanisms. I argue that the results do not hold in my sample because I use a recent time period, where most of the listed US firms have good corporate governance mechanisms. There are not many papers about the determinants of a corporate spin-off, so this research gives a new insight, but also shows that there is more research needed to find out what really determinants a spin-off transaction.

My study also has a few limitations. I used data from US-firms, so it is not clear whether there results can be generalized to the rest of the world. Specifically, the corporate governance differences between spin-off firms and control firms might be bigger in other parts of the world, which would lead to different results than those documented by my study. Moreover, my sample is relatively small due to data limitations on segmental disclosures and corporate governance measures. Future research could investigate whether corporate governance mechanisms influence the spinoff decision using an international sample. Also, the result of board experience on the likelihood of performing a corporate spin-off could be researched further to look if this effect is generalizable to the whole spin-off population. Studies can look specifically at the effect of prior and current boards that a director is sitting on. It is interesting to look if these studies also find that boards with more experience have a negative

31

relation with the likelihood of performing a spin-off. This is important, because this would indicate that the board members may not be able to work for multiple boards at the same time. This means that it is more effective for a board to have directors that only work for their own board. Furthermore, Ahn and Walker (2007) also found significant effects on outside director ownership and the age of directors in relationship with the likelihood of engaging in a corporate spin-off. I did not include these measures in my research, so it would be interesting to research if these effects stand in a newer time period or if these effects also disappear. In addition, Feng et al. (2015) used the pay-performance sensitivity to measure the effect of managerial incentives on the likelihood of performing a spin-off and found a significant positive result. Future research can use a different way of measuring managerial incentives and look whether this has an effect on the corporate spin-off.

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35 Appendix A

Variable Definition Source

Spin-off decision (Spin) Dummy variable, 1 if the firm performed a spin-off and 0 if the firm did not.

SDC Platinum

Board Effectiveness (Beffect) The factor analysis of Board Independence,

Board Size and Board Experience

BoardEx

Board Independence (Bind) The number of independent non-executive directors (NED) divided by board size.

BoardEx

Board Size (Bsize) Number of all directors at the annual report date

BoardEx

Board Experience (Bexp) The total number of current directorships that the directors have in other firms.

BoardEx

Board Effectiveness (Beffect) This is an approximation of the average number of shares held by all the directors in a given company divided by the company’s total number of shares

BoardEx

Managerial Ownership (CEOown) Percentage of Total Shares Owned by the CEO

Compustat Executive Compensation / BoardEx

36

Firm Size (Fsize) Total value of assets reported on the balance sheet.

Compustat

Market Value (MV) Common shares outstanding multiplied by the month-end price that corresponds to the period end date

Compustat

CEO Turnover (CEOturn) Dummy variable, 1 if the CEO changed and 0 if the CEO remained the same

Compustat Executive Compensation

CEO Dual (CEOdual) Dummy variable, 1 if the CEO is also the chairman of the board and 0 otherwise

BoardEx

Return on Assets (ROA) Net income divided by total assets Compustat

Leverage Total debt divided by the total assets Compustat

Loss Dummy variable, 1 if the company made a

loss and 0 otherwise