DO BOARD STRUCTURE AND MANAGERIAL INCENTIVE
ALIGNMENT IMPACT SPUN-OFF FIRMS PERFORMANCE?
By:
GERBEN SNIPPE S3844633
G.G.Snippe@student.rug.nl
MCs Business Administration Management Accounting & Control
Supervisor: Dr. Vlad Porumb
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ABSTRACT
Spinoffs are corporate divestitures that aim to increase operational focus and create shareholder value. This study analyses the relationship between board structure and CEO incentive compensation and the post-spinoff stock market performance of spun-off firms. I rely on Agency theory and Resource Dependence theory to examine the impact of board structure (board size and, board diversity), and CEO incentive compensation on the post-spinoff stock market performance of spun-off firms. I use a total of 414 firm year observations from the 2001 and 2019 period to find that board size and CEO incentive compensation have a negative effect on the post-spinoff stock market performance of spun-off firms. These findings suggest that, subsequent to a major corporate divestiture, general corporate governance mechanisms can influence the performance trajectory of the spun-off firm. In the context of worldwide increase in volume and value of spinoff divestitures, this study provides valuable insights on the association between corporate governance arrangements and firm performance.
Keywords Spinoffs are corporate divestitures that aim to increase operational focus and create
shareholder value. This study analyses the relationship between board structure and CEO incentive compensation and the post-spinoff stock market performance of spun-off firms. I rely on Agency theory and Resource Dependence theory to examine the impact of board structure (board size and, board diversity), and CEO incentive compensation on the post-spinoff stock market performance of spun-off firms. I use a total of 414 firm year observations from the 2001 and 2019 period to find that board size and CEO incentive compensation have a negative effect on the post-spinoff stock market performance of spun-off firms. These findings suggest that, subsequent to a major corporate divestiture, general corporate governance mechanisms can influence the performance trajectory of the spun-off firm. In the context of worldwide increase in volume and value of spinoff divestitures, this study provides valuable insights on the association between corporate governance arrangements and firm performance.
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1. Introduction
Investors will be surprised to learn that 4 in 10 spinoffs don’t generate any value over year one.
Ryan Mendy, COO of The Edge consulting group.
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structure characteristics and CEO incentive alignment - on the post-spinoff performance of spun-off firms.
Prior research regarding shareholder value creation through spinoffs focused mostly on the performance implications for the parent firms (Daley et al., 1997; Desai and Jain, 1999; Aggarwal and Garg, 2019; Bergh et al., 2008). More recent research started exploring the performance implications of the spun-off companies (Semadeni and Cannella, 2011; Feldman, 2016b; Corley and Gioia, 2004; Seward and Walsh, 1996). Those studies focused mostly on the parent-spunoff interconnections post spin-off, and how this influences the performance trajectory of both the parent and the spun-off firm. These interconnections are corporate governance mechanisms (CGMs), placed by the parent to maintain influence over the spun-off in the post-spinoff period (Semadeni and Cannella, 2011; Feldman, 2016b). Other literature discussing the interconnections between corporate governance mechanisms (CGMs) and spinoffs have approached it from several different perspectives, focussing mostly on the parent firm.1 However, it remains unclear how general CGMs - that are not linked to the parent post-spinoff, but nonetheless are heavily influenced by the parent - affect the post-spinoff performance of the spun-off firm. Moreover, prior literature suggests that monitoring and incentive-based CGMs can lead to improved firm performance.2 The aim of this study is to delve deeper into the challenge for corporate spinoffs to create value-adding effects concerning stock market valuation of spun-off firms. This comes to address the two decades-old call of
1 Boreiko and Murgia (2016) state that spin-off decisions are often triggered by firm’s governance earthquakes, like the
appointment of a new CEO. Feng et al. (2014) reveal that CEO’s with stronger equity incentives are more likely to engage in corporate spin-offs. Ahn and Walker (2007) provide evidence on the effectiveness of CG characteristics, especially board structure and ownership, on the firm’s choice to undertake a value-increasing, refocusingtransaction. Ahn and Walker (2007) concluded that firms with more effective CG are more likely to spin-off a division.
2 Bell et al. (2014) state that effective monitoring and incentive-based CGMs lead to improved stock market valuation. In
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Seward and Walsh (1996) who stated that ‘we need to know more about how the design of the governance and control mechanisms of a spun-off firm affects its future’ (1996: 37).
This study complements the work of Feldman (2016b) and Semadeni and Cannella (2011), by looking at board structure, CEO incentive alignment and their performance implications for the spun-off firm in the post-spinoff period. The parent firm has a lot of discretion in the spinoff process, being potentially involved in setting certain initial CGMs. I aim to assess which strategic choices are best suited in setting CGMs from a parent- and spun-off firm perspective. Spinspun-offs are inherently initiated out of good reasons, and are aimed at increasing firm value (Feldman, 2016a; Cusatis et al., 1993). However, I would like to assess which CGMs are associated with the success of corporate divestitures. Firstly, I draw on Agency Theory to examine corporate spinoffs and its relationship with CGMs. Secondly, I use Resource Dependence Theory (RDT) developed by Jeffrey Pfeffer as a counterpart of Agency theory to motivate the focus on board structure.
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Lastly, I asses the influence of CEO incentive alignment on stock market performance of the spun-off firm subsequent to the spinoff. On the one hand, incentive alignment could lead to aligning the interest of the CEO and shareholders, which could lead to better stock market performance (Aron, 1991). On the other hand, CEO’s might hedge against the risk exposure in a way that it impairs the interest alignment of CEO and shareholders (Aggarwal and Samwick 2002). Test results indicate that CEO incentive alignment has a negative effect on the stock market performance of the spun-off firm subsequent to the spinoff. Similar to prior results, this means the CEO’s might hedge against risk exposure in a way that it impairs the interests of the shareholders (Aggarwal and Samwick 2002). Furthermore, the results for board size and CEO incentive alignment are both highly economically significant. In economic terms, adding one board member to the board, or four million dollars in incentive compensation can lead to a decrease in stock market performance of about ten percent.3
This study generates various insights that help to contribute to the research about corporate spinoffs, monitoring and incentive-based CGMs regarding the board of directors and managerial incentive alignment, yielding significant theoretical implications for Agency Theory and RDT as well. This study contributes to Agency theory and RDT by looking at a unique context, namely a corporate spinoff, and how this specific context relates to proposed relations regarding board structure, managerial incentive alignment and firm performance (Semadeni and Cannella, 2011, Feldman, 2016b). Furthermore, this study generates various insights for several stakeholders both involved and not involved in the spinoff process (Ahn and Walker, 2007). Firstly, this study generates insights for CEOs, managers, and board of directors of both parent- and spun-off firms. It provides answers to which strategic choices are best suited in setting the initial CGMs of the spun-off firm.4 Secondly, this study generates
3Please see Section 4 for the formal computation of the economic significance
4 This is emphasized by major executive search firm Heidrick & Struggles who state the following: While the success of the
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various insights for shareholders and investors. Knowing that investors base their decisions on a multitude of factors, the relations explained in this study can be added in their analysis of investments (Bell et al., 2014). Furthermore, shareholders who receive shares of the spun-off can use the relations explained in this study in assessing the future profitability of their investment (Feng et al., 2015).
The remainder of this paper is structured as follows: In the second section, relevant literature is reviewed including relevant theories, which leads to the development of hypotheses and the conceptual model. The third section describes the used methodology including the sample, procedures, and measures. In the fourth section, an analysis of the results and findings is presented. Finally, the fifth section includes a discussion and conclusion of the findings of this research.
2. Theoretical background, related literature, and hypothesis
development
2.1 Theoretical background Agency theory
Scholars have used Agency theory in various fields such as accounting (Demski and Feltham, 1978), finance (Fama, 1980), and organizational behaviour (Eisenhardt, 1988). At its core, agency theory focuses on the misalignment of incentives, resulting in differing risk preferences between principals (owners) and agents (managers) (Semadeni and Cannella, 2011). This theoretical approach focuses on the universal agency relationship, in which the principal delegates the work to another (the agent), who carries out the work. The metaphor of a contract is used to describe this relationship (Jensen and Meckling, 1976).
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Agency theory aims to determine the most efficient contract that governs the principal-agent relationship, given assumptions about information, organizations, and people.5 The focus is on two aspects in the agency relationships that can be problematic and from which agency problems can arise: when the goals and desires of the principal and agent are in conflict, and when it is difficult or expensive for the principal to verify the behaviour of the agent (Eisenhardt, 1988). Aligning incentives and lowering information asymmetry decreases agency problems, resulting in improved performance (Semadeni and Cannella, 2011; Eisenhardt, 1988). This theory has frequently been used to study organizational phenomena such as compensation and board relationships, and in the spinoff context when explaining the occurrence of a spinoff (Eisenhardt, 1988; Semadeni and Cannella, 2011, Feldman, 2016b).
Resource dependence theory
Resource dependence theory, developed by Salancik and Pfeffer (1978), is one of the most influential theories in strategic management and organizational theory. RDT looks at a corporation as an open system that is dependent on the external environment and its contingencies. RDT acknowledges the impact of external factors on organizational behaviour. Despite constrained by their conditions, managers can undertake actions to reduce the uncertainty of- and dependence on the environment (Hillman et al., 2009). The concept of power is fundamental to those actions, which is the control over critical resources (Ulrich and Barney, 1984). Organizations try to reduce the power others have over them, often by trying to increase their own power over others.
Salancik and Pfeffer (1978) highlight five6 actions an organization can take to minimize environmental dependence, which includes the board of directors. The board of directors is the
5Information: information is a commodity which can be purchased. organizations: goal conflict among members. people:
self-interest, bounded rationality, risk aversion (Jensen and Meckling, 1976).
61. Mergers/vertical integration 2. joint ventures and other interorganizational relationships 3. board of directors 4. political
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area of RDT’s greatest research influence.7 Pfeffer (1973) highlights that board of directors enable firms to minimize its dependence and gain resources. Resource dependence theorists argue that the composition, size, and diversity of a board needs to match the needs of a firm (Pearce and Zahra, 1992; Pfeffer, 1973). Consequently, it can be of high value in securing critical resources and gaining prestige and legitimacy. Research on spinoffs used this approach when explaining the occurrence of a spinoff, and when explaining the post-spinoff linkages between parent and spun-off (Semadeni and Cannella, 2011; Feldman, 2016b).
2.2 Corporate Spin Offs
A spinoff is a unique form of corporate reorganization because it creates value without any cash being involved in the process (Cusatis et al., 1993). Reasons to get engaged in a spin-off are numerous such as: strengthening firm’s strategy, increasing corporate focus (Wruck and Wruck, 2002), redeploying resources (Helfat and Eisenhardt, 2004), gain better access to capital markets (Wruck and Wruck, 2002), removing underperforming units (Hayward and Shimizu, 2006), creating distinct and targeted investment opportunities (Wachtell et al., 2016), and clarifying shareholder and analysts’ perceptions8 (Bergh et al., 2008). Independently of the reason to perform a spinoff, it is most likely an economically rational decision (Feldman, 2016a). This suggests that the parent firm believes the value of spinning off a part of the business exceeds the value of keeping it. Numerous empirical studies reinforce this suggestion by showing a positive relationship between a spinoff and firm value, created through a number of ways9 (Feng et al., 2015; Ahn and Walker, 2007; Veld and Veld-Merkoulova, 2004; Cusatis
7Although Agency Theory is the predominant theory used in research on board of directors (Johnson et al., 1996; Zahra and
Pearce, 1989), empirical evidence shows that RDT is a more successful lens for understanding boards (Hillman et al., 2009).
8 It is difficult for shareholders and investors to assess the future performance and profitability of a diversified firm. When a
company splits into two or more companies it becomes easier to assess the future performance of those firms because they become independent companies.
9These deals create shareholder value in a number of ways: by improving the focus of managerial and financial resources
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et al., 1993; Desai and Jain, 1994; McConnell et al., 2001). Concurrently, literature also agrees that effective CG has a positive effect on firm performance (Bell et al., 2014; Ahn and Walker, 2007).
The initial corporate governance structure of the spun-off firm is installed by the parent firm (Spinoff Guide, 2016). This makes it different from other companies where that company itself develops the corporate governance structure. Certo (2003) argues that stock market performance is a critical factor as it reflects how CGMs are valued and perceived by potential investors. Berg et al., (2008) state that a spin-off provides the opportunity for investors to better understand and assess the value creating potential of the restructuring. In this sense, Bell et al., (2014) argued that effective governance practices are vital for improving stock market performance. Research on CGMs in relation to the spun-off performance remain underexposed.
2.3 Corporate Governance Mechanisms
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The primary monitoring CGM is the board of directors, which bears great responsibility towards the shareholders.10 A spun-off differs from the normal process of appointing members of the board of directors.11 In case of a spun-off, the parent firm is responsible for the appointment of the spun-off firms’ initial board of directors. The Spinoff Guide (2016) highlights this as follows:
Because a spin-off company is typically a wholly owned subsidiary or is created
as a wholly owned subsidiary of the parent, its corporate structure, charter and
bylaws can be established by the parent without holding a vote of public
shareholders. The parent will need to select the jurisdiction of incorporation of
the spin-off company, draft its constitutive documents such as its charter and
bylaws, and determine the size and composition of the board of directors. (p. 19)
Daily and Dalton (1994) suggest, from a RDT perspective, that board composition and size can have significant impact on firm performance. Board members are connected to external resources and possess industry-specific knowledge, which is used to counsel the management. Consequently, top management can have an impact on firm performance when their interests are aligned with that of the shareholders. Incentive-based CGMs are focused at aligning the interest of shareholders and managers. Literature suggests that incentive compensation can align shareholders’ and managers’ interests (Feldman, 2016b; Chalmers et al., 2006). When incentive compensation is closely tied to firm performance, both managers and shareholders benefit12 (Devers et al., 2007).
10The board of directors is responsible for appointing the top management team and setting their compensation packages,
setting the strategic goals and direction of the company, and monitoring top management to ensure that it acts on shareholder behalf by taking actions that maximizes shareholder value (Feldman, 2016a).
11 Normally, a firm has a nominating committee that proposes the appointment of board members, and in turn, the
shareholders of the firm vote by proxy on these nominations.
12The logic behind this benefit is, that when ownership and control of a firm are separate, the interest of shareholders and
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2.3.1 Board Structure
RDT highlights that the board of directors, representing the shareholders, is a core strategic resource (Seward and Walsh, 1996), because the directors are a key source of knowledge, information, expertise, and capabilities (Feldman, 2016a; Kroll et al., 2008; Hillman, 2005; Lester et al., 2008). The board composition is critically important in this sense (Seward and Walsh, 1996; Daily and Dalton, 1998; Peng, 2004; Hillman et al., 2009). Semadeni and Cannella (2011) highlight that the most dramatic finding of their study is that the parent firm has a central role in setting the performance trajectory of the spun-off firm because the parent firm establishes the governance structure of the child’s board.
Studies regarding the composition of the board in the spinoff context mainly focus on the parent-spinoff firm linkages. The parent can appoint directors that serve simultaneously on board of the parent and spun-off firm. Feldman (2016a) shows that the presence of these dual directors has a positive influence on the average stock market performance of parent and spun-off firms. Semadeni and Cannella (2011) found that a spun-spun-off firm can benefit from ownership and governance ties to the parent firm, yet having too many is negatively related to performance. Both Feldman (2016a) and Semadeni and Cannella (2011) delve deeper into monitoring linkages between parents and spun off firm regarding board composition. However, general monitoring mechanisms regarding board composition that are influenced by the parent company, such as board size and board diversity, remain underexposed.
Board Size
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RDT perspective, it can be argued that a larger board brings more diverse expertise and resources to the firm, which in turn leads to higher performance (Goodstein et al., 1994; Pearce and Zahra, 1992). However, literature on board size predominantly suggests that performance is better with smaller boards (Yermack, 1996; Eisenberg et al., 1998; Cheng, 2008).
Ahn and Walker (2007) argue from an agency theory perspective that larger boards suffer from the free rider problem and that a larger board is not as conducive to open dialogue, making them less effective monitors (Yermack, 1996). Agency problems become more severe as the board grows larger (Jensen, 1993). Research associates large boards with difficulty in making timely decisions and reaching consensus (Boivie et al., 2016; Cheng, 2008). However, empirical evidence shows that more directors lead to more monitoring by the boards, and increase the ability to curb CEO power (Kiel and Nicholson, 2003; Haynes et al., 2017). A firm can include more prestigious directors in larger boards, which is an important RDT related factor (Certo, 2003). Resource dependence theorists argue that by increasing the size and diversity of a board, links to the external environment are created and critical resources are secured, including prestige and legitimacy (Pearce and Zahra, 1992; Pfeffer, 1973). The advantage of having a smaller board can conflict with forming a more diverse board.
Board Diversity
Board diversity has become more important over the last two decades. The recent spinoff of Match Group Inc. from IAC/InterActiveCorp. confirms this, as Match assembles a more diverse board after spinning off from IAC, including more women and people of colour.13 In the past two decades numerous studies have been conducted on the relationship between board diversity and firm performance showing mixed results reaching from finding a positive,
13Match CEO, Shar Dubey, an immigrant from India, said that a more diverse board brings extensive expertise across
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negative or no relation (Carter et al., 2003; Adams and Ferreira, 2009; Dobbin and Jung, 2011). Recent studies on U.S. companies mostly find a positive relationship (Schrand et al., 2018; Conyon, and Lerong, 2017; Terjesen et al., 2015).
Research regarding the benefits of having a more diverse board highlight several factors: more creativity is brought by a diverse board (Hillman et al., 2009), more diverse boards allow for better decision making because issues at hand are discussed from more perspectives (Adams and Flynn, 2005), and diverse boards are more effective in problem-solving (Milliken and Martins, 1996). In contrast, Jackson et al., (2003) show that women and ethnic minorities are more likely to cause conflict, which negatively influences decision-making. Farrell and Hersch (2005) found that while board diversity positively influences the return on assets, the market failed to react on appointing a more diverse board. However, Adams and Ferreira (2009) show that attendance ratings are higher among boards with greater female presence. Meetings are the primary way through which boards operate and conduct business. This suggests that attendance rate is an important factor of board success (Adams and Ferreira, 2009). Furthermore, Adams and Ferreira (2009) highlight that it is more likely for diverse boards to hold the CEO responsible for poor stock market performance. These factors further the idea that diverse boards can have a value adding effect to a company.
2.3.2 Managerial Incentive Alignment
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for executives.14 Incentive compensation of divisional managers prior to the spinoff typically consists of a component based on divisional profitability and one on stock market performance of the firm (Feldman, 2016b). Furthermore, the higher a divisional manager sits within the divisional hierarchy, the greater is the share of compensation based on overall stock market performance (Feldman, 2016b). Therefore, divisional managers may not be motivated to increase shareholder value since overall stock market performance is a noisy indicator of its performance (Feldman, 2016b; Seward and Walsh, 1996). Prior research on incentive compensation and spin-off firm performance is scarce, yet brings important insights.
Feng et al. (2015) researched the relationship between executive compensation and the spinoff decision. CEOs with stronger equity incentives are more likely to undertake a spinoff. Furthermore, they find that high incentive firms have better long run stock market performance meaning that the level of CEO incentives matters. Feldman (2016b) shows that managerial incentive alignment improves for managers of the spun-off firm, yet found no significant improvement for the managers of the parent firm.15 However, both Feng et al. (2015) and Feldman (2016b) do not show whether incentive compensation influences the performance of spun-off firms.
Research on the relation of incentive compensation and firm performance show different results. Core et al. (1999) found a negative relationship stating that due to the severity of the agency problem, firms with greater compensation perform worse; Frye (2004) found a positive relationship between firm performance and equity-based compensation; and Canarella and Nourayi (2008) found a non-linear and asymmetric relation between executive
14Setting compensation packages for managers is a complex process. The challenges it possesses for diversified firms are
even higher because the compensation package of the divisional managers has to be aligned with the performance of the division they run.
15 She found that the alignment of incentive compensation with stock market performance improved both in absolute and
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compensation and firm performance. Li et al. (2015) show that the profitability of the company matters in this relation.16 One example of the importance of incentive alignment is the disclosure of the, in 2018 set, compensation package of Tesla CEO Elon Musk. All the compensation he receives is tied to the financial performance of the company. The stock price of Tesla has more than doubled since his compensation package was announced.
2.4 Hypothesis development
2.4.1 Is there an association between board size and post-spinoff spunoff firm performance?
Traditionally, board size is considered as an important attribute of board composition (Finkelstein and Mooney, 2003; Pearce and Zahra, 1991). In spite of the pervasive number of studies on its effect, the literature does not agree if smaller or larger corporate boards are desirable in relation to firm performance. On the one hand, research based on agency theory generally state that a larger board has a negative effect on firm performance. For example, Jensen (1993) showed that larger boards are easier for a CEO to control, and therefore function less effectively. Larger boards are associated with difficulty in making timely decisions and reaching consensus (Boivie et al., 2016; Cheng, 2008). It seems likely that a spun-off will face a multitude of situations in which it will have to make timely decisions and reach consensus as it becomes a new independent company.
On the other hand, a significant number of papers document a positive effect of board size on firm performance (Carter et al., 2003; Adams and Ferreira, 2009; Dobbin, and Jung, 2011). According to Coles et al., (2006), larger boards lead towards greater value for firms that require more advice. It seems likely that a spinoff will need a great deal of advice since it will
16 They find a positive relationship between incentive compensation and firm performance for the more profitable firms and
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need to function as a standalone company, and therefore has to deal with buyers, suppliers, the government, and others (Feldman, 2016b; Spinoff Guide, 2016). It is advanced that child firms that are successful, are those that have strong management teams and understand that a new freestanding publicly traded company needs to ‘’break out of the box’’ and enhance a new, more entrepreneurial set of management practices (Miles and Woolridge, 1999). This suggests that significant adaptation is often needed for spun-off firms that want to be successful post-spinoff. It seems likely child firms need a great deal of advice to successfully execute the adaptation of being independent.
Pearce and Zahra (1992) highlight that selecting and implementing the company’s strategy, developing the mission, and defining the firm’s business concept belong to the strategic role of the board of directors. Spinoff firms must overcome its liability of newness and attain legitimacy in the marketplace (Certo, 2003; Deutsch and Ross, 2003). This suggests that the strategic role of the board of directors is a critical tool in maximizing shareholder value as it influences the strategy of the company. From an agency theory perspective, it can be argued that a larger board impairs the strategic role of the board because it can lead to coordination and communication problems (Cheng, 2008). From an RDT perspective, it can be argued that a larger board leads toward greater value for the strategic role because a larger board can bring more knowledge and expertise resulting in better advice (Dalton et al., 1999). Furthermore, more prestigious directors can be included in larger boards, which is an important RDT related factor (Certo, 2003).
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timely decisions and reaching consensus. This suggests that a spun-off will benefit from a larger board as it gives better advice regarding the external environment, yet making timely decisions can become a problem.
The relationship between the size of boards and their financial performance is not obvious a priori. Larger boards suffer from coordination and communication problems, which makes the board function less effectively (Lipton and Lorsch, 1992; Jensen, 1993). The board cohesiveness is undermined because a larger board will make it less likely to share a common purpose, communicate clearly with each other, and reach consensus when different directors have different points of view (Lipton and Lorsch, 1992). It seems likely that coordination and communication play a significant role in the context of a spun-off as it becomes an independent company having to deal with a multitude of factors different from when it was part of the parent. Furthermore, Yermack (1996) and Ahn and Walker (2007) argue that larger boards suffer from the free rider problem and that a larger board is not as conducive to open dialogue. Free-riding increases because the cost incurred by any individual director of not exercising its tasks falls in proportion to the board size (Lipton and Lorsch, 1992). Lipton and Lorsch (1992) suggest that as the board becomes larger and get beyond a certain point, the inefficiencies outweigh the initial advantages from having a larger board, leading to lower firm performance. Given the evidence from the literature and the uncertainty surrounding the association between board size and spunoff financial performance, I formulate my hypothesis in an alternate form:
H1: Board size is associated with the post-spinoff stock market performance of spun-off firms.
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Board diversity is under constant debate in recent literature where mixed results are found both positive and negative and no relationship at all (Carter et al., 2003; Adams and Ferreira, 2009; Dobbin and Jung, 2011). However, most recent U.S. studies mostly find a positive relationship (Schrand et al., 2018; Conyon and Lerong, 2017; Terjesen et al., 2015). Ahn and Walker (2007) show, in the context of a spinoff, that diversified firms conducting a spinoff have characteristics that are associated with more effective corporate governance including board diversity. They show that these spinoff firms perform significantly better than a set of peer firms that did not engage in a spinoff. These findings indicate that firms with less diverse boards maintain a value destroying diversification strategy, while firms with a more diverse board are more likely to engage in a value increasing spinoff transaction (Ahn and Walker, 2007). This suggests that diverse boards take actions that enhance firm value. Furthermore, according to the major executive search firm Heidrick & Struggles, parent companies that wait many months before starting the recruiting process, end up with a spun-off board that consists of eight white males, all having similar backgrounds. They highlight that this is problematic for the public's perception, and more important, the benefits of a more diverse board will not be used. In contrast, Dobbin and Jung (2011) argue that institutional investors and shareholders can be negatively influenced by sociological and psychological factors because of the bias against women and ethnic minorities. They found that stock value significantly decreases when gender diversity on boards increase. However, their sample reaches from 1997 to 2006. It seems likely that the opinion about gender diversity partly changed over the past two decades.17
Several scholars highlight the value implications regarding a more diverse board. A more diverse board promotes better monitoring, specifically between genders regarding the decision-making process, resulting in improved firm performance (Lavy and Schlosser, 2011;
17RBC Global Asset Management Responsible Investment Survey showed that in 2018 the majority of the world’s
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Carter et al., 2003; Adams and Ferreira, 2009; Green and Homroy, 2018). Factors like the ability to act as an independent company, top management lacking governance expertise, and the ability to attain legitimacy within the market place suggest that monitoring is crucial for the survival of spun-offs. In contrast, Jackson et al., (2003) show that women and ethnic minorities are more likely to cause conflict, which negatively influences decision-making, which in turn might have a negative effect on firm performance. Nonetheless, a diverse board can be a signal of quality to the public, possibly resulting in increased firm reputation and legitimacy, which might have a positive effect on firm performance (Bell et al, 2014; Certo, 2003).
Pearce and Zahra (1992) argue that a more diverse board of directors reduces uncertainty surrounding strategy development and enhances firm performance. Furthermore, each director uses a unique ‘’lens’’ when analysing different situations and providing advice to top management regarding strategy (Beekun et al., 1998; Carter et al., 2003). A more diverse board provides a broader range of perspectives and experiences (Conyon and Lerong, 2017; Carter et al., 2003). It seems likely that these broader range of perspectives and experiences have a positive effect on the advice of the board to the top management as different situations are analysed through more unique ‘’lenses’’. In addition, Semadeni and Cannella (2011) highlight that the composition of the board is critical for the performance trajectory of the spun-off firm post-spinspun-off. The afore discussed arguments suggest that the composition of the board more diversity is beneficial to the board composition. Therefore, I hypothesize the following:
H2: Board diversity is positively associated with the post-spinoff stock market performance of
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2.4.3 Is there an association between CEO incentive compensation and post spinoff spunoff firms performance?
Agency theory related literature suggests that a spinoff offers the opportunity to mitigate agency problems. In this sense, Hite and Owers (1983) highlight that contracting efficiency is improved after a spinoff. Aron (1991) demonstrates, through a theoretical model, that spinoffs make it easier to write and enforce performance-based contracts. This is highlighted in the registration statement of AOL-Time Warner’s 2009 spinoff of AOL, in which they state the following: “The spinoff will enable AOL to create incentives for its management and employees
that are more closely tied to its business performance and shareholder expectations. Separate
compensation arrangements should more closely align the interests of AOL’s management and
employees with the interests of its shareholders”. This statement suggests that incentive
compensation is beneficial for the shareholders since it is aimed at improving firm performance. In contrast, Core et al. (1999) found a negative relationship between total compensation and firm performance stating that due to the severity of the agency problem, firms with greater compensation perform worse. They highlight that CEOs at firms with greater agency problems receive greater compensation, and that firms with greater agency problems perform worse.18
In the same vein, there are scholars that show a negative relationship between CEO incentive compensation and firm performance when a company has a high level of risk (Aggarwal and Samwick 2002; Garvey and Milbourn 2003; Cao and Wang 2013). CEO’s might hedge against the risk exposure that is accompanied by a spinoff, through negotiating a compensation package in a way that it impairs the interest alignment of CEO and shareholders.
18 Literature on IPO firms point out that rational adaptation is needed with regard to external market conditions and
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Basing a large part of the compensation on the performance of a firm can be risky for the CEO because it will be an independent standalone company. Furthermore, like is mentioned in the introduction, 4 out of 10 spinoffs do not generate any value over year 1. This suggests that the risks around spinoffs are an important factor.
Feldman (2016b) highlights in her study that writing and enforcing a compensation package that aligns the divisional managers interests with that of the shareholders is complicated, resulting in not fairly awarding divisional managers for their efforts. Consequently, divisional managers might not act, to the best of their abilities, in the interests of the shareholders because the compensation package is does not align the interests sufficiently. In this sense, Feldman (2016b) shows that incentive alignment improves for the managers of the spun-off company post spinoff, resulting in awarding managers more directly for their efforts. Incentive compensation is aimed at aligning the interests of managers with those of the shareholders. A major interest of the shareholders is the stock market performance of the firm in which they invested. Therefore, it seems likely that if the interests of the managers are aligned with those of the shareholders, managers increase their own earnings by increasing stock market performance. However, this can also result in risk taking behaviour from a CEO with the aim of maximizing his earnings. Given the evidence from the literature and the uncertainty surrounding the association between incentive compensation and spunoff financial performance, I formulate my hypothesis in an alternate form:
H3: CEO incentive compensation affects the post-spinoff stock market performance of
spun-off firms.
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The following figure represents the conceptual model of this research, containing three different hypotheses related to monitoring and incentive-based CGMs and stock market performance. H1: +/- H2: + H3: +/-
3. Methodology
3.1 ApproachThis research follows a quantitative approach since the purpose of this study is to contribute to literature through testing hypotheses using an aggregation of numerical data (Blumberg et al., 2014). Based on a confirmatory scientific method, this approach states a set of hypotheses grounded in existing theory, which afterwards are tested using quantitative data to verify whether or not they are supported (Antwi and Hamza, 2015). This confirmatory scientific method uses deductive reasoning, based on existing theory, to ground certain hypotheses. The existing theory is also used in previous empirical studies, books and theoretical articles to increase the comprehensibility of the theories (Colquitt and Zapata-Phelan, 2007). The purpose of this deductive research approach is to analyse certain theory in literature, construct certain related hypotheses and evaluate whether that theory holds under certain conditions. The deductive research approach is a process that goes beyond general considerations and makes it specific (Pelissier, 2008).
Board size
Board diversity Stock market
performance
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Therefore, this method is the most appropriate since the purpose of this study is to fill a gap in theory by means of specific hypotheses based on existing literature (Colquitt and Zapata-Phelan, 2007). Furthermore, several scholars argued that we need to know more about the performance implications for the spun-off firm (Feldman, 2016b; Semadeni and Cannella, 2011; Seward and Walsh, 1996). Performance measures are numerical of nature making a quantitative approach best suitable.
3.2 Data collection and sample
The sample I use is the result of data mergers from different datasets. First, I use the SDC Platinum Database to obtain information about completed spinoffs undertaken by listed US firms during the period from 2001 until 2019. The reason I only use listed US firms is that corporate governance mechanisms can vary significantly around the world making it possible that results are biased (Chizema and Shinozawa, 2011). Furthermore, executive compensation level and structure differ around the world, making it possible that those results are biased (Mehran, 1995). Financial information is derived from the COMPUSTAT North America. Executive compensation information is derived from ExecuComp. Finally, the corporate governance information was derived from the BoardEx database. The initial sample derived from SDC Platinum consists of 455 spinoff events between 2001 and 2019. The company identifiers for the spun-off firm used to derive data on spun-off firms from different sources were incomplete. In order to merge the financial data, I need the GVKEY and to merge financial data with governance data I need the ISIN code. Therefore, I collected the missing ISIN and GVKEY codes for the spun-off firms between 2001 and 2019. This reduced the initial sample to 218 spun-off firms of which both the ISIN and GVKEY are known.
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database with the financial data derived from COMPUSTAT, which reduces the sample size to 214 companies with 902 firm-year observations. Secondly, I merge this data with the dataset from ExecuComp which reduces the sample to 132 companies with 540 firm-year observations. Lastly, I merge this dataset with the data from BoardEx reduces the sample to 127 spun-off companies with a total of 477 firm-year observations.
After merging the data, I check the sample for missing data, which reduces the sample to a final size of 115 spun-off companies with 414 firm year observations. To compare with others, Feldman (2016b) and Feldman (2016a) had a sample of 228 completed spinoffs, Semadeni, Cannella (2011) had a sample of 142 completed spinoffs, and Feng et al. (2015) had a sample of 113 completed spinoffs. Chai et al. (2018) highlight in their research that the average sample size was 97 of 16 previous US studies conducted between 1983 and 2011. Therefore, this sample is comparable to samples of prior studies.
3.3 Measurements 3.3.1 Dependent variable
Stock market performance refers to shareholder return. Following Feldman (2016b), I define
StockMarketPerformance as the annual stock returns.19 Stock market performance is often used in research as a proxy for firm performance. Whether stock market performance is a suitable proxy for firm performance is continuously debated in literature (Mehran, 1995). The same accounts for Tobin’s Q and ROA that are often used to assess firm performance (Mehran, 1995). Scholars have argued that both Tobin’s Q and ROA are subject to measurement problems, Q is a better proxy for the firm’s growth opportunity than its performance, and ROA bears little information about economic rates of return and is most often used as a proxy for operational performance (Mehran, 1995). The three proxies have their own shortcomings,
19 (R
t): (Pt + Divt – Pt - 1)/Pt - 1. Pt represents the end-of-year stock price in year t and Divt represents dividends in year t
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however, they are highly correlated (Landsman and Shapiro, 1989; Jacobson, 1987). This suggests that the qualitative nature of the results should not be influenced by the choice of the proxy. As a robustness test, I use Tobin’s Q as an alternate measure for stock market performance to see whether the contentions also hold under a different measure for firm performance. Both stock market performance and Tobin’s Q are linked to market performance. As an additional test, I will use ROA to test the effects on operational performance.
The reason I choose for stock market performance is based on several reasons. Firstly, the intention of a spinoff is to create shareholder value and stock market performance refers to shareholder return. Secondly, a spinoff transaction results in a new independent publicly listed company having its own shares creating opportunities for investors. Lastly, Agency-grounded-theory often conceptualize and operationalize incentive and monitoring CGMs as having a unique ability to impact stock market performance (Sanders and Boivie, 2004; Ibrahim and Samad, 2011; Beatty and Zajac, 1994; Florackis, 2008).
3.3.2 Independent variables
The independent variables in this research are BoardSize, BoardDiversity, and
IncentiveCompensation. Following Carpenter et al. (2003) I define BoardSize as the total
number of directors serving on the board during a fiscal year. I compute this variable as the average board size during a fiscal year. I take the starting board size in a fiscal year and the ending board size in a fiscal year and compute the average of those two values.
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proportion of female directors at the Annual Report Date selected. A higher proportion of female directors brings more diversity to the board. Lastly, I include the Nationality Mix measured as the proportion of directors from different countries at the Annual Report Date selected. A higher proportion of directors from different countries brings more diversity to the board. I compute the Board Diversity variable using the principal component analysis in STATA where these three variables are used as the components. Furthermore, I take the average board diversity during a fiscal year, which is computed in the same way as the
BoardSize variable.
Following Feldman (2016b), I define IncentiveCompensation as the portion of an executive’s total compensation that is linked to firm performance. In ExecuComp, the total compensation of an executive consists of seven components: salary, bonus, other annual compensation, the total value of stock options granted, the total value of restricted stock granted, long-term incentive pay-outs, and other long-term compensation. The only components that are not somehow equity-linked are salary and bonus. Accordingly, following Feldman (2016a), Zajac and Westphal (1994), and Jensen and Murphy (1990), I calculate incentive compensation as the executive’s total compensation minus his salary and bonus.
3.4.3 Control variables
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Feldman (2016b), I include indicator variables regarding the industries based on the 1-digit SIC code to control for industry-specific performance effects.
Secondly, I control for several firm-level financial characteristics that are likely to influence stock market performance, and have been often used in studies on corporate spinoffs. Following Dang et al. (2018), I define FirmSize as the natural log of market capitalization.20 Following Ahn and Walker (2007), I define Leverage as the firm’s indebtedness, which is calculated as the sum of the short- and long-term debt scaled by total assets.21 Following Kim et al. (2011), and Florou and Kosi (2015), I define Tangibility as the net property, plant, and equipment divided by total assets.22
Lastly, following Feldman (2016b) I include two indicator variables that control for financial distress within a firm. NegativeNetIncome takes the value of 1 if a firm has a negative net income in that year, and a 0 if not. NegativeEquity, calculated through total assets minus total liabilities, takes the value of 1 if a firm has a negative equity in that year, and a 0 if not.
3.4 Empirical model
I examine whether BoardSize, BoardDiversity, and IncentiveCompensation have an effect on the StockMarketPerformance of spun-off firms. I winsorized and standardized all continuous variables at the 1% and 99% levels. Winsorizing treats the lowest and highest 1% values of the variables to remove the effect of outliers. Outliers have a dominant role in the regression, which gives an unrepresentable picture. Standardizing the continuous variables equalizes the range and variance of the variables and makes the interpretation of the regression coefficient more
20A study conducted by Dang et al. (2018) showed that market capitalization is a better proxy for firm size than the total assets
or total sales. Furthermore, they highlight that if researchers want to control for the size of the stock market then market capitalization should be used.
21 Performance can be influenced by the indebtedness of an organization, and it can influence executive compensation
(Mehran, 1994).
22 Previous research show that firm performance is expected to be positively associated with tangible assets (Kim, et al.,
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understandable. To check for possible multicollinearity, I conduct a test that analyses the values for the Variance Inflation Factor (VIF), which should not exceed 10 points (Kline, 2011). I use the ordinary least squares (OLS) regression to perform the empirical analysis. The model is constructed as follows:
StockMarketPerformance = β0 + β1 × BoardSize + β2 × BoardDiversity + β3 ×
IncentiveCompensation + β4 × FirmSize + β5 × Leverage + β6 × Tangibility + β7 × NegativeNetIncome + β8 × NegativeEquity + Year and Industry Fixed Effects + εt
4. Results
4.1 Descriptive statistics
In table 1, the descriptive statistics are shown. All variables have the same number of observations, missing values were excluded which reduced the number of observations to 414. Table 1 shows the mean, standard deviation, minimum and maximum of each variable. All continuous variables are winsorized and to remove potential bias from outliers. The average board size of my sample is 8.75 which is close to the observed average board size found in the study on spun-offs by Wruck and Wruck (2002).23
[Add Table 1 here]
4.2 Correlations
Table 2 shows the correlations between the different variables used in this study. The outcome can be between -1 and 1, and to have a reduced risk of multicollinearity the values should be between -0.7 and 0.7. The values for the variables vary between -0.4 and 0.6 so there is a reduced risk of multicollinearity. In addition, I perform a multicollinearity test of the
23Wruck and Wruck (2002) show that spinoff boards on average have 6 to 7 members, which is relatively small compared to
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independent variables. The figures of the Variance Inflation Factor (VIF) are between 1 and 1.14. This shows that there is no problem of multicollinearity between the independent variables. As expected, stock market performance is correlated with both firm size and negative income. The firm size variable controls for the size of the stock market which influences the stock market performance. Furthermore, it seems likely that a negative income during a fiscal year influences the stock market performance of that company.
[Add Table 2 here]
4.3 Regression analysis
Table 3 displays the results of the hypotheses testing. Hypothesis 1 proposed that board size would influence stock market performance of the spun-off firms in either a positive or negative way. Based on the analysis presented in models 1,2,3 and 4 I found a highly significant negative relationship between BoardSize and StockMarketPerformance (p<0.01). Model 3 is clustered on the 1-digit SIC, where model 4 is clustered on the 2-digit SIC. Both models are highly significant, and the coefficients differ minimally (β=−-0.0675 and β=-0.0805). The results suggest that stock market performance decreases when board size increases. This provides empirical evidence that supports hypothesis 1 and, that board size has a negative effect on stock market performance of spunoff firms within the first five years post-spinoff.
[Add Table 3 here]
Furthermore, the use of standardized coefficients for the independent variables makes the computation of the economic significance straightforward. The standardized coefficients refer to how many standard deviations a dependent variable, in this case
StockMarketPerformance, will change per standard deviation increase in predictor variable, in
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standardized coefficient of BoardSize is -0.0675 based on the 1-digit SIC, and the standard deviation is 1.787. This implies that, all else held equal, within the first five years after the spinoff the stock market performance would decrease by 0.0675 × .531 = 0.0358425 basis points when board size increases with 1,787 board members. In percentage terms, relative to the mean of the unstandardized stock market performance, this corresponds to a 0.0358425/166 = 21.59 percent decrease in stock market performance. Per board member increase this refers to 21,59/1.787 = 12.08 percent decrease in stock market performance.
Hypothesis 2 proposes a positive relationship between board diversity and stock market performance of spun-off firms. Board diversity gets included as an independent variable in model 2, 3 and 4 and therefore provides evidence on this hypothesis. Every model still shows significance for the coefficient of the BoardSize. However, the coefficient of BoardDiversity is not significant in any model. Therefore, the hypothesis that board diversity has a positive effect on stock market performance must be rejected.
Hypothesis 3 predicts a relationship between CEO incentive compensation and the stock market performance of spun-off firms. Incentive compensation gets included as an independent variable in model 3 and 4 and therefore provides evidence on this hypothesis. Every model still shows significance for the coefficient of the BoardSize and a non-significance for the coefficient of BoardDiversity. Based on the analysis presented in models 3 and 4 I found a significant negative relationship between IncentiveCompensation and
StockMarketPerformance (p<0.05). Moreover, both model 3 and 4 are significant and the
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Furthermore, the standardized coefficient of IncentiveCompensation is -0.0591 based on the 1-digit SIC, and the standard deviation is 5483.625. The unit of the
IncentiveCompensation variable is thousands of dollars. StockMarketPerformance has an
unstandardized mean of .166 and a standard deviation of .531 within the first five years after the year of the spinoff. This implies that, all else held equal, within the first five years after the spinoff the stock market performance would decrease by 0.0591 × .531 = 0.0313821 basis points when incentive compensation increases with $5.483.625. In percentage terms, relative to the mean of the unstandardized stock market performance, this corresponds to a 0.0313821/.166 = 18.9 percent decrease in stock market performance. Per million dollars increase in incentive compensation, it refers to a (18.9/5483625) ×1000000 = 3.45 percent decrease in stock market performance.
4.4 Robustness tests
To assess the robustness of my results, I performed several robustness tests. Firstly, I clustered by the 1 and 2 digits SIC which did not change the significance or coefficients of the variables in a problematic way. Moreover, I clustered by firm identification code (GVKEY) which did not change the significance or coefficients of both BoardSize and BoardDiversity. For
IncentiveCompensation the coefficient did not change, however the significance changed
slightly (p<0.1). Furthermore, to assess the effect of the indicator variable YearAfterSpinoff, I clustered this variable in several different ways which did not change the significance, signs, or coefficients in a problematic way.24 Lastly, I performed regression analysis, found in table 4, with TobinsQ as dependent variable to assess whether my assumptions also hold for another
24 I clustered this indicator variable in the following ways: value 1 for the first year after the spinoff and 0 for the
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measure of firm performance. As expected and described in the methodology chapter,
StockMarketPerformance and TobinsQ are highly correlated (p<0.01).
The results from the regression show similar results as the regression with stock market performance as a dependent variable. Based on the analysis presented in models 1,2,3 and 4 I found a highly significant negative relationship between BoardSize and TobinsQ (p<0.01). Moreover, both model 3 and 4 are highly significant (p<0.01) and the coefficients differ minimally (β=-0.0867 and β=-0.0830). The results suggest that Tobin’s Q decreases when board size increases. BoardDiversity gets included as an independent variable in model 2, 3, and 4. Every model still shows significance for the coefficient of the BoardSize. However, the coefficient of BoardDiversity is not significant in any model.
[Add table 4 here]
IncentiveCompensation gets included as an independent variable in model 3 and 4.
Every model still shows significance for the coefficient of the BoardSize and a non-significance for the coefficient of BoardDiversity. Based on the analysis presented in models 3 and 4 I found a highly significant negative relationship between IncentiveCompensation and TobinsQ (p<0.01). Moreover, both model 3 and 4 are significant and the coefficients differ minimally (β=−-0.0982 and β=-0.0833). The results suggest that Tobin’s Q decreases when CEO incentive compensation increases.
4.5 Additional test
To extend my analysis I perform an additional test where I examine the effect of the corporate governance characteristics on the operational performance of spun-off companies. The results of this test are displayed in Table 5.
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Based on the analysis presented in models 1, 2, 3, and 4 I found a highly significant negative relationship between IncentiveCompensation and StockMarketPeformance. Model 3 is clustered on the 1-digit SIC, where model 4 is clustered on the 2-digit SIC. Both models are highly significant (p<0.01), and the coefficients differ minimally (β=−-0.0118 and β=-0.0116). The results suggest that operational performance, proxied by return on assets, decreases when incentive compensation increases.
5. Discussion and conclusion
5.1 Summary of the results and discussion
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Regarding Hypothesis 1, my results show a negative relation between board size of spun-off firms and the post-spinoff stock market performance of spun-off firms. This result is consistent with the view that agency problems like communication and coordination problems become more severe when a board grows larger (Cheng, 2008). A larger board impairs the ability to make timely decisions and reach consensus. Based on RDT, it can be argued that a larger board brings a wider set of expertise, more prestigious directors can be included and that a larger board leads toward greater value for firms that require more advice. Nonetheless, the results show that the problems that are associated with a larger board have a bigger effect than the advantages of a larger board. Following Lipton and Lorsch (1992), the inefficiencies outweigh the initial advantages from having a larger board, leading to lower firm performance. Furthermore, the relationship between board size and stock market performance is statistically, as well as economically significant. Per board member increase, the stock market performance decreases with 12.08 percent.
As well as Farrell and Hersch (2005), I find no evidence to support Hypothesis 2 that board diversity is a value enhancing strategy which leads towards better stock market performance. This result could be explained by investors not reacting on the attempts of a company to increase board diversity. It could be that investors do not award value to a more diverse board but that other factors play a more important role. Alternatively, when minimum expectations are met, the firm does not continue to actively search for greater diversity (Farrell and Hersch, 2005).
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not generate any value in year one. Basing a large part of the compensation on performance can be risky. Another explanation is that if a large part of the compensation is based on performance, a CEO might take more risky actions to increase performance. These risky actions might result in a decrease in stock market performance. Incentive compensation is aimed at aligning the interests of the CEO with those of the shareholders. Nonetheless, the results of my research show that incentive compensation negatively influences stock market performance. Furthermore, the relationship between incentive compensation and stock market performance is statistically, as well as economically, significant. Per million dollars increase in incentive compensation, the stock market performance decreases with 3.45 percent. Considering that the mean value of the incentive compensation in sample is 5.222.000 million dollars, it seems likely that an increase/decrease of a million dollars happens regularly.
5.2 Contributions
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In the first place, this study sheds light on the effect of board size on stock market performance. The effect of board size on firm performance is continuously debated in existing literature. This study is the first to provide an answer on the strategic choice whether a small or a large board should be implemented in the context of a spun-off. The parent firm, responsible for the implementation of the initial board of directors, should consider the size of the board as it could have a serious economic impact on the stock market performance. This finding contributes to Agency theory and RDT by empirically showing that a larger board leads to a decrease in firm performance, meaning that the arguments based on Agency theory outweigh the arguments based on RDT (Jensen, 1993). This finding implicates that, in spite to previous findings, Agency theory is a better lens for understanding the effect of board size than RDT.
The effect of incentive compensation is continuously debated existing literature. This study provides an answer on the strategic choice whether to focus on a compensation contract where a big part is based on firm performance in the context of a spun-off. The board of the spun-off firm should consider the economic impact of incentive compensation on the stock market performance when writing a compensation package. This finding contributes to Agency theory by empirically showing that incentive compensation, leads to a decrease in firm performance (Aggarwal and Samwick, 2002; Garvey and Milbourn, 2003). This implies that even though incentive compensation should align the interests of CEO’s with the interests of shareholders, it has a negative effect on stock market performance which is not in the interest of shareholders. This indicates that Agency theory used in studies on incentive alignment does not have the same implications in the context of spun-off firms.
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5.3 Limitations and future research
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5.4 Conclusion
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