Sources of Hidden value and risk within Tracking Stock

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Sources of Hidden value and risk within Tracking
Stock

• Harper and Madura
• Financial Management (2002)

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Motivation

• CEO Michael Eisner, Go.com will unlock the
  value and potential of our combined Internet
  assets
• Tracking stock (TS) follows on the popularity of
  carve-outs and spin-offs.
• Seek to identify agency- and information-related
  sources of any hidden value that can be released
  with the creation of TS.

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1. Background

• Upon shareholder approval, the parent firm and
  the tracking unit file separate financial data
  with the SEC. The value of the tracking unit is
  related to the specific performance of the unit,
  which can pay dividends to shareholders
  independent of the parent firm.
• A tracking stock unit is completely controlled by
  the parent. No transfer of ownership of assets or
  cash flows to tracking stock shareholders (Tax
  free).
• Voting rights of TS differ by company fixed or
  variable (relative market valuation of TS).

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Background Cont.

• While TS performance should reflect its units
  performance, claims in bankruptcy are on the
  assets of the firm as a whole, not on the unit.
• TS unit does not have its own board of directors.
  
• TS can be issued in different ways as a stock
  dividend that is distributed to the parent firms
  shareholders, through IPO or acquisition. The IPO
  method is similar to an equity carve-out, except
  that there is no legal separation between the
  unit and the parent firm.

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2. Motivation for TS structure

• The potential sources of value through reducing
  1) the diversification discount, 2) asymmetric
  information, and 3) agency costs.
• On diversification discount
• Zuta (1999) finds that the value of TS structure
  is higher than the diversified firm, but lower
  than a structure of two independent firms.
• Billet and Mauer (2000) find no relation between
  announcement effects and diversification discount.

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2. Motivation for TS structure (Cont.)

• On Asymmetric information between managers and
  market
• Signaling information about the unit thru TS by
  segmenting the firm into distinct units.
• The possibility that investors may assess the
  operating units may unlock hidden value.
• Since TS forces analysts and investors to
  explicitly value a unit separately from the rest
  of the firm, it may apply a higher
  price-multiple.
• DSouza and Jacob (2000) find no increase in the
  number of analysts following while Zuta finds
  increased analyst coverage.
• Chemmanur and Paeglis (2000) indicate that while
  the number of analysts increases, there is no
  reduction in information asymmetry.
• Billet and Vijh (2000) find that for a three-year
  period following TS, forecasts by analysts do not
  improve the transparency of firm earnings.
• Gilson, Healy, Noe, and Palepu (2001) find
  improved accuracy for non-specialists and
  specialist analysts following conglomerate stock
  breakups (3 TS only in 103).

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2. Motivation for TS structure (Cont.)

• On Agency benefits through TS issue
• May improve a units operating decisions, because
  explicitly value a unit separately from the rest
  of the firm, making managers more accountable.
• Allows for better incentive plans for the unit
  manager
• However, the benefit may be offset by new agency
  problems. Wealth transfer from the unit to the
  rest of the firm can reduce the unit managers
  compensation.
• Wealth expropriation is another agency problem.
  Managers may issue TS simply to achieve a
  short-term increase in share price. Dechow and
  Skinner (2000) high stock valuations and the
  emergence of stock-based compensation encourage
  the management of earnings to maintain aor
  improve stock valuation in the short run.

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2. Motivation for TS structure (Cont.)

• On Agency benefits through TS issue
• Potential conflicts and inter-firm wealth
  transfer between a unit and the rest of the firm
  can complicate interpretation of the units
  reported performance.
• Billet and Mauer (2000) firms with more
  efficient internal capital markets benefit more
  form TS.
• With no legal separation of assets, TS
  shareholders cannot rely on the market corporate
  control to prevent agency problems.
• DSouza and Jacob (2000) TS stocks are linked to
  the parent firms return patterns rather than the
  units corresponding industry.
• Haushalter and Mikkelson (2001) TS does not
  improve operating performance.

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3. Related Research on Corporate Restructurings

• Research on equity carve-outs and spin-offs may
  offer some insight into the advantages and
  disadvantages of TS.
• Schipper and Smith (1986) ECO enhances the
  value.
• Seifer and Robin (1989) spun-off units
  experience negative abnormal returns once they
  are traded.
• Michaely and Shaw (1995) the choice between
  spin-0offs and carve-outs depends on the firms
  access to the capital market.

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4. Hypotheses and Questions

• The ultimate impact of TS depends on managerial
  intentions.
• The effects of TS on the issuing firms is a
  function of
• Firm characteristics that differentiate the level
  of agency costs among firms
• TS characteristics that differentiate the ability
  to prevent agency problems among TS.
• H1 Firms with higher agency costs, poor past
  performance, and lower market values should
  benefit from TS.
• The method of distribution can affect agency
  relationship stock dividend, IPO, acquisitions
• A stock dividend maintains existing cash flow
  streams and claims for current shareholders. Also
  allows for more monitoring and reduction in
  asymmetric information.
• IPO creates additional agency problems 1)
  creates free cash flow retained by the parent,
  creating further agency problems. 2) potential
  wealth transfer from new shareholders to current
  shareholders.

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4. Hypotheses and Questions

• Creation of TS shares thru an acquisition. GM-E
  and GM-H. The target becomes a separate
  independent market-monitored unit under the
  control of the acquirer. Target SH receives the
  acquirers stocks or a cash payment along with
  TS.
• Since acquiring firms experience unfavorable
  market responses. This may negatively affect the
  valuation of a parent. The acquirer faces the
  difficulty in merging two firms, subject to any
  possible overpayment.
• Valuation effects for parents that create TS are
  expected to be less favorable when the firm is
  simultaneously engaged in an acquisition.

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4. Hypotheses and Questions

• Voting rights can be assigned on a fixed basis or
  linked to market valuation and performance in
  relation to the parents valuation.
• Market-weighted voting rights prevent investors
  from obtaining cheap voting stock with fixed
  voting rights in the event that the tracking unit
  under-performs the parent, and thus protect the
  existing shareholders.
• Fixed voting rights can create agency problems.
• With a variable voting structure, control and
  relative voting power will change as a result of
  market performance.
• The units potential to outperform subjects
  parent firm shareholders to a possible loss of
  some control with variable voting rights.

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4. Hypotheses and Questions

• Two TS unit characteristics related to agency
  problems relative size and TS industry
• The larger the size of the unit, the greater the
  proportion of future cash flows to be allocated
  to TS unit, which will have a negative effect on
  the value of the firm to current shareholders.
• Firms that assign TS to internet units may be
  using TS as a way to time the market in order to
  create wealth for the firm from new stockholders.
  Of 13 TS issued in 1998 and 1999, 8 or 62 relate
  to internet units.
• Hypo Firms that creates TS for internet units
  may experience more favorable initial valuation
  effects.
• Hypo Given significant delayed reaction in
  corporate restructurings, do we observe any
  long-run effects?

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5. Sample and description

• All announced TS reported on Lexis/Nexis
• 31 final samples during 1984 thru 1999
• Proxy and SEC statement on voting rights, issuing
  methods, operating ratios.

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6. Methods and Models

• hidden value measured by the abnormal stock
  returns.
• Specifically, CAR (-1,0) cumulative abnormal
  returns over two days around the announcement
  date.
• CAR b b1STKDIV b2ACQ b3VOTE b4SIZE
  b5DEBT b6MKBK b7RELSIZE b8NET b9MFAR
• where
• STKDIV 1 for stock dividend ACQ 1 for
  acquisition VOTE 1 SIZE log of parents
  sales before MKBK market-to-book of parent
  before RELSIZE relative asset size NET 1 for
  internet MFAR matched firm adjusted return for
  T months before.

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Expected sign based on agency motivations

• Positive
• Size, stock dividend, market-weighted voting
  rights, internet TS
• Negative
• High debt, poor past performance, IPO,
  acquisitions, relative size of the unit.

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Table IV Regression
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8. Summary and Conclusions

• The creation of TS might unlock hidden value if
  better monitored, more accurately valued by the
  market.
• Advantages any potential synergies are
  achievable better incentive scheme for the unit.
• Disadvantages Conflict between parent and units
  The unit not subject to the market for corporate
  control.

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8. Summary and Conclusions

• Positive overall market response upon the
  announcement.
• Valuation effects are more favorable for firms
  that are large and have less leverage, when the
  intent is other than to facilitate mergers, and
  when TS units are in technology businesses.
• Long-term valuation effects are negative. Firms
  with TS under-perform similar firms.
• Pittston Corp. has consolidated its TS into
  general stock.
• Staples announced a repurchase of TS.
• Go to Clayton and Qian (2004) for different
  results

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7. Results

• The mean CAR is 2, significant at the 1 level.
• ACQ ( - ) gt agency costs increase when the
  parent firm involve an acquisition.
• DEBT ( - ) gt less value
• SIZE ( ) gt less agency costs, increase in
  value
• RELSIZE ( - ) gt greater proportion of cash flows
  go to TS.
• MFAR (-) gt more poorly performing firms benefit
  more.