November 12, 2014
Underpricing, partial price adjustments, and equity carve-outs
ABSTRACT
We examine the extent to which carve-out parent announcement and ex-date subsidiary initial market-adjusted returns reflect public information for 260 equity carve-outs and their parents for the period 1990-2012. We evaluate four hypotheses related to carve-outs and their parents: partial price adjustment, prospect theory, managerial discretionary, and leaning against the wind. To test these hypotheses we use four primary variables: the percentage of the subsidiary retained by the parent, filing range adjustments, the percentage of the offering used to retire subsidiary debt, and the CBOE Volatility Index (VIX) to predict initial returns. We show that 29%-98% of the variation in market-adjusted equity carve-out returns can be predicted using public information known prior to the offer date. In addition, consistent with prospect theory, we show that the increase in share value for shares retained by parent companies (overhang) offsets the level of underpricing.
JEL classification: G32, G34
Keywords: Carve-outs, Partial price adjustments
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1. Introduction
An equity carve-out is a partial IPO of a subsidiary firm. The parent must retain at least a one-third interest in the subsidiary.[1] Schipper and Smith (1986) note that subsidiaries benefit from carve-outs in many ways. First, the subsidiary can obtain separate financing for its own growth opportunities. Next, the newly traded company reduces uncertainty by disclosure of information. Also, subsidiary managers can provide increased shareholder wealth and their own as well, if awarded shares through stock ownership plans.
Equity carve-outs can provide funds that can be used to retire debt, to increase cash for investment, or to cash-out insiders. Also, Schipper and Smith (1986) note that the carve-out phase of the two-stage combination creates a market for the new subsidiary’s stock prior to a spin-off or other second divestiture and provides more corporate information from additional analyst coverage. In addition, Klein, Rosenfeld, and Beranek (1991) observe that carve-outs allow parents to showcase their subsidiaries to prospective buyers. Carve-outs reflect insiders’ preferences to hold the shares to be divested later and the potential market price increases (Leland and Pyle, 1977; and Loughran and Ritter, 2002). The low levels of secondary offerings and reported insider selling result in an overhang of future share sales.
Underwriters discount IPO prices to ensure that all shares are sold in the offering. This discount is called underpricing. Loughran and Ritter (2004) report that underpricing leads to money left on the table. Also, they note that overhang, the ratio of the subsidiaries’ shares retained by parents to the shares in the offering, influences the amount of money left on the table. With higher percentages of subsidiary ownership retained and the resulting increased levels of overhang, equity carve-outs can result in more underpricing and money left on the table than pure IPOs. Carve-out insiders allow this increased underpricing since only the shares offered are underpriced. The retained shares gain in value. We evaluate four hypotheses related to equity carve-out underpricing: partial price adjustment, prospect theory, managerial discretion, and leaning against the wind. Also, we investigate the extent to which carve-out (partial IPO) underpricing can be predicted based on public information available before the announcement and offer dates, for a sample of 260 carve-outs and their parents during the period 1990-2012. In addition, we examine impact of our variables on the three-year returns for equity carve-outs and their parents.
Although Thompson (2010, 2013) and Ghosh et al (2012) study carve-outs or their parents, the specific contributions of this study are that we examine results from different perspectives in our hypothesis tests. Unlike the referenced and other carve-out studies, we contrast initial period and long-term returns for carve-outs and their parents.[2] Also, we examine the change in wealth over the short and long terms. In addition, we examine results during low and high market volatility periods and for increased, decreased, and unchanged initial filing adjustments. Moreover, we show that 29%-98% of the variation in market-adjusted equity carve-out returns can be predicted using public information known prior to the offer date. Furthermore, we show that due to prospect theory, the increase in share values retained by carve-out parents offsets the impact of underpricing. Consistent with Bradley and Jordan (2002) and Thompson (2010) we conclude that many factors available prior to an equity carve-out can predict underpricing. The implications are that models with public information reduce the need for information asymmetry models.
We examine several variables to test our hypotheses. Ritter (1991) introduced the study of filing range adjustments for IPOs. Bradley and Jordan (2002) extended Ritter (1991) by examining changes in filing ranges from the initial filing to the final filing to the offering price. Thompson (2010) applied two factors, filing range adjustments and option market volatility to equity carve-outs. Consistent with Thompson (2010) we observe filing range adjustments are highly significant for carve-out initial returns and that our volatility measure, the S&P 500 option index (VIX), is a highly significant predictor for parent and subsidiary market-adjusted carve-out initial returns. We add a third factor for parents, the ratio of offering size to parent market capitalization, that is significant during the carve-out announcement phase. A fourth factor, the portion of offering proceeds used to retire debt is highly significant for parents during ex-date returns. Figure 1 compares partial price adjustments and percentage underpricing. Generally, the percentage of underpricing varies with the level of partial price adjustment.
(Insert Figure 1 about here)
2. Sample selection and data
Carve-outs and their parents must meet three initial criteria to be included in this study. First, the parent must retain one-third or more ownership in the subsidiary after the carve-out. For 1990 we examined news releases for initial public offerings of subsidiaries. Mergers and Acquisition Magazine provides a list of carve-outs for the 1991-2006 periods. We use news articles and a set of equity carve-outs from Thomson Reuters for the 2007-2012 timeframe. From these sources and adjusting for divestiture IPOs[3], there are 341 carve-outs with an offering price of $5 or better from 1990 to 2012. Second, to preclude the confounding effects of joint ownership, we eliminate 15 subsidiaries with more than one parent. Third, we remove 66 private or foreign parents that did not trade on the NYSE, Amex, or NASDAQ (over-the-counter). This provides a sample of 260 carve-outs.
We cross check all carve-outs with Lexis-Nexis, the Investment Dealer’s Digest, Standard and Poor’s Dividend Record, Mergent Dividend Record (formerly Moody’s). The Mergent Industrial Manual (formerly Moody’s), the Dow Jones News Service, Research Insight (Compustat) and Mergent provide operating data including book values of equity. SEC filings and news articles provide additional information for the sample. The Center for Research in Security Prices (CRSP) provides stock return data.
Similar to Ritter (1991) and Vijh (2002), we use market-adjusted returns for carve-outs. This avoids the confounding effect, in a market model, of estimating separate returns for parents and their newly traded subsidiaries. Following Allen and McConnell (1998), we measure announcement-period cumulative excess returns over the three day period centered on the announcement day. There are two initial period returns for carve-outs. Similar to Bradley and Jordan (2002) and Loughran and Ritter (2002), we measure the carve-out subsidiary initial return as the offering price to first-day closing price (ex-date return). Underpricing reflects unadjusted ex-date returns. Parent company stocks ex-date returns are holding period returns from the day prior. Three-year returns are annualized market adjusted weekly returns from the carve-out ex-date. Following Ritter (1991), Vijh (2002), and Thompson (2010) we adjust stock returns by the CRSP equal-weighted index results (to include distributions) during the sample period.
3. Hypotheses tested and supporting variables
We examine four hypotheses associated with equity carve-outs and IPOs: partial price adjustment, prospect theory, managerial discretion, and leaning against the wind. These hypotheses can impact returns in various ways. The managerial discretion hypothesis and partial price adjustments can increase initial parent and subsidiary returns and lead to increased demand and possible underpricing. Insiders (including parents) via prospect theory receive increased values from their post-offering holdings. The leaning against the wind hypothesis reflects reaction to underpricing. Below we define our hypotheses and the critical variables that test them.
3.1. Partial price adjustment hypothesis
Hanley (1993) notes that the initial prospectus expected price range must reflect a “bona fide estimate” of the final offering price per SEC Regulation S-K (17CFR229) and that this range reflects the lowest acceptable price from the issuer and the highest offering price that the underwriter predicts will clear the market. Since this range should be the best credible offer for the issuer, prices within this range demonstrate that all information is reflected in the offering price.
With an amended filing underwriters can increase (decrease) the price range, if there is excess (low) pre-offering demand. This creates a challenge for the underwriters in that they must sell all offering shares to maintain their professional reputation. Thus, the price must be high enough to meet increased demand and to appease the issuer, but low enough to encourage buyers with a potential price increase. This partial adjustment creates underpricing as defined as the percentage change in price from the final offering price to the first day closing price. Thus, the issuer leaves money on the table. This supports the Benveniste and Spindt (1989) theory that IPOs whose offering prices are above the initial filing price range contribute to underpricing due to a partial adjustment of the offering prices. Bradley and Jordan (2002) extend the partial price adjustment analysis to include changes in the IPO filing range from initial filing through final filing to the offer price. Consistent with the partial price adjustment hypothesis the adjusted filing mid-points and partial price adjustments on carve-out offerings should provide significant changes in market value. We examine the effect of partial price adjustment on parent and subsidiary short and long term results.
3.1.1. Partial price adjustment
Extending the Hanley (1993) study, Bradley and Jordan (2002) and Loughran and Ritter (2002) show that the timing of the increase or decrease of the filing range influences the underpricing. The Bradley and Jordan (2002) measures for increases and decreases of initial filing ranges are: first, UP1 (DW1) is the percentage difference between the original midrange file price and the amended midrange file price for those companies that amend their file range up (down), zero otherwise. The variables are defined as:
UP1 = max [0, (midpoint amended - midpoint original)/midpoint original] * 100% (1)
DW1 = min [0, (midpoint amended - midpoint original)/midpoint original] * 100% (2)
where amended and original reflect the original and final amended file ranges. These two variables allow for the possibility of an asymmetric effect from file range increases or decreases. Second, two variables capture the potential for asymmetric effects between the final file range and the final offering price.UP2 (DW2) is the percentage difference between the final midrange file price and the final offer price for those companies that have offer prices above (below) the amended midrange file price, zero otherwise.
3.1.2. Money left on the table
In their IPO study, Loughran and Ritter (2002) define money left on the table as underpricing (first day close-offering price) times the number of shares offered. We calculate an equivalent value for money left on the table (MLOT) as:
MLOT = % underpricing * offering proceeds[4] (3)
Conversely % underpricing can be determined as:
% underpricing = MLOT/offering proceeds (4)
3.2. Prospect theory
Loughran and Ritter (2002), in their prospect theory, observe that many issuers are insensitive to money left on the table and show that insiders receive a wealth increase despite the dilution of share values caused by underpricing. If the offering is large relative to the pre-issue shares outstanding, the dollar loss due to underpricing and dilution will exceed the wealth increase for non-selling shareholders. Prospect theory is particularly applicable to equity carve-outs, partial IPOs. Carve-out parents retain at least one-third of their subsidiaries’ ownership at initial offerings. Thus, overhang, unsold shares divided by the shares sold, may be related to underpricing. However, only the shares from the offering are underpriced. The shares retained by parent company insiders reflect their market value. Thus, for a given level of underpricing, money left on the table is offset as overhang increases (Bradley and Jordan, 2002). We examine the benefits of prospect theory to equity carve-outs and their parents. In later sections we investigate whether insiders are compensated for reduced offering prices with increased post-offering values.
3.2.1. Percentage retained by parents
Loughran and Ritter (2004) show that announcement period returns can vary positively with the percentage of ownership to be given up by the parent in its divestiture (% retained). Benveniste et al (2008) observe similar results for carve-out parents.
3.2.2. Overhang
Bradley and Jordan (2002) show that overhang, the ratio of subsidiary shares retained to shares sold in the offering, provides a positive signal for investors, and later benefits from the subsidiary’s price appreciation. Loughran and Ritter (2002) report two sources of overhang. First, there may be a scarcity premium, based on supply and demand, for firms that sell a small fraction of the company to the public. In the case of companies that plan to spin-off their subsidiaries, parents must retain at least 80% ownership to effect a tax free dividend (26USC, Section 355). Thus, with underpricing it is most likely that equity carve-outs will generate wealth increases for non-selling shareholders. A second reason is that there may be an optimal amount of capital to be raised in an IPO. This is particularly evident for equity carve-outs given their larger offering sizes. Using the percentage of the shares retained by the parent (RET) we define overhang as:
Overhang = % retained/ (1-% retained) (5)
3.3. Managerial discretion hypothesis versus net present value of reinvested proceeds
In their managerial discretion hypothesis, Allen and McConnell (1998) find that corporations initiate carve-outs due to their high levels of leverage or operational troubles. In a contrary position, Mikkelson and Partch (1986) observe that carve-out returns vary with the proportion of proceeds reinvested in the company. Thus, a positive (negative) DEBT (USE) coefficient indicates support for the managerial discretion hypothesis. Likewise, a negative (positive) DEBT (USE) coefficient offers support for Mikkelson and Partch (1986).