Enhancing Managerial Incentives and Value Creation- Evidence From Corporate Spinoffs

7/30/2019 Enhancing Managerial Incentives and Value Creation- Evidence From Corporate Spinoffs

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JOURNAL OF ECONOMICS AND FINANCEVolume 31 Number 3 Fall 2007 341

ENHANCING MANAGERIAL INCENTIVES AND

VALUE CREATION:

EVIDENCE FROM CORPORATE SPINOFFSBy Unyong Pyo

*

AbstractWe study corporate spinoffs with changes in CEO compensation to examine how spinoffs

affect managerial incentive compensation and whether the changes in managerial compensation

can explain the value enhancement and operating performance improvements that occur following

spinoffs. Analyzing a sample of 124 non-taxable spinoffs during 1990-1997, we find that changes

in incentive compensation are a significant motive for spinoffs. Changes in managerial incentives

alone are consistent with the post-spinoff changes in operating performance, while changes in

business focus are not. Spinoffs that are not accompanied by enhanced pay-performance

relationship do not improve operating performance even with increased business focus. (JEL G34,

J33)

Introduction

A corporate spinoff divides a company into two or more independent firms and offers a firman opportunity to improve managerial incentives with fresh compensation packages directly tied toits own stock price. The initial round of studies on corporate spinoffs shows that the marketreaction on spinoff announcements is significantly positive at about 3% on average. 1 Thesubsequent research explains the source of gains based on improved business focus orinformation. 2 More recently, removing diversity costs and negative financial synergies issuggested as the source of gains from spinoffs.3 Unfortunately, these explanations are neithermutually exclusive nor inconsistent with the explanation based on managerial incentives. 4Although scholars in disciplines including financial economics have studied managerial

compensation to reduce agency conflicts between shareholders and managers for decades, there isno empirical evidence on whether corporations implementing spinoffs enhance managerialincentive compensation for either the post-spinoff parent firms (hereafter post-parents) or thespinoff subsidiaries.5 Little is known, either, about whether enhancing managerial incentivesfollowing spinoffs are related to operating performance improvements.

To better understand the sources of gains from corporate spinoffs, we examine a sample of124 spinoffs during 1990-1997 and investigate the managerial incentive hypothesis directly bycollecting a broad amount of compensation data for the CEOs both prior to and following thespinoff. Since a firm's stock price is not a reliable measure of a divisional manager's performance

* Unyong Pyo, Faculty of Business, Brock University, 500 Glenridge Avenue, St. Catharines, ON Canada L2S 3A1,Phone: 905-688-5550 ext. 3147, Fax: 905-378-5723, email: [email protected]. I am grateful for numerous comments fromJames K. Seward, Antonio S. Mello, Howard E. Thompson, Martin Ruckes, and Robert Miller. I am also grateful forhelpful suggestions from the anonymous referee of this journal.

1 See Schipper and Smith (1983), Hite and Owers (1983), Miles and Rosenfeld (1983), Cusatis et al. (1993), andSlovin et al. (1995).

2 For business focus, see Daley et al. (1997) and Desai and Jain (1999). For information, see Kudla and McInish(1988), Nanda (1991), Habib et al. (1997), Bliss (1997), Krishnaswami and Subramaniam (1999), and Gilson et al. (1998).

3 See Burch and Nanda (2003) and Kwak (2001) for diversity costs and Leland (2007) for financial synergies.4 See Aron (1991) and Seward and Walsh (1996).5 Although no parent/subsidiary relation exists following spinoffs, we refer to spinoff divisions as spinoff

subsidiaries for convenience. We focus on these corporate spinoffs to examine the impact of spinoffs on managerialincentives.


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JOURNAL OF ECONOMICS AND FINANCEVolume 31 Number 3 Fall 2007342

within a multi-divisional firm, spinoffs enable corporations to design and implement freshcompensation packages that are based on the stock price of separated divisions. This potentiallychanges and improves managerial incentives. Examining changes in the pay-performance

sensitivity (hereafter PPS) with business focus related to operating performance will shedinsights on how firms use managerial incentive compensation following spinoffs.The results from analyzing PPS suggest that changes in managerial incentives following

spinoffs have significant explanatory power on value enhancements for spinoff subsidiaries ratherthan for post-parents. Results supporting the managerial incentive hypothesis are that spinoffsubsidiaries increase PPS in line with size effects; that PPS for subsidiaries does not decreasewhen the CEO of pre-spinoff parent firms (hereafter pre-parents) jumps to a spinoff subsidiary;and that changes in PPS for spinoff subsidiaries created from the focus-increasing (hereafter FI)spinoff are higher than those for those created from the non-focus-increasing (hereafter NFI)spinoff.6

The investigation of changes in operating performance provides additional intuition indistinguishing the managerial incentive hypothesis from the business focus hypothesis. We findevidence supporting the managerial incentive hypothesis and against the business focus hypothesis.Operating performance improves with managerial incentives, while it does not with business focus

following spinoffs. While the relation between business focus and operating performance isminimal, the relation between managerial incentives and operating performance is significant.

Hypotheses Development

Changing Managerial IncentivesAron (1991) argues that corporate spinoffs themselves act as incentives for divisional

managers because the stock value of a diversified parent firm is a noisy signal of the productivityof any division and that of a spinoff subsidiary reflects a cleaner measure of the performance of adivision. Thus, a spinoff subsidiary can naturally improve managerial incentives by increasing itsPPS relative to the parents PPS, while the parent with remaining multiple divisions does notchange PPS.

For spinoff transaction it is natural that firms experience downsizing and thus increase the

sensitivity. To exhibit genuine improvements in managerial incentives following spinoffs, theincreased PPS for either post-parents or spinoff subsidiaries must be at least consistent with thosefor pre-parents adjusting for size effects.7 Schaefer (1998) examines the relation between firmsize and PPS and finds that the sensitivity appears to be approximately inversely proportional tothe square root of firm size, while he ignores the changes in the value of previously granted stockoptions in his regression analysis. We estimate the regression model using the data with thechanges in the value of previously awarded stock options and compare the size-inducedsensitivities with the estimated sensitivities for spinoff subsidiaries to control for size effects. Thus,we estimate the following equation using the sample in pre-parents:

,stockcommonofValueMarket

1ysensitiviteperformanc-Pay ++= (1)

where PPS is computed from stock options and stock holdings.Using the estimates of the coefficients above and the market values, we compute the fitted

6 A spinoff is considered as a FI spinoff if the first two-digit SIC code of the parent firm is different from that of thesubsidiary. Otherwise, a spinoff is treated as a NFI spinoff.

7 Murphy (1998) finds that when a new CEO position is created following a spinoff, the procedure of setting CEOcompensation is similar to that in other firms and the size adjustment is one of themain determinants in setting CEOcompensation.


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sensitivity, which is PPS induced by the corresponding firm size. The size-induced sensitivity iscompared with the observed sensitivity to see whether the change in the observed sensitivity islarge enough to reflect size effects. Therefore,

Hypothesis 1: The increased PPS for spinoff subsidiaries will be equivalent to that forpre-parents adjusting for size effects.

Hypothesis 2: PPS for post-parents will be equivalent to that for pre-parents adjusting for sizeeffects.

Establishing Top ManagementThe origin of the spinoff subsidiarys CEO appears to have impact on the gains from spinoffs.

Seward and Walsh (1996) find that the majority of new CEO come from inside (48 out of 76CEOs) and the market reaction is positive on selecting an inside CEO. In a related study Wruckand Wruck (2002) suggest that the way in which top management for spinoff subsidiaries isestablished explains value changes that occur following spinoffs. They find that the market reactspositively when a top manager of the pre-parent moves to join the top management of the spinoffsubsidiary. However, they did not measure changes in PPS related to restructuring top

management in spinoffs.Both studies find that the market welcomes spinoffs where the former CEO of pre-parents

jumps to spinoff subsidiaries. The market might recognize improved incentives for those jumpingCEOs as the source of gains from spinoffs. We focus on the findings by both studies to examinewhether the stock market gains due to the CEO origin can be explained by increasing PPS forspinoff subsidiaries. Therefore,

Hypothesis 3: Changes in PPS for the subsidiaries when a pre-parent's CEO becomes a

subsidiary's CEO will be the same as those when someone else becomes the

subsidiary's CEO adjusting for size effects.

Managerial Incentives with Business FocusSpinning off unrelated divisions to shareholders, firms can increase business focus and create

value. Daley, et al. (1997) find that the announcement period abnormal returns for FI spinoffs arelarger than for NFI spinoffs. Desai and Jain (1999) show that both the announcement period andthe long-run abnormal returns for FI spinoffs are significantly greater than the correspondingabnormal returns for NFI spinoffs.

Although Desai and Jain (1999) use three measures of business focus, both studies arecommon on one measure of focus: two-digit SIC codes. A spinoff is defined as a FI spinoff whenthe parent and spinoff subsidiaries carry different two-digit SIC codes. Desai and Jain (1999)report that the results are similar across the different measures of business focus including ameasure displaying the degree of diversification. We use this common measure of focus toexamine whether FI spinoffs rather than NFI spinoffs are related to improvements in thepay-performance relations.

While both studies show evidence that an increase in business focus explains the stock marketgains resulting from spinoffs, we are interested in whether enhancing managerial incentives canbetter explain the gains. Since the two explanations are not mutually exclusive, we first examine if

there is any change in managerial incentives between the two groups of spinoffs in terms ofchanging business focus. If there is no change in incentives around spinoffs, the business focuswill better explain the gains associated with spinoffs as found in the literature. When there arechanges in incentives around spinoffs, we need to investigate that the changes in PPS arecoincided with the changes in business focus. Therefore,

Hypothesis 4: Changes in PPS for spinoff subsidiaries created from FI spinoffs will be thesame as those created from NFI spinoffs.


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Hypothesis 5: Changes in PPS for post-parents involved in FI spinoffs will be the same asthose involved in NFI spinoffs.

Operating Performance Around SpinoffsMehran (1995) examines the relation between managerial incentive compensation andoperating performance in manufacturing firms and finds that firm performance is positivelyrelated to the percentage of equity-based compensation, which provides managerial incentives.Although his approach employing ordinary least-squares appears to be well specified, his measureof compensation, the percentage of CEOs' equity-based compensation, is not as robust as ourmeasure, the value change of the compensation. In addition, he does not consider the value ofexisting stock option holdings, which this study explicitly measures.

Daley et al. (1997) and Desai and Jain (1999) suggest that the value creation for FI spinoffscomes from operating performance improvements. Both studies do not support the managerialincentive hypothesis as the source of gains following spinoffs because they do not observe theoperating performance improvements in subsidiary units following spinoffs. However, they do notdirectly associate changes in operating performance with changes in managerial incentivesbecause they do not measure managerial incentive compensation. Recall that the business focus

hypothesis and the managerial incentive hypothesis are not mutually exclusive. Since firms canchange both their business focus and managerial compensation following spinoffs, the improvedfocus might be a medium to facilitate the enhanced managerial compensation package or viceversa. Thus, one source of stock market gains might not be the ultimate source of gains.

The operating performance improvements can come either from the focus increase, from theincentives enhancement, or from both because the two hypotheses are not mutually exclusive. Toseparate out the source of gains, we examine the relation between the changes in operatingperformance and the changes in managerial incentives and compare it with the relation betweenthe changes in operating performance and the changes in business focus. If managerial incentiveslead business focus and is solely responsible for the operating performance, the changes inbusiness focus could be secondary to the changes in operating performance.

The proponents of the business focus hypothesis argue that increased business focusfollowing spinoffs creates value because the spinoffs allow managers to focus attention on the

core business they are best suited to manage. However, if their managerial incentive compensationremains the same as prior to spinoffs, why would managers bother to focus attention on the corebusiness, while most of their newly created value goes to shareholders? It is more conceivable thatmanagers with more powerful compensation packages would strive to create value. If theyconsider increased business focus as a necessary step to improve firm performance, they will do soas a secondary motivation to their managerial incentive compensation. The motivation providedby enhanced managerial incentives might dominate that provided by increased business focus.Thus, we expect that increasing managerial incentives would be the driving force in improvingoperating performance. Enhanced incentives rather than increased business focus followingspinoffs should lead operating performance improvements for both the parent firms and spinoffsubsidiaries. Therefore,

Hypothesis 6: Operating performance for the pro-forma combined firms increases with

business focus.Hypothesis 7: Operating performance for post-parents increases with business focus.

Hypothesis 8: Operating performance for post-parents increases with PPS.

Hypothesis 9: Operating performance for spinoff subsidiaries increases with PPS.


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Sample and Pay-Performance Relations

Sample of Spinoffs

The sample firms involved in spinoffs are selected in two stages. First, a list of 475 spinoffannouncements during 1990-1997 is obtained from the Securities Data Company (SDC). Second,the actual distributions are verified by consulting the CCH Capital Changes Reporter. We removethe cancelled spinoffs (222) following announcements and the taxable distributions (64). Wefurther reduce the sample by stock price information from CRSP because we measure thepay-performance relations based on stock price performance. Twenty three (23) firms are notlisted in CRSP (2 parent firms and 21 spinoff firms). We also remove spinoff firms whose sharesare traded either one year prior to (9 firms) or following (5 firms) the distribution.8 Six (6) spinofffirms are either delisted from CRSP or acquired within one year following spinoffs and areexcluded from the sample.9

When we examine the pay-performance relationship, we require at least one pair of matchingfirms of either two parent firms prior to and following the distribution or a parent firm prior to anda spinoff subsidiary following the distribution. If both parent firms and spinoff subsidiaries afterthe distribution do not have stock price information, the comparison of the pay-performancerelations would not be meaningful. Ten firms fall into this category and are removed from thesample.

To collect the compensation data, we first exclude firms (6) with tracking stocks because theyare not spinoffs and their motivation for tracking stock might be different from that for spinoffs.Second, we remove CEOs (5) who hold ownership in more than a third of their firms, where thecompensation package could deviate from the otherwise optimal contract and still show a strongpay-performance relations (Guay, 1999). Third, we exclude the CEO (1) who holds less than ahalf time appointment in the firm, where compensation might be different from that of the otherfull time CEOs in terms of contracting purposes. The final sample is reduced to 124 non-taxablespinoffs. The annual distribution of the sample exhibits that the number of actual spinoffs isgradually increasing throughout the nineties, consistent with the previous studies in spinoffscovering the time period up to 1991.10

Compensation DataWe construct compensation data from two sources: the corporate proxy statements11 and

10-K filings. The year of spinoff transactions is the base period from which to select thecompensation data for each firm. After arranging all sample firms around the distribution year, wecollect the compensation data for up to 3 years both prior to and following the distribution. Thus,compensation data set from spinoff distributions covers the years from 1988 to 1999.

To measure PPS, we initially require compensation data for at least 3 years if available foreach of three sets of firms: pre-parents, post-parents, and spinoff subsidiaries. When firmsfollowing the distribution are either acquired or delisted, stock prices are no longer available. Thus,we limit the compensation data to the period during which stock prices data are available fromCRSP. Even in this case, we have compensation data for at least one year from the previousscreening.

Data collection in managerial compensation is not trivial mainly because of dynamic positions

in stock options. The enhanced reporting convention starting from fiscal years ending afterDecember 15, 1992 is not enough to relieve the cumbersome work in tracking dynamic positions

8 If newly created shares are not traded around the distribution, managers might not receive immediate benefits fromincentive compensation following spinoffs.

9 To measure managerial compensation, we need firms to be listed at least for one year following the distribution.10 See Cusatis et al. (1993), Daley et al. (1997), and Desai and Jain (1999).11 Corporate proxies cover detailed information on the amount of stock options granted during the year, the exercise

prices and the time to maturity of the options.


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in stock options. Fortunately, utilizing those enhancements in reporting requirements, Core andGuay (2002) develop a simple method to estimate the value of CEO's option portfolios from onlythe current year's proxy statement.12 We apply the same method to evaluate the stock options

granted in previous years. For stock option holdings before 1992, we look back from 1992 stockoption positions to compute the option holdings at the end of each fiscal year to December 1988by tracking new option grants and exercises.

Pay-Performance RelationsTo measure PPS provided by cash compensation, we run a simple OLS regression as in

Jensen and Murphy (1990):

(Change in CEO Cash Compensation)t = a + b1 (Change in Shareholder Wealth)t (2)

CEO cash compensation consists of the sum of salary, bonus, and other compensation. The changein shareholder wealth is rtVt-1, where rt is the rate of stock return with dividends realized in fiscalyear t, and Vt-1 is the firm value at the end of the previous year.

Table 1:Compensation Data Summary Statistics (in thousands)

Firms Var. Mean Std. Dev Min 1st Q. Median 3rd Q. Max

Pre-parents MV 5772911 12884507 9381 334948 1936662 6236860 103073258Post-parents MV 5946490 14437799 15456 304752 1815083 5004947 132833457

Spinoffs MV 1988280 6443460 2287 103731 409400 1519579 91062711

Pre-parents SBO 1472 1238 99 722 1125 1716 7022Post-parents SBO 1696 1759 0 646 1186 1958 13531

Spinoffs SBO 1002 1109 0 370 735 1273 13105

Pre-parents SO 1343 4552 0 0 303 1066 66541Post-parents SO 2021 6225 0 0 528 1640 69009

Spinoffs SO 1447 3169 0 0 308 1448 22369

Pre-parents RS 121 519 0 0 0 0 6644

Post-parents RS 288 1085 0 0 0 0 10477Spinoffs RS 393 1242 0 0 0 95 10309

Note: The sample is 124 spinoffs during 1990-1997. The `MV' stands for market value, `SBO' for salary, bonus, and othercompensation, `SO' for stock options, and `RS' for restricted stock. The `1st Q' stands for the first Quartile of thecorresponding numbers.

For stock options valuation, we use the Black-Scholes formula as modified by Merton (1973)to reflect dividend payments.13 The stock return volatility is computed with stock price and stockreturn information from CRSP. When the fiscal year ends within six months following a spinoffdistribution, the price history for post-parents and spinoff subsidiaries is not long enough toestimate the stock return volatility. In this case we estimate the forward looking volatilities by

12 They consider previously granted options as two single grants: the executive's exercisable and unexercisableoptions and compute the average realizable value of the exercisable and unexercisable options based on the number ofoptions that are exercisable and unexercisable. They then approximate time-to-maturity of the exercisable options as 6-7years and unexercisable options 9-10 years based on exercisability and the existence of new option grants.

13 The drawbacks of using the Black-Scholes formula for executive stock options are well known because executivesusually do not have the same level of ownership right over their stock option holdings as outside investors have. Theycannot hedge their options' values in the secondary market due to institutional restrictions. However, the Black-Scholesformula appears more convincing for options' value than does the ex postpaper gain realized by executives. Furthermore,the disclosure requirements established by SEC (1992) and FASB (1993) implicitly endorse the Black-Scholes approachfor executive stock options.


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using the post-spinoff stock prices.14 To estimate PPS provided by stock options, we compute theBlack-Scholes delta () multiplied by the option holding ratio (the number of options over theshares outstanding) as used in Yermack (1995). Since the delta () for stock is one, the sensitivity

provided by stock holdings is simply the proportions of stock holdings to the shares outstanding.Thus, PPS provided by stock options and stock holdings is obtained by adding up the twocorresponding sensitivities.

Summary StatisticsThe final sample with managerial compensation includes 124 firms and 344 executive-years

for pre-parents, 123 firms and 367 executive-years for post-parents, and 122 firms and 352executive-years for spinoff subsidiaries. Table 1 presents descriptive statistics for the data during1990-1997. The median (mean) market values for pre-parents, post-parents, and spinoffsubsidiaries are $1.9 billion ($5.7 billion), $1.8 billion ($5.9 billion), and $409 million ($1.9billion), respectively. The median CEO in each group of firms received $1.12 million, $1.18million, and 0.73 million in salary, bonus, and other compensation and 0.3 million, 0.52 million,and 0.3 million in stock option values, respectively. Wilcoxon rank-sum tests for comparisonshow that both stock option grants and restricted stock grants increase for both post-parents and

spinoff subsidiaries following the spinoff distribution.15

Results

Table 2:The Sensitivities from Stock Options and Stock Holdings

Stock option holdings Stock Holdings Stock & Stock options

Pre- Post- Spin- Pre- Post- Spin- Pre- Post- Spin-Firms Parents Parents offs Parents Parents offs Parents Parents offs

Mean .00852 .01116 .01574 .02042 .01105 .01711 .02894 .02222 .03286Std.Err. .00077 .00088 .00128 .00237 .00139 .00210 .00251 .00172 .00264Median .00294 .00488 .00817 .00281 .00199 .00234 .00852 .00855 .01356Std.Dev. .01432 .01685 .02401 .04404 .02671 .03941 .04657 .03297 .00495

Min. 0 0 0 0 0 0 0 0 0Max. .09777 .12008 .15338 24652 .23942 .25553 .25750 .25214 .28676

Sample 344 367 351 344 367 351 344 367 351

Note: The sample is 124 spinoffs during 1990-1997. All the numbers except for `Sample' are per $1,000 increase in firmvalue. Sensitivities are computed for 124 spinoffs during 1990-1997. PPS provided by stock option holdings is computedas the proportional ownership multiplied by the delta of the Black-Scholes formula. The sensitivity provided by stockholdings is the proportions of stock holdings. Sensitivities for `stock & stock options' are the sum of the two sensitivitiesabove in each category.

Changing Managerial IncentivesStock options and stock ownership are the main forces driving PPS. 16 Since we have

confirmed that the sensitivities from cash compensation are trivial, we concentrate on stock andstock options for the measure of PPS hereafter. Table 2 shows PPS from stock and stock option

14 Seward and Walsh (1996) consider two assumptions: (1) that the market uses the pre-spinoff volatility estimate forthe post-spinoff volatility; (2) that the market has perfect foresight. While they choose the former assumption in theiranalysis, we employ the latter assumption because the firms' volatilities are more likely to change following spinoffs.

15 Conducting Wilcoxon rank-sum tests in this paper when they are necessary to compare two samples, we onlydiscuss the relevant results without presenting full details to save space.

16 Murphy (1998) documents that stock option and stock ownership cover more than 95% of PPS for CEOs in mostindustries but utilities in 1996. Holding constant all of the other components of compensation, Hall and Liebman (1998)analyzed the change in CEO wealth resulting from revaluation of stock and stock options to emphasize the magnitude ofstock and stock option holdings.


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holdings. Since the distribution of the sensitivities is skewed to the right, the median is better thanthe mean for comparison. From the stock and stock options, the median sensitivities forpre-parents and post-parents are about the same at $8.52 and $8.55 per $1,000 change in firm

value, respectively. The Wilcoxon rank-sum test statistic in comparing the two sensitivities is-0.6465 and is not significant at the 10% level. Although the median sensitivity for the spinofffirms changes to $13.56 per $1,000 change in firm value and is significantly different from that($8.52) for pre-parents at the 1% level, we cannot draw conclusion from this result because firmsizes are not the same.

Since pre-parents distribute the fraction of their assets through spinoffs, their firm sizes arenaturally reduced following spinoffs. If firms involved in spinoffs improve managerial incentivesfollowing spinoffs, we expect PPS both for post-parents and for spinoff subsidiaries to beconsistent with the firm size. To control for size effects in PPS, we estimate the followingequation as in Schaefer (1998) from pre-parents:

level.1%attSignifican***(1.5662);(0.00295)

level.10%attSignifican***);*(11.4819(1.8927*)

:errorstandard

:statistict

.firmofValueMarket

1984.170055.0iessensitiviteperformanc-Pay +=

Using the above estimation and the corresponding mean market values in Table 1, wecompute the size-induced sensitivities. Since the intercept is not significant at the 5% level, weignore it in the following computation. We compute the size-induced sensitivities with their 95%confidence interval as $7.485 ($6.20, $8.76), $7.375 ($6.11, $8.63), and $12.754 ($10.56, $14.93)per $1000 change in firm value for pre-parents, post-parents, and spinoff subsidiaries,respectively.17 The value ($7.485) is close to the observed median sensitivity ($8.52) of thecorresponding pre-parents. Since the 95% confidence intervals for the size-induced sensitivitiescontain the corresponding median sensitivities for all three groups of firms, we cannot reject eitherhypothesis: H1 or H2. However, the increase in PPS for spinoff subsidiaries is indeed consistentwith the size effects. It implies that PPS increases for spinoff subsidiaries, but not for post-parentsadjusting for size effects.

The fact that the increased sensitivities for spinoff subsidiaries are consistent with thedecreased firm sizes strengthens the incentive hypothesis because the size adjustments in settingthe compensation package for new CEOs of spinoff subsidiaries are a major determinant inexecutive compensation.18 Since firms cannot simply separate their asset base into pieces toenhance managerial incentives, spinoffs facilitate firms to distribute assets to shareholders andprovide managers with the corresponding compensation packages tied to a subsidiary's own stockprice.

Establishing Top ManagementTable 3 presents PPS by the CEO origin. The improvement in the pay-performance relations

for spinoff subsidiaries which are led by the formerly pre-spinoff parents' CEO is not greater thanthat for the other spinoff subsidiaries which are not led by the formerly pre-spinoff parents' CEO.

There is no improvement for spinoff subsidiaries with the formerly pre-spinoff parents' CEO.

17 For example, observing that the mean market value of pre-parents in Table 1 is $5,772,991 (in thousands), wecompute the size-induced sensitivity with the 95% confidence interval for pre-parents as follows;

( ).00876.0,00620.0.007485.05772911

1984.17 =

18 Murphy (1998) shows that industry surveys with firm size adjustments are the main determinants for managerialcompensation.


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When the CEO of spinoff subsidiaries comes from the formerly pre-spinoff parents' CEO, themedian sensitivities for pre-parents and the spinoffs are $15.30 and $14.00, respectively. TheWilcoxon rank-sum test statistic for comparison is 0.6819 and is not significant at the 10% level.

The size effect does not have impact on these sensitivities. The firm sizes ($988 million vs. $913million) as measured in the median market value are equivalent to each other and the Wilcoxontest statistic (0.9499) for comparison is not significant at the 10% level.

By contrast there seems to be a significant improvement for the other spinoff subsidiaries toour surprise. When spinoff subsidiaries are not led by the formerly pre-parent's CEO, the mediansensitivities for pre-parents and the spinoffs are $7.10 and $13.50, respectively. The Wilcoxonrank-sum test statistic is -4.4251 and is significant at the 1% level. However, it might be due to thesize effect because there is a significant reduction in firm size for these spinoff subsidiaries. Themedian market values for pre-parents and spinoff subsidiaries are $2,083 billion and $350 millionwhen the formerly pre-parent's CEO does not become the subsidiary's CEO.

Table 3:Sensitivities by CEO Origin

Firms Pre-parents Post-parents Spinoffs

CEO No-jump Jump No-jump Jump No-jump JumpMean .0232 .0586 .0192 .0246 .0282 .0568Median .0071 .0153 .0074 .0146 .0135 .0140Std.Dev. .0376 .0744 .0288 .0401 .0427 .0743

Min 0 .0001 0 0 0 0Max .2346 .2575 .2521 .2156 .2867 .2355

Med. MV ('000) 2083258 988548 2007386 1125218 350345 913701Sample 129 198 142 210 126 211

Note: Jump: The CEO of the pre-parent becomes the CEO of a spinoff firm. No-jump: Someone else becomes the CEO ofa spinoff firm. All the numbers except for 'Sample' are per $1,000 increase in firm value unless denoted otherwise.

To examine the size effect on the sensitivities in these firms, we compare the mediansensitivities with the size-induced sensitivities in Table 4. The pre-parent's sensitivity ($7.10) isequivalent to the size-induced sensitivity ($7.70) and is contained in the 95% confidence interval($6.40, $9.00). However, the spinoff subsidiaries' sensitivity ($13.50) is less than the size-inducedsensitivity ($20.70) and is not contained in the confidence interval. Hypothesis 3 is thus rejected.When spinoff subsidiaries are not led by the formerly pre-parent's CEO, these subsidiariesexperience decrease in the size-adjusted PPS, while other spinoff subsidiaries led by the formerlypre-parents' CEO do not. The results indirectly support the hypothesis on top management and areconsistent with Seward and Walsh (1996) and Wruck and Wruck (2002).

Table 4:The Size-Induced Sensitivities for CEO Origin

Firms CEO OriginMeanMV

MedianSensitivity

Size-Induced Sensitivitywith 95% C. I.

No-jump 5421806 0.0071 0.0077 (0.0064, 0.0090)Pre-parents

Jump 6345000 0.0153** 0.0071 (0.0059, 0.0083)

No-jump 5554247 0.0074 0.0076 (0.0063, 0.0089)Post-parents Jump 6488114 0.0146** 0.0070 (0.0058, 0.0082)

No-jump 748476 0.0135** 0.0207 (0.0172, 0.0243)Spinoffs

Jump 2823721 0.0140** 0.0107 (0.0088, 0.0125)

Note: Jump: The CEO of the pre-parent becomes the CEO of the spinoff firm. No-jump: Someone other than the CEO ofpre-parents becomes the CEO of the spinoff firms. All the numbers except for `Mean MV' are per $1,000 increase in firmvalue. `Mean MV' stands for the mean market value and the numbers are in thousands. Two asterisks denote that themedian sensitivities are not contained in the 95% confidence interval.


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Furthermore, when the formerly pre-parents CEO becomes new CEO of spinoff subsidiaries,the firm size and the pay-performance relations of spinoff subsidiaries are large and are equivalentto those of pre-parents. On the other hand, when the firm size of spinoff subsidiaries are small and

the pay-performance relations for the pre-parents is relatively small, pre-parents CEO do notjump to become the head of spinoff subsidiaries. This pattern is consistent with the notion thatself-interested managers are unlikely to embrace an increase in sensitivity and a decrease incompensation level from a small firm created from spinoffs. The pattern also reflects the strongmanagers behavior rather than the form of management dismissal as found by Wruck and Wruck(2002).

Managerial Incentives with Business Focus

Table 5 presents PPS by changes in business focus. We find evidence against Hypothesis 4.The change in PPS for spinoff subsidiaries created from FI spinoffs is significantly positive, whilethat from NFI spinoffs is not. The median sensitivities of pre-parents and spinoff subsidiariesinvolved in FI spinoffs are $6.10 and $14.10 per $1000 increase in firm value, respectively. TheWilcoxon rank-sum test for the comparison shows that the difference is significant at the 1% level.The corresponding sensitivities of pre-parents and spinoff subsidiaries involved in NFI spinoffs

are $12.90 and $13.00 per $1000 increase in firm value, respectively. The Wilcoxon rank-sum testfor the comparison shows that the difference is not significant at the 10% level.

Table 5:PPS by Changing Business Focus

Firms Pre-parents Post-parents SpinoffsBusiness focus No-increase Increase No-increase Increase No-increase Increase

Mean .0383 .0230 .0247 .0170 .0429 .0262Median .0129 .0061 .0140 .0064 .0130 .0141

Standard Deviation .0024 .0431 .0290 .0317 .0634 .0379Minimum 0 0 0 0 0 0Maximum .2575 .2297 .1242 .2521 .2867 .2555

Median M.V. 1909497 2372006 1806297 1963601 442804 350345

Sample 129 198 142 210 126 211Note: The sample is 124 spinoffs during 1990-1997. All the sensitivities are per $1,000 increase in firm value unlessdenoted otherwise. The sensitivity provided by stock option holdings is computed as the proportional ownership multipliedby the delta of the Black-Scholes formula. The sensitivity provided by stock holdings is the proportions of stock holdings.The sensitivities reported here are the sums of the two sensitivities.

However, we find evidence supporting Hypothesis 5. There is no change in PPS for eithergroup of firms. Post-parents seem to maintain their previous compensation contracts inheritedfrom pre-parents. The median sensitivities for the parents involved in FI spinoffs change from$6.10 to $6.40 around the spinoff. This is consistent with the arguments by Paul (1992) and thefindings by Anderson et al. (2000). The corresponding sensitivities for the parents involved in NFIspinoffs change from $12.90 to $14.00 around the spinoff. The Wilcoxon rank-sum test shows thatneither difference is significant at the 10% level.

To see whether the results above merely reflect the size effects on PPS, we compare themarket values of the corresponding pairs. Pre-parents involved in NFI spinoffs are smaller thanthose involved in FI spinoffs. The median market values of the corresponding firms are$1,909,497 and $2,370,006 in thousands, respectively. The smaller size for NFI spinoffs seems tojustify the higher PPS in pre-parents. However, this difference disappears in post-parents andspinoff subsidiaries.

The only other significant difference in firm sizes lies between pre-parents and spinoffsubsidiaries as observed in the previous section. The parent firms maintain the same level of PPS


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following spinoffs, while their size difference disappears. Spinoff subsidiaries created from FIspinoffs show increase in managerial incentives while their size changes from pre-parents aresimilar to those created from NFI spinoffs. The size effect does not appear to be significant in the

results about business focus as shown in Table 6. All the median sensitivities for firms involved inNFI spinoffs are higher than the size-induced sensitivities and those for firms involved in FIspinoffs are equivalent to the size-induced sensitivities.

Table 6: The Size-Induced Sensitivities for Business Focus

Firms Focus Mean MV Median PPS Size-Induced PPS with 95% C. I.

No-increase 5024699 0.0129** 0.0080 (0.0066, 0.0093)Pre-parents

Increase 6603720 0.0061 0.0070 (0.0057, 0.0081)

No-increase 5477492 0.0140** 0.0076 (0.0063, 0.0090)Post-parents

Increase 6540015 0.0064 0.0070 (0.0058, 0.0082)

No-increase 2952807 0.0130** 0.0104 (0.0086, 0.0122)Spinoffs

Increase 1507391 0.0141 0.0146 (0.0121, 0.0171)

Note: The sample is 124 spinoffs during 1990-1997. All the numbers except for `Mean MV' are per $1,000 increase in firmvalue. `Mean MV' stands for the mean market value and the numbers are in thousands. The size-induced sensitivities arecomputed using the mean market value. Two asterisks denote that the median sensitivities are not contained in the 95%confidence interval and not consistent with the size-induced sensitivities.

The pay-performance relations for the subsidiaries appear to converge towards the highersensitivities whether their parent firms improve business focus or not. The median sensitivities forboth groups of spinoff subsidiaries are about the same ($13.00 vs. $14.10) and the two sensitivitiesare not significantly different from each other at the 10% level. The levels of the sensitivitiesconverge to the higher sensitivity ($12.90) of pre-parents, which are involved in NFI spinoffs. Theconvergence towards higher sensitivities for spinoff subsidiaries seems to support the argument byAron (1991). Unlike divisional managers of multi-divisional firms, the CEOs of spinoffsubsidiaries receive a compensation package tied to its own stock price. PPS of a newly createdspinoff subsidiary is no less than that of its pre-parent. Thus, the mere possibility of a future

spinoff can improve current incentives for divisional managers.

Changes in Operating PerformanceFor the measure of operating performance, we follow Barber and Lyon (1996) and take the

return on asset (ROA) of the year-end operating cash flow (Compustat data item #13) divided bythe year-end total assets (Compustat data item #6). We compute the changes in the ratio becausethe change, rather than the level, reflects a firm's previous performance. To detect abnormalperformance with robustness, we use two measures of operating performance: (1) unadjusted(raw) measure and (2) size-adjusted measure.

For the size-adjusted measure, we compute the median return on assets (ROA) for all firms inthe same industry (defined as the first two-digit SIC code) with asset values within 20% of theasset value of the spinoff firm in the same fiscal year except for the spinoff firm and subtract themedian ROA from the raw ROA of the spinoff firm to obtain the size-adjusted ROA. Obtainingthe change in the size-adjusted ROA for each spinoff firm, we record the median change across all

spinoffs for the results. When the number of matching firms is less than three, we relax the assetpercentage from 20% to 50% to maintain at least three matches for each spinoff firm.

Pro-forma Combined FirmsWe compute the combined ROAs following spinoffs by dividing the sum of the operating

income of post-parents and subsidiaries by the sum of the total assets of the corresponding firms.Panel A of Table 7 presents the results for changes in operating performance of the pro-formacombined firm of a parent with its subsidiaries for FI and NFI spinoffs, respectively.


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We find evidence against Hypothesis 6. In panel A of Table 7 the median change in ROAduring the year (-1, +1) is -0.3% for FI spinoffs. The size-adjusted change in ROA is 0.6%. Nochange is significant at the 10% level. These results indicate that operating performance for FI

spinoffs virtually remains the same following spinoffs. The corresponding changes for NFIspinoffs are 1.4% and 3.4% and are again not significant at the 10% level. The Wilcoxontwo-sample median test rejects the equality of median ROA changes between FI and NFI spinoffsfor the unadjusted measures at the 5% level, while the test rejects the equality at the 10% level forthe size-adjusted changes. Operating performance for NFI spinoffs substantially improvesfollowing spinoffs and the improvements are significantly greater than those for FI spinoffs.

Table 7: Changes in Operating Performance (ROA) by Business Focus

Panel A. Pro-forma combined firms

Period (-1, +1) (-1, 0) (0, +1) (+1, +2)

Focus FI NFI Z FI NFI Z FI NFI Z FI NFI Z

UROA -0.3% 1.4% 2.16 0.5% 1.1% 0.15 -0.3% -0.0% 0.52 0.2% 0.4% -0.06

SROA 0.6% 3.4% 1.66 0.2% -0.0% 0.43 0.1% 0.6% 0.54 1.0% 0.5% -0.40Panel B. Parent firms

Period (-1, +1) (-1, 0) (0, +1) (+1, +2)

Focus FI NFI Z FI NFI Z FI NFI Z FI NFI Z

UROA 0.8% 2.7% 1.50 0.9% 2.6% 1.37 -0.0% -0.4% -0.69 0.0% 0.5% -0.25SROA -0.0% 2.3% 1.33 0.2% 1.5% 1.25 0.1% -0.3% -0.54 0.8% 0.3% -0.42PPS $0.40 $1.66 1.65 $0.16 $0.65 0.66 $0.48 $0.96 0.34 -$0.04 $0.35 -0.49

Panel C. Spinoff subsidiariesPeriod (-1, +1) (-1, 0) (0, +1) (+1, +2)

Focus FI NFI Z FI NFI Z FI NFI Z FI FI Z

UROA 0.1% 1.7% 1.97 -0.2% 1.9% 1.45 0.1% 0.3% 0.43 -0.6% 0.4% 1.71SROA -0.8% 1.3% 1.01 -1.2% 1.1% 1.06 0.1% -0.3% -0.43 -1.5% 2.1% 2.50PPS N/A N/A N/A N/A N/A N/A $0.55 $1.71 1.55 $1.05 $0.89 0.10

Note: Median change in operating performance for 95 spinoffs during 1990-1997. In the 60 FI spinoffs, both post-spinoff

parents and subsidiaries carry different two-digit SIC codes. In 35 NFI spinoffs, both carry the same two-digit SIC codes.The ROA is the ratio of operating income before depreciation (Compustat item #13) to total assets (item #6). Pre-spinoffROAs are measured directly in the fiscal year preceding the spinoff. The post-spinoff combined ROA (UROA) is obtainedby summing the operating income of the parent and subsidiary in the fiscal year following the ex-dividend year anddividing the sum by the combined parent/subsidiary end-of-fiscal-year asset value. Size-adjusted medians (SROA) areobtained by subtracting the median value for all firms (except the spinoff firm) in the same two-digit SIC code, whose assetvalue lies within 20% of the asset value of the parent firm. Median changes are tested against zero using the Wilcoxon signrank test statistics. Superscript numbers represent significance at the 10% (1), 5% (2), and 1% (3) level. The Z-stat istics (Z)test the equality of distributions for matched pairs of observations using the Wilcoxon sign rank test.

Our findings directly contrast with those of Daley et al. (1997) and Desai and Jain (1999).Both studies find that the operating performance for FI spinoffs is significantly higher than that forNFI spinoffs. One explanation for the contrast is the different sample period. They cover a periodof the eighties, while this study covers most of the nineties. There have been significant changes inmanagerial incentives during the nineties. Since managerial incentives are economically minimal

during the eighties (Jensen and Murphy, 1990), business focus might play a role in corporatespinoffs during the period. However, the improved managerial incentives during the nineties(Murphy, 1998) might dominate the impact of business focus on operating performance andprovide a motive for spinoffs. Another explanation is that the impact of increasing business focusmight be reduced over time. Since firms involved in spinoffs already have several unrelatedbusiness divisions, separating one or more unrelated divisions might not help much in improvingoperating performance.

Though the changes in ROA for NFI spinoffs show noticeable improvements over those for


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FI spinoffs during the year (-1, +1), both changes across business focus are indistinguishable fromyear +1 to year +2. The unadjusted and the size-adjusted changes for FI spinoffs during the year(+1, +2) are 0.2% and 1.0%, respectively, while the corresponding changes for NFI spinoffs are

0.4% and 0.5%, respectively. No change is significant at the 10% level, implying that thedifference in operating performance between FI spinoffs and NFI spinoffs disappears during thesecond year following the distribution.

The fact that changes in operating performance for FI spinoffs are close to zero in the secondyear following the spinoffs is consistent with the finding by Daley et al. (1997). Thecorresponding ROA changes for FI spinoffs are -0.4% and +1.8% and are insignificant at the 10%level. For NFI spinoffs, they find that an ROA increases from year (+1) to year (+2) at the 10%level, weakening the business focus hypothesis.

Overall, the results from the parent/subsidiary combined firms show significant improvementsin operating performance for NFI spinoffs alone. The FI spinoffs do not appear to displayoperating performance improvements following spinoffs. We cannot support the business focushypothesis that an increase in business focus leads to an increase in operating performance asfound by the two previous studies.

Parent FirmsTo investigate the association between operating performance and managerial incentives, we

change the method of measuring the operating performance from that in the previous section. PPSfollowing spinoffs reflects a compensation for one CEO of a firm, either a post-parent or a spinoffsubsidiary, while the operating performance of a parent/subsidiary combined firm followingspinoffs reflects performance for the two. Thus, we cannot directly compare the combinedoperating performance with PPS. We measure the operating performance of post-parents alone.Though the size of the asset base for pre-parents is greater than that for post-parents, the samemanagement leads the same firm and is compensated by the same firm prior to and following thespinoff. Thus, it makes sense to use the parent firms alone for comparing operating performancewith managerial incentives. PPS used here may not be as robust as operating performance becausewe only use the unadjusted measures for the sensitivities due to the limitations in the data.19However, the unadjusted quantities still provide us with an overall picture about the relation

between managerial incentives and operating performance.Panel B of Table 7 presents the results for changes in operating performance and PPS of the

parent firms by changes in business focus. We find evidence against Hypothesis 7. For FI spinoffs,the median change in ROA during the year (-1, +1) is 0.8%. The size-adjusted change in ROA is-0.0%. No change is significant at the 10% level. The corresponding changes for NFI spinoffs are2.7% and 2.3% and are significantly greater than zero. The pattern of change in operatingperformance is consistent with that in the combined operating performance.

However, we find evidence supporting Hypothesis 8. The large change in the ROAs for NFIspinoffs is matched with the large change in managerial incentives. The median changes in PPSare $0.40 and $1.66 per $1000 increase in firm value for FI and for NFI spinoffs, respectively. TheWilcoxon rank-sum test shows that the change of $1.66 is greater than the change of $0.40 at the10% significance level. Improved operating performance is directly related to the higher PPS.

Although subsidiaries do not exist as separate and publicly-traded companies prior to the base

year, we obtain most data for pre-spinoff operating performance from subsequent annual reports.For subsidiaries, we find a similar pattern of operating performance to that for parent firms asshown in Panel C of Table 7. While most changes in ROAs for subsidiaries created from FIspinoffs are close to zero, the subsidiaries created from NFI spinoffs seem to express some degree

19 To obtain some benchmark for PPS, we would need to hand-collect compensation data from proxies of a widearray of firms similar to our spinoff firms. Even the ExecuComp database in Compustat will not provide much help inobtaining a benchmark for the sensitivities.


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of abnormal operating performance during (-1, +1). The unadjusted change in ROA is 1.7%. TheZ-statistics for testing the equality of ROA changes are 1.97, supporting operating performanceimprovements in the subsidiaries created from NFI spinoffs alone. ROA losses for the subsidiaries

created from FI spinoffs increase during the year (-1, +1), while those from NFI spinoffs remainpositive.This finding contrasts with the finding by Desai and Jain (1999). Reporting that the

subsidiaries distributed from NFI spinoffs substantially underperform their matching firms overthe same two periods, they imply that the parent firms involved in NFI spinoffs spin offunderperforming subsidiaries. On the contrary, our finding suggests that parent firms spin offwell-performing subsidiaries. The difference might come from two reasons: increased managerialincentives and decreased business focus during the nineties. Their study covers a period of theeighties, while this study covers most of the nineties. It is also likely that the subsidiaries createdfrom NFI spinoffs improve managerial incentives better than those from FI spinoffs becausemanagers with powerful compensation packages will have enhanced incentives to deliver strongperformance. The change in PPS for subsidiaries created from NFI spinoffs is modestly higherthan that from FI spinoffs (1.71 vs. 0.55), while the pattern is not significantly reversed during thefollowing year (0.89 vs. 1.05).

Table 8 displays changes in operating performance and provides additional evidencesupporting Hypothesis 8. For the parent firms with large enhancement in managerial incentives,the median change in ROA during the year (-1, +1) is 1.6% in Panel A. The size-adjusted changein ROA is 2.1%. Both changes are significant at the 1% level. The corresponding changes for theparent firms with the small increase in PPS are -0.3%, and -0.8% and are not significant at the10% level. The Wilcoxon two-sample median test confirms that both median ROA changes forfirms with the large increase are significantly greater than those for firms with the small increaseat the 5% level. The median ROA changes during the year (+1, +2) are all insignificant,suggesting that they are not reversed in the second year following spinoffs.

Examining changes in managerial incentives alone for the parent firms earlier, we find thatthe parent firms do not change managerial incentives following spinoffs. It now appears thatalthough parent firms do not change managerial incentives following spinoffs on average, parentfirms enhancing managerial incentives following spinoffs improve operating performance. This

result is possible because we associate the changes in managerial incentives with the changes inoperating performance.

These two way findings on the changes in PPS and in operating performance further supportthe incentive hypothesis. Since the managerial incentive hypothesis is still in debate, the realimpact of enhancing managerial incentives on operating performance following spinoffs is yet tobe observed by both academicians and practitioners. Thus, parent firms distributing theirsubsidiaries through spinoffs may or may not enhance managerial incentives for their CEOsfollowing spinoffs. However, those parent firms enhancing managerial incentives subsequentlyexperience improved operating performance.

Panel B of Table 8 presents the corresponding measures for subsidiaries, which are divided bychanges in PPS of the parent firms. All the individual changes in ROAs are not significant at the10% level, indicating that subsidiary ROAs are hardly affected by changes in PPS of the parentfirms. This result is not surprising because spinoffs completely separate the distributed

subsidiaries from their parent firms.The results indicate that operating performance improvements are directly related tomanagerial incentive enhancements for both the parent/subsidiary combined firms and the parentfirms alone, which is in line with the managerial incentive hypothesis that managers deliver betterperformance when compensated efficiently following spinoffs. Causality might not be clearconsidering the notion that managers anticipating good performance following spinoffs couldselect compensation sensitive to performance. On the other hand, the pattern might be consistentwith positive relation between growth opportunities and managerial incentives. However, our


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finding that firms involved in NFI spinoffs experience higher operating performance than thoseinvolved in FI spinoffs in the nineties weakens the business focus hypothesis that managersbecome more productive when managing core assets after unloading unrelated assets.

Table 8: Operating Performance Changes by PPS

Panel A. Parents firms in spinoffs by own incentives

Period (-1, +1) (-1, 0) (0, +1) (+1, +2)

Small Large Z Small Large Z Small Large Z Small Large Z

PPS $0.96 $4.08 8.83 -$0.13 $1.93 4.35 -$0.22 $2.08 3.34 -$0.39 $0.62 2.10

UROA 0.3% 1.6% 2.11 2.0% 1.3% -0.27 -0.9% 0.3% 1.88 -0.4% 0.8% -1.03

SROA -0.8% 2.1% 2.53 0.2% 1.3% 0.87 -0.7% 0.6% 1.19 0.4% 0.7% -0.41

Panel B. Spinoff subsidiaries by parents incentives

Period (-1, +1) (-1, 0) (0, +1) (+1, +2)

Small Large Z Small Large Z Small Large Small Large Z

PPS N/A N/A N/A N/A N/A N/A $0.78 $0.81 -0.25 $0.83 $0.89 -0.13UROA -1.0% 0.6% 1.21 -2.0% 0.3% 0.47 0.7% 0.2% 0.26 0.2% -0.8% -1.08

SROA -1.0% 0.2% 1.00 -0.9% -0.6% 0.89 0.5% -0.1% -0.37 0.4% -0.5% -0.64

Panel C. Spinoff subsidiaries by own incentives

Period (0, +2) (0, +1) (+1, +2)

Small Large Z Small Large Z Small Large Z

PPS $0.80 $10.98 6.42 $0.10 $3.21 2.74 $0.27 $4.96 5.22

UROA -0.6% 0.6% 1.14 0.2% 0.3% -0.16 -1.2% 1.1% 2.20

SROA -2.0% 1.6% 2.44 -0.8% 0.4% 1.59 -0.3% 2.4% 1.83

Note: For 54 `Small' changes in the sensitivities, the changes in PPS belong to the lower half among all the changes in thesensitivities for parent firms from year -1 to year +1. For 53 `Large' changes in the sensitivities, the changes in PPS belongto the upper half among all the changes in the sensitivities for parent firms from year -1 to year +1. The median PPS (PPS)

is computed as in Table 3. The UROA is the ratio of operating income before depreciation (Compustat item #13) to totalassets (item #6). Size-adjusted medians (SROA) are obtained by subtracting the median value for all firms (except thespinoff firm) in the same two-digit SIC code, whose asset value lies within 20% of the asset value of the parent firm.Median changes are tested against zero using the Wilcoxon sign rank test statistics. Superscript numbers representsignificance at the 10% (1), 5% (2), and 1% (3) level. The Z-statistics (Z) test the equality of distributions for matchedpairs of observations using the Wilcoxon sign rank test.

Spinoff SubsidiariesWe now focus on the operating performance of subsidiaries to examine whether the

managerial incentive enhancements induce the operating performance improvements in thesubsidiaries as well. Since the subsidiaries do not exist as separate, publicly-traded companiesprior to the spinoffs, we do not have managerial compensation data for subsidiaries during theyear (-1) and cannot use the same time period (-1, +1) for comparison as in the parent firms. Usingthe time interval (0, +2) instead and ignoring changes in business focus, we divide the subsidiaries

into two groups by their changes in PPS to observe the impact of managerial incentives onoperating performance. If managerial incentives play a role in operating performance, we expectthe large increase in PPS to lead the large improvement in operating performance as in the parentfirms.

Panel C of Table 8 presents the results for changes in operating performance by changes inPPS for the subsidiaries. The subsidiaries with large changes in PPS increase their CEO pay$10.98 for every $1,000 increase in firm value during the year (0, +2), while those with smallchanges in PPS increase their CEO compensation only $0.80 for every $1,000 increase in firm


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value over the same period. We find some evidence supporting Hypothesis 9. For the subsidiarieswith the large increase in PPS, the median change in ROA during the year (0, +2) is 0.6%. Thesize-adjusted change in ROA is 1.6%. The corresponding changes for subsidiaries with the small

increase in PPS are -0.6 and -2.0%, respectively. The Wilcoxon two-sample median test confirmsthat the median size-adjusted ROA change for subsidiaries with the large enhancement issignificantly greater than that for subsidiaries with the small enhancement at the 5% level.

To examine the timing of such changes more closely, we also investigate performancechanges from year 0 to +1 and from year +1 to +2. We find that while the performance change isindistinguishable between the two groups during the period (0, +1), the performance improvementfor the subsidiaries with the large increase in PPS is significantly greater than that for those withthe small increase from year +1 to +2.

For robustness, we also perform multivariate analysis using two measures of operatingperformance as dependent variables with business focus, PPS, and firm size as independentvariables and find that the analysis confirms the main results supporting the managerial incentivehypothesis.

Table 9 presents the results of the hypotheses. In summary, we find that there is a strongrelationship between operating performance and PPS. Business focus has virtually no effect on

operating performance. The evidence supports the managerial incentive hypothesis that enhancedmanagerial compensation packages rewritten through corporate spinoffs create value. We believethat the value creation from increased business focus reported in the literature is not a matter ofincreasing business focus, but a matter of enhancing managerial incentives.

Table 9: Summary of Hypotheses and the Results

Hypotheses Result

1. The increased PPS for spinoff subsidiaries will be equivalent to thatfor pre-parents adjusting for size effects.

Not rejected

2. PPS for post-parents will be equivalent to that for pre-parents adjusting forsize effects.

Not rejected

3.Changes in PPS for the subsidiaries when a pre-parent's CEO becomes a

subsidiary's CEO will be the same as those when someone else becomes thesubsidiary's CEO adjusting for size effects.

Rejected

4. Changes in PPS for spinoff subsidiaries created from FI spinoffs will be thesame as those created from NFI spinoffs.

Rejected

5. Changes in PPS for post-parents involved in FI spinoffs will be the same asthose involved in NFI spinoff.

Not rejected

6. Operating performance for the pro-forma combined firms increases withbusiness focus.

Rejected

7. Operating performance for post-parents increases with business focus. Rejected8. Operating performance for post-parents increases with PPS. Not rejected9. Operating performance for spinoff subsidiaries increases with PPS. Not rejected

Note: PPS: Pay-performance sensitivity, FI: Focus-increasing, NFI: Non-focus.

Conclusion

We present new results to better understand the sources of gains in corporate spinoffs. Wefind that the pay-performance relations improve following spinoff distributions in three aspects.First, we find that PPS increases for spinoff subsidiaries but remains the same for the parent firms.Second, PPS for spinoff subsidiaries does not decrease when a pre-parents CEO becomes aspinoff subsidiarys CEO adjusting for size effects. Third, the higher incentives are offered to theCEO of spinoff subsidiaries created from FI spinoffs than that of pre-parents involved in FI


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spinoffs.The results for the parent/subsidiary combined firms show that the operating performance for

FI spinoffs virtually remains the same around spinoffs, while that for NFI spinoffs exhibits

improvement. Focusing on the parent firms alone further drives the convincing hypothesis towardmanagerial incentives and away from business focus. Operating performance improvements forthe parent firms involved in NFI spinoffs are significant, while those involved in FI spinoffs arenot.

Furthermore, changes in operating performance are consistent with changes in PPS. Theparent firms with the large increase in PPS significantly improve operating performance, whilethose with the small increase in sensitivities do not improve their operating performance. Thesubsidiaries with the large increase in PPS significantly improve operating performance, whilethose with the small increase in sensitivities do not improve their operating performance.

Changes in managerial incentives are significant motives for corporate spinoffs. Firms appearto use spinoffs as a way to rewrite managerial compensation contracts more efficiently and toimprove firm performance. While the managerial incentive hypothesis and the business focushypothesis are not mutually exclusive, the results from operating performance show that themanagerial incentive effect appears to dominate the business focus effect.

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Enhancing Managerial Incentives and Value Creation- Evidence From Corporate Spinoffs