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Split-Off IPOs Market Returns and Efficiency

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Split-Off IPOs Market Returns and Efficiency

    Working Paper #00-12

    Split-Off IPOs: Market Returns and Efficiency

    Ahmet Tezel Associate Professor of Finance

    St. Joseph’s University

    Department of Finance

    5600 City Avenue

    Philadelphia, PA 19131

    Ph: (610) 660-1670

    Fax: (610) 660-1986

    Email: atezel@sju.edu

    Oliver Schnusenberg

    Assistant Professor of Finance

    St. Joseph’s University

    Department of Finance

    5600 City Avenue

    Philadelphia, PA 19131

    Ph: (610) 660-1648

    Fax: (610) 660-1986

    Email: oschnuse@sju.edu

    Split-Off IPOs: Market Returns and Efficiency

    Abstract

     This paper investigates split-off initial public offerings (IPOs). Our objective is to

    investigate the returns prior and subsequent to the offering date of split-off IPOs for high-

    technology firms in the most recent bull market. Such an investigation is warranted for at

    least two reasons. First, if both the parent’s and the subsidiary’s stock price increase

    significantly prior to the IPO, but the parent’s stock price declines but a greater, share-

    adjusted, basis than the subsidiary’s stock price increases following the IPO, arbitrage

    opportunities may result. Second, in light of the large, one-day returns observed during 1999

    for high-technology companies, an observation of mispriced technology split-off IPOs may

    be possible.

     Using a sample of ten recent split-off IPOs, the market price of parent companies

    carving out a small percentage of a major subsidiary tends to rise one month prior to the

    filing date and continues to rise until the offering date. Furthermore, this increase is highly

    related to the success of the IPO on the first trading day subsequent to the IPO. Furthermore,

    the market appears to anticipate the extent of the success of the IPO correctly. Subsequent to

    the offering day, the subsidiaries perform well for about three months, while the parent

    company performs poorly, on average, giving up nearly all of its pre-offering gains. Further

    investigation of potential arbitrage opportunities indicates that, if both the parent and the

    subsidiary can be shorted, very large trading profits can be obtained. This result holds for

    pairs of stocks where the parent’s price includes at least 20 percent of the subsidiary’s price.

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    Split-Off IPOs: Market Returns and Efficiency

    1. Background and Introduction

     This paper investigates split-off initial public offerings (IPOs). In many split-offs the

    parent incubates an Internet or technology company that is very favorably valued by the

    market. Some incubator firms require large additional investments and the parent was not

    willing to finance the required investments. Consequently, the parent avoids financing

    additional and risky investments and limits its exposure to the existing investment by

    splitting off a small portion of the subsidiary to the public. Conversely, the parent may

    decide to spin-off its share of the subsidiary to its shareholders rather than selling it in the market to raise funds. Essentially, a split-off is a variation of the spinoff in which the existing shareholders receive all the newly issued shares of a subsidiary. Split-off IPOs may be

    viewed as a long-term continuing public offering, possibly followed later by a seasoned

    equity issue if the parent eventually sells most of its holdings in the subsidiary to finance the growth in its core business or to incubate other businesses.

     Previous empirical literature has investigated the abnormal returns accruing to both

    parents and subsidiaries involved in split-offs, spin-offs, and equity carve-outs. Our present objective is to investigate the returns prior and subsequent to the offering date of split-off IPOs for high-technology firms in the most recent bull market. Such an investigation is

    warranted for at least two reasons. First, if both the parent’s and the subsidiary’s stock price increase significantly prior to the IPO, but the parent’s stock price declines but a greater,

    share-adjusted, basis than the subsidiary’s stock price increases following the IPO, arbitrage opportunities may result. Second, in light of the large, one-day returns observed during 1999

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    1for high-technology companies, an observation of mispriced technology split-off IPOs may

    be possible. This renders the investigation of split-off IPOs an interesting research topic. To

    our knowledge, this is the first study to investigate the pre- and post-offering performance of

    split-off IPOs.

     To accomplish the objectives states above, we utilize a sample of ten split-off IPOs

    consisting entirely of high-technology firms. Consequently, the sample investigated here

    consists entirely of split-off IPOs involving incubator firms. In general, in anticipation of

    split-off IPOs, the parent share price rises significantly just prior to the IPO and declines

    significantly during the three months subsequent to the IPO. Furthermore, on the day of the

    IPO, the subsidiaries’ one-day average return in relation to the offering price is 142 percent and their stock price rises an additional 80 percent during the following three months.

    Clearly, the timing of these IPOs is perfect as the subsidiaries gain very significantly amount

    on the first day and over the next three months.

    Our results suggest that the parent companies appear to harvest the past successful

    investments in their subsidiaries during the favorable market conditions at the end of 1999,

    thereby providing additional capital for the continuing growth of their subsidiary.

    Furthermore, our findings indicate that the parent companies may be mispriced subsequent

    to the offering date.

2. Review of Related Literature

     In spin-offs, no money changes hands and the parent’s shareholders receive on a pro rata basis the subsidiary’s shares in a tax-free exchange. In an early study, Miles and

     1 In 1998, for example, the nominal one-day return following an Internet company IPO averaged 68 percent.

    See Madura (1999).

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    Rosenfeld (1983) estimate the effect of voluntary spinoff announcements on shareholder wealth over the 1963 to 1980 period and find significantly positive abnormal returns of 3.3 percent over a two-day announcement period. Similar findings are reported by Schipper and Smith (1983) and Hite and Owers (1983). Furthermore, Copeland, Lemgruber, and Mayers (1987) distinguish between completed and uncompleted spin-offs and find that the former generate large abnormal returns than the latter. More recently, Cusatis, Miles, and Woolridge (1993) also find that the market performance of spin-off and their parents are significantly positive in the long-term after the spin-off.

     In split-offs or equity carve-outs, a parent company sells some of its subsidiary shares to the public in an initial public offering. Rather than spinning off a subsidiary, a parent company may prefer a split-off IPO to raise some funds for its subsidiary without loss of control, to establish a public market value for the subsidiary, or to limit its exposure to the subsidiary. Schipper and Smith (1986), for example, attribute the positive abnormal returns of 1.8 percent accruing to the parent over a five-day announcement period following the carve-out announcement to the effects of improved information and better alignment of incentives. Correspondingly, Nanda (1991) argues that a parent will sell unseasoned equity in the subsidiary rather than seasoned equity in the parent when managers feel that the parent is undervalued and the subsidiary is overvalued. Thus, the parent company appears to time the split-off IPO when outside investors are likely to overvalue these subsidiaries. More recently, Slovin, Sushka, and Ferraro (1995) find a slightly negative valuation effect (-1 percent) on the rivals of the subsidiary while parent companies earn a positive return.

     Various studies have investigated the short- and long-term underpricing of IPOs. An early study by Ibbotson (1975), for example, finds that the average abnormal return sixty months subsequent to the offering date is 11.4 percent. A subsequent study by Ritter (1991)

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found that the initial abnormal returns, measured over the time period beginning with the

    offering and ending when the first closing price is reported, is 14.1 percent. Hence, Ritter

    2found “flipping” to be highly profitable for investors. Nevertheless, while Ritter finds that

    the average abnormal returns remains positive over the two months subsequent to the

    offering date, he also finds that the average abnormal returns over the three-year period after

    the first close was -37.4 percent. Other studies by Ibbotson, Sindelar, and Ritter (1988) and

    by Rock (1986) report similar findings.

     While the studies cited above all investigate the performance of split-offs, spin-offs,

    equity carve-outs and IPOs, no study to date has investigated the pre- and post-offering

    performance of split-off IPOs involving high-technology stocks in the “new economy” associated with the recent bull market. The remainder of this article is organized as follows.

    Section 3 discusses the data and methodology; results are discussed in Section 4. Section 5

    concludes.

3. Data and Methodology

    3.1 Data

     To identify the sample, we perform the following steps. First, we utilize the

    Securities and Exchange Commission’s EDGAR database (www.edgar-online/ipoexpress) to

    identify IPOs with a share price ranging from $5 to $50 and an offering amount ranging

    from $50 million to $500 million since January 1966. The share price and offering amount

    screens are intended to eliminate small-capitalization firms. Next, using the same EDGAR

    site, we check the list of shareholders to see if a parent company is involved in the IPO to

     2 Investors who quickly sell their share in order to capture this initial price spurt are known as “flippers.”

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identify split-off IPOs. This results in a final sample of ten where the ownership relationship

    from the financial statements and other sources can be confirmed.

    [INSERT TABLE 1 ABOUT HERE]

     The sample companies are displayed in Table 1. All companies, with the exception

    of Silicon, filed their IPOs in 1999. As shown in Table 1, the average IPO offering price is

    $16. Furthermore, the parent owns 71 percent of the subsidiary, on average, prior to the IPO.

    Table 1 also reports the parent’s ownership percentage of each share of the subsidiary. In our sample, each share of a parent includes an average of 0.61 shares of the subsidiary, ranging

    from a maximum of 1.52 shares to a minimum of 0.1 shares.

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    3.2 Methodology

     To investigate the return performance of split-off IPOs, we compute the nominal and

    abnormal returns for both the subsidiary and the parent over seven different time periods

    relative to the IPO offering date. Specifically, we investigate the return performance

    beginning two months prior to the IPO filing date to three months after the offer date for

    each group. For each time period, returns are computed as follows:

    PitR??1, (1) itPit?1

    where R = the nominal buy-and-hold return for firm i over period t, it

     P = the share price for firm i on day t, and it

     P = the share price for firm i on day t-1. it?1

3x?a?(N/N) Let x be the parent’s percentage ownership of each share of the subsidiary, then , sp

    NNwhere a is the percentage ownership the parent has in the subsidiary and and represent the number ps

    of shares outstanding of the subsidiary and the parent, respectively.

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     In the previous literature investigating the short- and long-term performance of IPOs,

    the parents’ and subsidiaries’ returns were usually compared to the returns on stocks of

    equal risk. Such an approach was taken in Ibbotson (1975) and in Loughran and Ritter

    (1995). Since all of our firms trade on the Nasdaq, we compute abnormal returns as

    follows:

    AR?R?NR , (2) ititit

    where = the abnormal return for firm i over period t, ARit

     R = the nominal return for firm i over period t, and it

     NR = the nominal return on the Nasdaq Composite Index over period t, it

    computed using Equation (1).

    For the parent companies, we investigate nominal and abnormal returns for seven

    time periods beginning two months prior to the filing date. For the subsidiaries, we

    investigate four separate time period commencing with the offering date.

    4. Results

    4.1 Pre- and Post Offering Returns

     The returns starting two months prior to the IPO filing date to three months

    subsequent to the offering date are displayed in Table 2. Nominally, the parent companies

    had a return of 19.76 percent during the month prior to the filing date. Adjusting for the

    Nasdaq return, the parent companies had an abnormal return of 14.74 percent during the

    same time period. Between the filing date and the offering date (usually about two-three

    months after the fling date), the parent companies had a nominal (abnormal) return of 37.09

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percent (17.75 percent). Conversely, the nominal (abnormal) return on the day of the

    subsidiary’s IPO is -1.96 percent (-2.77 percent). In fact, the average return of the parent subsequent to the IPO was consistently negative in each of the next three months, as were the

    cumulative returns over the next three months. For example, one month subsequent to the

    offering date, the abnormal return was -15.77 percent. Two (three) months subsequent to the

    offering date, the average return of parent companies was -11.20 percent (-7.01 percent).

    These results indicate that the parent companies’ stock price tends to rise significantly in

    anticipation of the split-off IPO and declines significantly subsequently over the next three

    months.

    [INSERT TABLE 2 ABOUT HERE]

     Regarding the subsidiaries returns on and subsequent to the offering date, the

    companies’ one-day average nominal (abnormal) return is 139.19 percent (142.95 percent), in accordance with the findings reported by Ibbotson (1975) and Ritter (1991). Furthermore,

    the subsidiary company prices rise an additional 80.76 percent during the next three months

    after adjusting for movements in the Nasdaq market. Clearly, the timing of these IPOs is

    perfect, as they gain very significant amount on the offering date and the next three months.

     An additional finding in Table 2 regards the relationship between parent share

    prices and subsidiary share prices on the offering day. Specifically, pre-offering rises in

    parent share prices are predictive of the size of the return of the subsidiary on the offering

    date. In fact, the rank correlation of the first day performance of the subsidiary (average

    return of 141.95 percent in Table 2) is 54 percent with the parent returns from filing to the

    offering (average return of 17.75 percent in Table 2) and 75 percent with the parent returns

    one month prior to filing of the IPO (14.74 percent in Table 2). Another piece of evidence

    for the market’s predictive ability is the -98 percent rank correlation between the parent

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returns from the filing date to the offering date and the residual percentage ownership of the

    parent at the time of filing, assuming perfect foresight with respect to the closing price of the

    subsidiary on the offering day. That is, the larger the residual ownership is (using the

    subsidiary’s future price) on the filing date, the smaller the price change of the parent from

    filing day to the offering day.

4.2 Profitable Trading Using the Residual Price

    The residual price is the remaining value of the parent after subtracting its share of the

    subsidiary. The residual per share price of the parent is equal to:

    Presid?P?x?P, (3) ps

    where = the residual price per share of the parent, Presid

     P = the share price of the parent company, p

     P = the share price of the subsidiary, and s

     x = a?(N/N), where a is the percentage ownership the parent sp

     has in the subsidiary and NN and represent the number of ps

     shares outstanding of the subsidiary and the parent,

     respectively.

     We investigate the possibility of trading profits by buying the parent and selling the

    subsidiary short when the residual price becomes too low or negative. Similarly, if the

    residual price becomes too high, one may sell the parent short and buy the subsidiary.

    Excluding the DTE and SGI parent companies, for which one share of the parent owns less

    than 20 percent of the share of the subsidiary, the total daily returns from eight stocks is 4.29

    percent over the three months period beginning a week after the offering day.

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