PROFITING FROM CORPORATE DIVESTITURE

An efficient market is characterized by the inability to earn abnormal returns over the long run. The U. S. capital markets are efficient enough that investment returns above those dictated by the riskiness of the portfolio are very elusive. However, hidden market inefficiencies do exist. Corporate Spin-Offs are one anomaly that offers a "free-lunch" to improve portfolio returns.

Spin-Offs often result in a higher aggregate value for the constituent pieces. Many diversified companies are electing to spin-off parts of their business, having found that this form of divestiture leads to greater shareholder value. A Spin-off is a tax-free transaction in which a parent corporation transfers the business to be spun-off to a new subsidiary, and then pays a special dividend to its shareholders consisting of the shares of the new subsidiary. After a spin-off, the new firm is a separate publicly traded company, with a shareholder base identical to that of the parent corporation. The shareholders of the parent company receive the shares of the subsidiary on a pro-rata basis, without paying any additional consideration or incurring any tax liability.

The foremost advantage of a spin-off is that it is tax efficient. This is especially significant in situations where the assets to be divested have a low cost basis but a high market value. Generally when a company distributes assets, including subsidiary stock, the company recognizes a gain as though it had sold such assets for their fair market value, and the recipient shareholder recognizes dividend income on the receipt of the distribution. However, a spin-off that meets the requirements of Section 355 of the Internal Revenue Code is tax-free to the parent corporation and the receiving shareholders.

Spin-offs often help satis~ shareholder demands to unlock hidden value and improve market performance. Institutional investors are increasingly pushing management to increase shareholder value. Many academic studies confirm that spin-offs on average have outperformed the general market (Standard & Poor's 500) by a significant margin. In addition, the evidence suggests a spin-off can improve the market performance of the parent company too.

From the point of view of the spun-off company, the spin-off can create an opportunity for improved operating performance under a highly focused management team with equity-based incentives. And, the spin-off can achieve a market valuation based on its own attributes, unaffected by the businesses of its former parent. A spin-off can offer opportunities for the parent and subsidiary company, particularly in cases where the two businesses have disparate operations or capital requirements.

Spin-offs help management successfully facilitate strategic objectives, such as refocusing on "core competencies", or separating a leveraged capital intensive businesses from high-growth divisions. Divestitures can remove conflicts of interest between two companies that constrain growth. For example, AT&T spun-off Lucent Technologies to enhance that divisions ability to sell equipment to AT&T's competitors.  Similarly, a spin-off can separate regulated businesses from unregulated businesses, thereby providing greater diversification opportunities.

Spin-offs have proven to be a tax-efficient and effective way to divest a business. They have gone from being a technique to eliminate poor performers to becoming a means of unlocking value. A spin-off yields important benefits to the parent and the subsidiary company that are not available in a typical sale transaction. We believe 1999 will be another strong year for spin-off activity.