Spin-offs have historically been a very attractive area of the market for active investors. The academic literature and research from leading financial firms indicate that on average spin-offs have generated cumulative excess returns relative to both the general market and industry peers over a three-year period post-transaction. These returns were persistent through many different time frames as well as market cycles.
While many investors might be familiar with these outstanding historical average returns, the studies also investigated many other interesting statistics, such as hit rate, median, and standard deviation of returns. Investors can use these insights from the past to improve their process for investing in spin-offs.
The key long-term studies, notably the S&P Global study analyzing spin-offs from 1989 – 2015 and the Krannert School of Management studies analyzing spin-offs from 1965 – 2000 and 2001 – 2013, find that excess historical cumulative spin-off returns have been over 20% on average over a three-year period. This historical outperformance persists despite differences in the timeframe and duration of the measurement period.
Importantly, each of these studies observe excess returns over the longer term despite initial underperformance, which is likely driven by structural market factors.
In fact, a study by Credit Suisse analyzed the initial underperformance of the subsidiary post-transaction. They found that spin-offs executed from January 1995 through July 2012 underperformed the S&P 500 by ~3.5% through the first five trading days following the effective date. Despite the initial poor performance, these companies went on to outperform the benchmark by over 13% at the end of the 12-month period post-transaction.
One of the key factors leading to the attractive historical performance is a re-rating of the valuation multiple. A study by J.P. Morgan showed that companies executing spin-offs transition from a “conglomerate discount” to a “focus premium”. They calculated that the weighted average EV/EBITDA multiple increased by over 20% post-transaction or ~13% when controlled for the market valuation multiple increasing during their measurement timeframe.
While the past performance from the subsidiaries looks compelling, the historical performance from the Parent Companies (RemainCo) is much less conclusive.
For the most part, any historical excess returns generated by the parent companies are not statistically significant (see above table). Now does this mean that the RemainCo in any particular spin-off situation is not interesting? Absolutely not. All this means is that historically, on average, the parent companies have not generated excess returns after spinning off a subsidiary. Every set of circumstances is different, and it could be the case that the RemainCo is the much more compelling opportunity in a specific situation.
While the historical spin-off returns look very attractive, they come with a number of caveats investors need to consider when investing in these types of situations. Investing in a company just because it is a spin-off does not guarantee a positive outcome. In fact, far from it. The studies found a handful of other statistics that suggests investors need to be very prudent with security selection.
Sub 50% Hit Rate
According to the S&P Global study, spin-offs had a hit rate of less than 50%, defined as the percentage of events with a positive excess return. This means that less than half the spins outperformed the benchmark.
The Median Spin-Off Underperformed
According to the Krannert study from 2001 – 2013 (McConnell, Sibley, and Xu), the median company underperformed the benchmark by nearly 7% cumulatively over three years.
High Standard Deviation of Returns
According to the Credit Suisse study, the standard deviation of returns after a year was 82% for the spun-off company and 42% for the parent.
A Spin-Off Needs to Overcome Obstacles
- They are typically smaller companies with less diversified businesses that have a higher cost of capital.
- They can no longer be supported by a larger parent company during difficult periods
- They frequently have increased financial leverage on the balance sheet
While these characteristics could turn off some, it is actually good news for investors because it suggests there is a substantial opportunity for stock picking. Having a median return less than the mean return suggests that there are significant “winners” driving the positive excess performance. Furthermore, a high standard deviation indicates a wide range of eventual outcomes.
These are the exact types characteristics investors need in an opportunity set to find compelling ideas.
In investing there are no blanket statements, everything needs to be evaluated on its own merits. With that said, the most important thing when investing in a spin-off is to avoid situations with very large downside. After all, the Krannert 2001 – 2013 study found that spin-offs in the 25th percentile underperformed by over 39% cumulatively over three years.
To identify these potentially devastating outcomes ahead of time, there are a few characteristics investors need to especially weigh.
Does the Business Model Fit the Balance Sheet?
- Spin-offs commonly raise debt to pay a cash dividend to the parent company to effect the transaction.
- This elevated level of financial leverage can put the new company in a difficult situation if the end markets are cyclical or the business model has difficulty generating free cash flow.
Is the Company Burdened with any Other Large Liabilities?
- The parent company could encumber the subsidiary with pension, environmental, and/or legal liabilities.
- These liabilities can be a drag on cash flow and inhibit the company from investing in the business, delevering the balance sheet, paying a dividend, buying back stock, or making acquisitions.
Was the Spin-Off Overly Reliant on the Parent or a Specific Customer(s)?
- Does the subsidiary generate a significant percentage of revenue or profits from the parent or a concentrated customer base?
- Did the subsidiary depend on the parent for funding during times of economic weakness?
- If so, then the subsidiary could have difficulty as a standalone company and perform poorly.
- Is the board solely comprised of individuals from the parent company or are there new members from outside the company?
- Investors in the newly public company should look for a balance of individuals who are close to the business and individuals who are truly independent.
None of these characteristics, in and of itself, disqualify a company from investment. Rather, they represent hurdles that must be overcome by substantial positive characteristics.
Talented and Incentivized Management Team
- Managers with a history of creating value through efficient operations and diligent capital allocation
- An executive compensation plan which incentivizes building value over the long-term
- Managers with ‘skin in the game’ through minimum ownership requirements or the potential to have significant ownership
- Lack of a publicly traded peer group
- Unique business with no peers
- Limited analyst coverage or misunderstood by the investment community
Attractive Business Model
- High Quality
The business generates an attractive ROIC and unit economics while efficiently converting revenue and earnings into free cash flow.
The business’ competitive advantage is sustainable and improving, or at the very least slowly shrinking.
- Ability to grow
Company-specific factors (price/volume, taking share, M&A, etc) coupled with a growing industry.
Margin Improvement Opportunity
- The business model has operating leverage (profits rise faster than revenue)
- Company-specific operational improvement initiatives (margins currently lower than peers but no structural differences).
Private Market Interest
- Strategic and/or financial buyers have been active within the industry
S&P Global Quantamental Research: Capital Market Implications of Spinoffs
They studied short-and long-term performance of spin-offs and their parents in the U.S. and international markets as well as equity carve-outs from 1989 through 2015.
Key Findings from the Study:
- From 1989 through 2015 U.S. spin-offs outperformed industry peers by a cumulative 8.4% and 22% in the one year and the three-year period following the transaction. This is despite underperforming by ~2.3% in the initial month post-transaction.
- There was no statistical significance to the parent company returns
- International spin-offs also outperformed their industry peers
- The long-term outperformance of equity carve-outs was not statistically significant unless investors participated in the IPO
Also, transaction size does not appear to impact performance: transactions less than $500 million as well as greater than $500 million both outperformed on average.
- Greater than $500 million transactions outperformed industry peers by a cumulative 22.3% on average over three years
- Sub $500 million transactions outperformed industry peers by a cumulative 17.8% on average over three years
Spin-offs executed by companies where the subsidiary is in the same industry (“Within-Industry Transactions”) vs the subsidiary in a separate industry (“Cross-Industry Transactions”) yield interesting results.
- The spun-off entity has historically outperformed in both cases
- While not statistically significant, the Parent has historically outperformed in Cross-Industry Transactions but underperformed in Within-Industry Transactions
Credit Suisse Quantitative Research Report: Do Spin-Offs Create or Destroy Value?
They studied spin-off performance from January 1995 through July 2012, investigating key issues such as performance, volatility, and timing.
The key finding from the report:
- The subsidiary underperformed the S&P 500 by ~3.5% over the first five trading days post-spin-off and continued to underperform for the first 27 days until “catching up” and outperforming afterward during their measurement timeframe (12 months)
The spin-off and parent outperformed the index by 13.4% and 9.6%, respectively, a year post-transaction, but with a significant standard deviation of returns. The standard deviation was 42% for the parent and 82% for the spun-off company.
Krannert School of Management Study (1965 – 2000): McConnell and Ovtchinnikov
This study analyzed the stock price performance of 311 spin-off subsidiaries (only tax-free, pro-rata distributions) and 267 parents from January 1965 through December 2000 (36 years of data).
The key findings from the study:
- Statistically significant excess returns are positive for the subsidiary over nearly every measured holding period
- Spin-offs outperformed their benchmarks on average by well over 20% cumulatively over the three years following the spinoff
- When removing one large outlier, they did not find statistically significant excess returns by the parent over the three years following the spinoff
Krannert School of Management Study (2001 – 2013): McConnell, Sibley, and Xu
This study analyzed the stock price performance of 153 spin-off subsidiaries (non-taxable, corporate spin-offs of non-REIT entities), their parents, and the spin-off ETF from 2001 through 2013.
The key findings from the study:
- The subsidiary generated statistically significant average excess returns over all measured holding periods
- The spin-offs outperformed the benchmark on average by over 26% cumulatively for the three-year period following the spin-off
- The median subsidiary return actually underperformed the benchmark suggesting that the excess aggregate average returns are driven by significant “winners” (see table below).
- On average, parent stocks underperformed until six months post-transaction. After this time, there is no statistically significant performance outcome for the parents.
Susquehanna University Study
This study analyzed the performance of both the parents and the subsidiaries four years post-transaction during a bear market (1999 – 2003).
The key finding from the study:
- Both parents and spin-offs outperform the market from the date of the transaction to four years later.
- An investor allocating $1 into the spin-off portfolio would have had $1.03 relative to just $0.996 if invested in the equally-weighted market portfolio.
- An investor allocating $1 into the ‘parents’ portfolio would have had $1.015 relative to just $0.915 if invested in the equally weighted stock market portfolio.
J.P. Morgan Shrinking to Grow Report: Evolving Trends in Corporate Spin-Offs
In this report, they reviewed the historical sources of returns for spin-offs.
A major source of return: multiple expansion
- They find that the valuation multiple at both the parent and spin-off increases post-transaction by 10% – 20%, controlling for the general market valuation
- The EV/EBITDA multiple increased from 6.9x to 8.0x at the parent (0.6x of which was excess expansion above the general market) and from 6.9x to 8.6x at the spin-off (1.3x of which was excess expansion above the general market).
These transactions enable the companies to go from a “conglomerate discount” to a “focus premium”. In other words, companies that have many different segments and subsegments typically trade at a discount to general market valuation. However, once they separate off different subsidiaries and become pure-play companies, they trade at a premium to the market valuation.
In the report, they suggest that this focus premium has increased in recent years to levels well above historical norms. This dynamic is helping drive corporate action activity.
On average, spin-offs have historically outperformed the general market and industry peers over many different timeframes post-transaction. While the average return is attractive, studies suggest that the hit rate is below 50%, the median spin underperforms the benchmark, and the standard deviation is high.
These factors imply that the return profile for spin-offs is skewed, has a high degree of variance, and the excess average return is being driven by very large winners offsetting laggards.
While some could be turned off by these characteristics, it is actually great news for investors. It suggests there is a substantial opportunity for stock picking and finding unique investment situations.
Given the appealing historical average returns and the wide range of potential future outcomes, spin-offs represent an attractive area of the market for active investors to allocate capital.