Splitting the Difference: Four Reasons Why Corporations Pursue Spinoffs

This is part 1 of a two-part series.

Breaking up can be hard to do, but that hasn't stopped corporations from breaking themselves into smaller pieces with increasing frequency.

Spinoff deals, deals in which a parent company jettisons a business unit to create a new standalone company, totaled $250.9 billion in 2015, up from $127 billion in 2014, the Wall Street Journal reported earlier this year.

While the jump in spinoffs hasn't generated as many headlines as the recent mergers and acquisitions boom, for investors it's a trend worth watching as companies look to turn the "bigger is better" ethos on its head.

"What we often hear is that a company as a whole is worth less than the sum of its parts," said Emilie R. Feldman, an associate professor of management at the University of Pennsylvania's Wharton School.

Here are four reasons why some companies are saying they are better off as separate units than they are as one bigger business:

Better management: While executives of a company may be well-suited to overseeing most of its lines of business, perhaps there's a unit that doesn't quite match their expertise. In another example, a specific unit may require more attention than it's getting from top management and its performance suffers as a result. In either case, spinning off the unit and putting it under new management may result in better performance in the unit-turned-independent company, while the parent company’s managers can now redouble their focus on their remaining units.

Separating growth trajectories and strategies: A business unit that's slow to make money might prove a drag on a sister unit that's experiencing robust growth, particularly if the parent company uses profits from the latter to subsidize the former. "You might be making one business slightly worse off at the expense of propping up the other one," Feldman said. She added that it can be difficult for executives to craft strategies in such situations "because you have to deal with two businesses with really different sets of constraints and opportunities." But when two such units are no longer under the same parent company, they can grow at their own pace and might even see more success in attracting investors who specifically seek out fast-growing or mature companies.

Better coverage from securities analysts: Research has shown that divestitures — including spinoffs and sales to other companies — by parent companies result in higher quality research by the analysts covering those parent companies. One study of 103 spinoffs, for instance, found that analyst forecast accuracy increased between 30 to 50 percent following spinoff transactions. One of the reasons why is that when a business is less complex, it's easier to analyze. In addition, after a corporation narrows its array of businesses, it may attract coverage from analysts with specializations matching those businesses who may provide more accurate forecasts about the corporation.

Unlocking shareholder value: Perhaps the biggest factor driving spinoffs is the idea that the parent company is undervalued — perhaps because of management or strategy issues described above — and that its remaining business valuation would be higher if it spun off one or more business units. Analysis by investment research firm The Edge and Deloitte found that a year after a spinoff, parent companies saw their post-spinoff share price increase 14 percent on average, while the spun-off companies added 22 percent on average. But it's also important to note that a significant proportion of spun-off companies do underperform: The Edge and Deloitte analysis found that 40 percent don't generate any returns in their first year.

Both parent companies and new companies can face significant challenges during and after a spin-off deal, ranging from how to handle employment contracts and pensions for a soon-to-be-divided labor force to determining how to handle once-shared back-office services such as human resources and information technology. A report on spinoffs by the investment bank Baird concluded that separating a parent company from one of its units is least risky "if both are already autonomous businesses with management teams in place and no customer overlap."

The complexity of pursuing a spin-off may explain why spun-off companies tend to perform better when their parent companies take their time in preparing the deal. According to The Edge and Deloitte analysis, when parent companies take more than six months to prepare for spinoffs, the resulting new companies see 50 percent greater returns one year later than companies born of faster splits.

Learn what investors can expect when a company announces a spin-off in part two of this series on corporate spinoffs.