The appeal of the equity carve-out.

• Author: Anslinger, Patricia

Here is what a carve-out does to help companies exploit growth opportunities and increase shareholder value.

The purpose of a corporate center is to do for the subsidiaries what they cannot do effectively for themselves. Many structures serve this purpose: operating companies, multi-business companies, holding companies, conglomerates, and even investment firms such as Berkshire Hathaway - all are different ways for a single, central parent to deliver value to its business units. The newcomer to the list is the equity carve-out.

Like its predecessors, the carve-out enables a subsidiary to draw on the wisdom, experience, and practical assistance of the executive center. But it also offers something new: a degree of independence that appears to foster innovation and growth.

An equity carve-out is the sale by a public company of a portion of one of its subsidiaries' common stock through an initial public offering. The decision on how much to carve out will depend on accounting and tax advantages. If the parent retains 80% it can be consolidated for tax purposes and subsidiary dividends are fully deductible. A stake greater than 50% allows a consolidation for accounting reasons. The parent or subsidiary can receive the proceeds of the IPO.

Each carved-out subsidiary has its own board, operating CEO, and financial statements, while the parent provides strategic direction and central resources. As in any other corporate structure, the parent can provide executive management skills, industry and government relationships, and employee plans, and perform time-consuming administrative functions, freeing the subsidiary's CEO to concentrate on products and markets. What is different is the way in which the role of the corporate center is clearly spelled out in contractual agreements.

Striking results

A number of companies have chosen to spin off a single subsidiary in this manner. A smaller group, including Thermo Electron, Enron, Genzyme, Safeguard Scientifics and, more recently, The Limited, have chosen the carve-out as their basic organizing structure, repeatedly selling stakes in their business units. The results are striking.

We examined the performance of U.S. equity carve-out subsidiaries from 1985 to 1995, in cases where 50% or more of each subsidiary's shares were retained by the parent. (We were interested only in those companies where the parent remained an operating center, not a loosely affiliated holding company, and had annual revenues of at least $200 million.) Over a three-year period, the subsidiaries in this sample of 119 carve-outs showed average compound annual returns of 20.3%, which was 9.6% better than the Russell 2000 Index. Those companies that repeatedly sold stakes in subsidiaries fared even better. Three years after the...