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ENHANCING MANAGERIAL INCENTIVES AND VALUE CREATION: EVIDENCE FROM CORPORATE SPINOFFS
By Unyong Pyo* Abstract We study corporate spinoffs with changes in CEO compensation to examine how spinoffs affect managerial incentive compensation and whether the changes in managerial compensation can explain the value enhancement and operating performance improvements that occur following spinoffs. Analyzing a sample of 124 non-taxable spinoffs during 1990-1997, we find that changes in incentive compensation are a significant motive for spinoffs. Changes in managerial incentives alone are consistent with the post-spinoff changes in operating performance, while changes in business focus are not. Spinoffs that are not accompanied by enhanced pay-performance relationship do not improve operating performance even with increased business focus. (JEL G34, J33)

Introduction
A corporate spinoff divides a company into two or more independent firms and offers a firm an opportunity to improve managerial incentives with fresh compensation packages directly tied to its own stock price. The initial round of studies on corporate spinoffs shows that the market reaction on spinoff announcements is significantly positive at about 3% on average. 1 The subsequent research explains the source of gains based on improved business focus or information. 2 More recently, removing diversity costs and negative financial synergies is suggested as the source of gains from spinoffs.3 Unfortunately, these explanations are neither mutually exclusive nor inconsistent with the explanation based on managerial incentives. 4 Although scholars in disciplines including financial economics have studied managerial compensation to reduce agency conflicts between shareholders and managers for decades, there is no empirical evidence on whether corporations implementing spinoffs enhance managerial incentive compensation for either the post-spinoff parent firms (hereafter post-parents) or the spinoff subsidiaries.5 Little is known, either, about whether enhancing managerial incentives following spinoffs are related to operating performance improvements. To better understand the sources of gains from corporate spinoffs, we examine a sample of 124 spinoffs during 1990-1997 and investigate the managerial incentive hypothesis directly by collecting a broad amount of compensation data for the CEOs both prior to and following the spinoff. Since a firm's stock price is not a reliable measure of a divisional manager's performance

* Unyong Pyo, Faculty of Business, Brock University, 500 Glenridge Avenue, St. Catharines, ON Canada L2S 3A1, Phone: 905-688-5550 ext. 3147, Fax: 905-378-5723, email: upyo@brocku.ca. I am grateful for numerous comments from James K. Seward, Antonio S. Mello, Howard E. Thompson, Martin Ruckes, and Robert Miller. I am also grateful for helpful suggestions from the anonymous referee of this journal. 1 See Schipper and Smith (1983), Hite and Owers (1983), Miles and Rosenfeld (1983), Cusatis et al. (1993), and Slovin et al. (1995). 2 For business focus, see Daley et al. (1997) and Desai and Jain (1999). For information, see Kudla and McInish (1988), Nanda (1991), Habib et al. (1997), Bliss (1997), Krishnaswami and Subramaniam (1999), and Gilson et al. (1998). 3 See Burch and Nanda (2003) and Kwak (2001) for diversity costs and Leland (2007) for financial synergies. 4 See Aron (1991) and Seward and Walsh (1996). 5 Although no parent/subsidiary relation exists following spinoffs, we refer to spinoff divisions as spinoff subsidiaries for convenience. We focus on these corporate spinoffs to examine the impact of spinoffs on managerial incentives.

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within a multi-divisional firm, spinoffs enable corporations to design and implement fresh compensation packages that are based on the stock price of separated divisions. This potentially changes and improves managerial incentives. Examining changes in the pay-performance sensitivity (hereafter PPS) with business focus related to operating performance will shed insights on how firms use managerial incentive compensation following spinoffs. The results from analyzing PPS suggest that changes in managerial incentives following spinoffs have significant explanatory power on value enhancements for spinoff subsidiaries rather than for post-parents. Results supporting the managerial incentive hypothesis are that spinoff subsidiaries increase PPS in line with size effects; that PPS for subsidiaries does not decrease when the CEO of pre-spinoff parent firms (hereafter pre-parents) jumps to a spinoff subsidiary; and that changes in PPS for spinoff subsidiaries created from the focus-increasing (hereafter FI) spinoff are higher than those for those created from the non-focus-increasing (hereafter NFI) spinoff.6 The investigation of changes in operating performance provides additional intuition in distinguishing the managerial incentive hypothesis from the business focus hypothesis. We find evidence supporting the managerial incentive hypothesis and against the business focus hypothesis. Operating performance improves with managerial incentives, while it does not with business focus following spinoffs. While the relation between business focus and operating performance is minimal, the relation between managerial incentives and operating performance is significant.

Hypotheses Development
Changing Managerial Incentives Aron (1991) argues that corporate spinoffs themselves act as incentives for divisional managers because the stock value of a diversified parent firm is a noisy signal of the productivity of any division and that of a spinoff subsidiary reflects a cleaner measure of the performance of a division. Thus, a spinoff subsidiary can naturally improve managerial incentives by increasing its PPS relative to the parents PPS, while the parent with remaining multiple divisions does not change PPS. For spinoff transaction it is natural that firms experience downsizing and thus increase the sensitivity. To exhibit genuine improvements in managerial incentives following spinoffs, the increased PPS for either post-parents or spinoff subsidiaries must be at least consistent with those for pre-parents adjusting for size effects.7 Schaefer (1998) examines the relation between firm size and PPS and finds that the sensitivity appears to be approximately inversely proportional to the square root of firm size, while he ignores the changes in the value of previously granted stock options in his regression analysis. We estimate the regression model using the data with the changes in the value of previously awarded stock options and compare the size-induced sensitivities with the estimated sensitivities for spinoff subsidiaries to control for size effects. Thus, we estimate the following equation using the sample in pre-parents:
Pay - performanc e sensitivit y = + 1 Market Valueof commonstock + ,

(1)

where PPS is computed from stock options and stock holdings. Using the estimates of the coefficients above and the market values, we compute the fitted

A spinoff is considered as a FI spinoff if the first two-digit SIC code of the parent firm is different from that of the subsidiary. Otherwise, a spinoff is treated as a NFI spinoff. 7 Murphy (1998) finds that when a new CEO position is created following a spinoff, the procedure of setting CEO compensation is similar to that in other firms and the size adjustment is one of the main determinants in setting CEO compensation.

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sensitivity, which is PPS induced by the corresponding firm size. The size-induced sensitivity is compared with the observed sensitivity to see whether the change in the observed sensitivity is large enough to reflect size effects. Therefore, Hypothesis 1: Hypothesis 2: The increased PPS for spinoff subsidiaries will be equivalent to that for pre-parents adjusting for size effects. PPS for post-parents will be equivalent to that for pre-parents adjusting for size effects.

Establishing Top Management The origin of the spinoff subsidiarys CEO appears to have impact on the gains from spinoffs. Seward and Walsh (1996) find that the majority of new CEO come from inside (48 out of 76 CEOs) and the market reaction is positive on selecting an inside CEO. In a related study Wruck and Wruck (2002) suggest that the way in which top management for spinoff subsidiaries is established explains value changes that occur following spinoffs. They find that the market reacts positively when a top manager of the pre-parent moves to join the top management of the spinoff subsidiary. However, they did not measure changes in PPS related to restructuring top management in spinoffs. Both studies find that the market welcomes spinoffs where the former CEO of pre-parents jumps to spinoff subsidiaries. The market might recognize improved incentives for those jumping CEOs as the source of gains from spinoffs. We focus on the findings by both studies to examine whether the stock market gains due to the CEO origin can be explained by increasing PPS for spinoff subsidiaries. Therefore, Hypothesis 3: Changes in PPS for the subsidiaries when a pre-parent's CEO becomes a subsidiary's CEO will be the same as those when someone else becomes the subsidiary's CEO adjusting for size effects.

Managerial Incentives with Business Focus Spinning off unrelated divisions to shareholders, firms can increase business focus and create value. Daley, et al. (1997) find that the announcement period abnormal returns for FI spinoffs are larger than for NFI spinoffs. Desai and Jain (1999) show that both the announcement period and the long-run abnormal returns for FI spinoffs are significantly greater than the corresponding abnormal returns for NFI spinoffs. Although Desai and Jain (1999) use three measures of business focus, both studies are common on one measure of focus: two-digit SIC codes. A spinoff is defined as a FI spinoff when the parent and spinoff subsidiaries carry different two-digit SIC codes. Desai and Jain (1999) report that the results are similar across the different measures of business focus including a measure displaying the degree of diversification. We use this common measure of focus to examine whether FI spinoffs rather than NFI spinoffs are related to improvements in the pay-performance relations. While both studies show evidence that an increase in business focus explains the stock market gains resulting from spinoffs, we are interested in whether enhancing managerial incentives can better explain the gains. Since the two explanations are not mutually exclusive, we first examine if there is any change in managerial incentives between the two groups of spinoffs in terms of changing business focus. If there is no change in incentives around spinoffs, the business focus will better explain the gains associated with spinoffs as found in the literature. When there are changes in incentives around spinoffs, we need to investigate that the changes in PPS are coincided with the changes in business focus. Therefore, Hypothesis 4: Changes in PPS for spinoff subsidiaries created from FI spinoffs will be the same as those created from NFI spinoffs.

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Hypothesis 5:

Changes in PPS for post-parents involved in FI spinoffs will be the same as those involved in NFI spinoffs.

Operating Performance Around Spinoffs Mehran (1995) examines the relation between managerial incentive compensation and operating performance in manufacturing firms and finds that firm performance is positively related to the percentage of equity-based compensation, which provides managerial incentives. Although his approach employing ordinary least-squares appears to be well specified, his measure of compensation, the percentage of CEOs' equity-based compensation, is not as robust as our measure, the value change of the compensation. In addition, he does not consider the value of existing stock option holdings, which this study explicitly measures. Daley et al. (1997) and Desai and Jain (1999) suggest that the value creation for FI spinoffs comes from operating performance improvements. Both studies do not support the managerial incentive hypothesis as the source of gains following spinoffs because they do not observe the operating performance improvements in subsidiary units following spinoffs. However, they do not directly associate changes in operating performance with changes in managerial incentives because they do not measure managerial incentive compensation. Recall that the business focus hypothesis and the managerial incentive hypothesis are not mutually exclusive. Since firms can change both their business focus and managerial compensation following spinoffs, the improved focus might be a medium to facilitate the enhanced managerial compensation package or vice versa. Thus, one source of stock market gains might not be the ultimate source of gains. The operating performance improvements can come either from the focus increase, from the incentives enhancement, or from both because the two hypotheses are not mutually exclusive. To separate out the source of gains, we examine the relation between the changes in operating performance and the changes in managerial incentives and compare it with the relation between the changes in operating performance and the changes in business focus. If managerial incentives lead business focus and is solely responsible for the operating performance, the changes in business focus could be secondary to the changes in operating performance. The proponents of the business focus hypothesis argue that increased business focus following spinoffs creates value because the spinoffs allow managers to focus attention on the core business they are best suited to manage. However, if their managerial incentive compensation remains the same as prior to spinoffs, why would managers bother to focus attention on the core business, while most of their newly created value goes to shareholders? It is more conceivable that managers with more powerful compensation packages would strive to create value. If they consider increased business focus as a necessary step to improve firm performance, they will do so as a secondary motivation to their managerial incentive compensation. The motivation provided by enhanced managerial incentives might dominate that provided by increased business focus. Thus, we expect that increasing managerial incentives would be the driving force in improving operating performance. Enhanced incentives rather than increased business focus following spinoffs should lead operating performance improvements for both the parent firms and spinoff subsidiaries. Therefore, Hypothesis 6: Hypothesis 7: Hypothesis 8: Hypothesis 9: Operating performance for the pro-forma combined firms increases with business focus. Operating performance for post-parents increases with business focus. Operating performance for post-parents increases with PPS. Operating performance for spinoff subsidiaries increases with PPS.

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Sample and Pay-Performance Relations

Sample of Spinoffs The sample firms involved in spinoffs are selected in two stages. First, a list of 475 spinoff announcements during 1990-1997 is obtained from the Securities Data Company (SDC). Second, the actual distributions are verified by consulting the CCH Capital Changes Reporter. We remove the cancelled spinoffs (222) following announcements and the taxable distributions (64). We further reduce the sample by stock price information from CRSP because we measure the pay-performance relations based on stock price performance. Twenty three (23) firms are not listed in CRSP (2 parent firms and 21 spinoff firms). We also remove spinoff firms whose shares are traded either one year prior to (9 firms) or following (5 firms) the distribution.8 Six (6) spinoff firms are either delisted from CRSP or acquired within one year following spinoffs and are excluded from the sample.9 When we examine the pay-performance relationship, we require at least one pair of matching firms of either two parent firms prior to and following the distribution or a parent firm prior to and a spinoff subsidiary following the distribution. If both parent firms and spinoff subsidiaries after the distribution do not have stock price information, the comparison of the pay-performance relations would not be meaningful. Ten firms fall into this category and are removed from the sample. To collect the compensation data, we first exclude firms (6) with tracking stocks because they are not spinoffs and their motivation for tracking stock might be different from that for spinoffs. Second, we remove CEOs (5) who hold ownership in more than a third of their firms, where the compensation package could deviate from the otherwise optimal contract and still show a strong pay-performance relations (Guay, 1999). Third, we exclude the CEO (1) who holds less than a half time appointment in the firm, where compensation might be different from that of the other full time CEOs in terms of contracting purposes. The final sample is reduced to 124 non-taxable spinoffs. The annual distribution of the sample exhibits that the number of actual spinoffs is gradually increasing throughout the nineties, consistent with the previous studies in spinoffs covering the time period up to 1991.10 Compensation Data We construct compensation data from two sources: the corporate proxy statements11 and 10-K filings. The year of spinoff transactions is the base period from which to select the compensation data for each firm. After arranging all sample firms around the distribution year, we collect the compensation data for up to 3 years both prior to and following the distribution. Thus, compensation data set from spinoff distributions covers the years from 1988 to 1999. To measure PPS, we initially require compensation data for at least 3 years if available for each of three sets of firms: pre-parents, post-parents, and spinoff subsidiaries. When firms following the distribution are either acquired or delisted, stock prices are no longer available. Thus, we limit the compensation data to the period during which stock prices data are available from CRSP. Even in this case, we have compensation data for at least one year from the previous screening. Data collection in managerial compensation is not trivial mainly because of dynamic positions in stock options. The enhanced reporting convention starting from fiscal years ending after December 15, 1992 is not enough to relieve the cumbersome work in tracking dynamic positions
8 If newly created shares are not traded around the distribution, managers might not receive immediate benefits from incentive compensation following spinoffs. 9 To measure managerial compensation, we need firms to be listed at least for one year following the distribution. 10 See Cusatis et al. (1993), Daley et al. (1997), and Desai and Jain (1999). 11 Corporate proxies cover detailed information on the amount of stock options granted during the year, the exercise prices and the time to maturity of the options.

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in stock options. Fortunately, utilizing those enhancements in reporting requirements, Core and Guay (2002) develop a simple method to estimate the value of CEO's option portfolios from only the current year's proxy statement.12 We apply the same method to evaluate the stock options granted in previous years. For stock option holdings before 1992, we look back from 1992 stock option positions to compute the option holdings at the end of each fiscal year to December 1988 by tracking new option grants and exercises. Pay-Performance Relations To measure PPS provided by cash compensation, we run a simple OLS regression as in Jensen and Murphy (1990): (Change in CEO Cash Compensation)t = a + b1 (Change in Shareholder Wealth)t (2)

CEO cash compensation consists of the sum of salary, bonus, and other compensation. The change in shareholder wealth is rtVt-1, where rt is the rate of stock return with dividends realized in fiscal year t, and Vt-1 is the firm value at the end of the previous year. Table 1: Compensation Data Summary Statistics (in thousands) Firms Var. Pre-parents MV Post-parents MV Spinoffs MV Pre-parents SBO Post-parents SBO Spinoffs SBO Pre-parents SO Post-parents SO Spinoffs SO Pre-parents RS Post-parents RS Spinoffs RS Mean Std. Dev 5772911 12884507 5946490 14437799 1988280 6443460 1472 1238 1696 1759 1002 1109 1343 4552 2021 6225 1447 3169 121 519 288 1085 393 1242 Min 9381 15456 2287 99 0 0 0 0 0 0 0 0 1st Q. Median 3rd Q. Max 334948 1936662 6236860 103073258 304752 1815083 5004947 132833457 103731 409400 1519579 91062711 722 1125 1716 7022 646 1186 1958 13531 370 735 1273 13105 0 303 1066 66541 0 528 1640 69009 0 308 1448 22369 0 0 0 6644 0 0 0 10477 0 0 95 10309

Note: The sample is 124 spinoffs during 1990-1997. The `MV' stands for market value, `SBO' for salary, bonus, and other compensation, `SO' for stock options, and `RS' for restricted stock. The `1st Q' stands for the first Quartile of the corresponding numbers.

For stock options valuation, we use the Black-Scholes formula as modified by Merton (1973) to reflect dividend payments.13 The stock return volatility is computed with stock price and stock return information from CRSP. When the fiscal year ends within six months following a spinoff distribution, the price history for post-parents and spinoff subsidiaries is not long enough to estimate the stock return volatility. In this case we estimate the forward looking volatilities by

12 They consider previously granted options as two single grants: the executive's exercisable and unexercisable options and compute the average realizable value of the exercisable and unexercisable options based on the number of options that are exercisable and unexercisable. They then approximate time-to-maturity of the exercisable options as 6-7 years and unexercisable options 9-10 years based on exercisability and the existence of new option grants. 13 The drawbacks of using the Black-Scholes formula for executive stock options are well known because executives usually do not have the same level of ownership right over their stock option holdings as outside investors have. They cannot hedge their options' values in the secondary market due to institutional restrictions. However, the Black-Scholes formula appears more convincing for options' value than does the ex post paper gain realized by executives. Furthermore, the disclosure requirements established by SEC (1992) and FASB (1993) implicitly endorse the Black-Scholes approach for executive stock options.

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using the post-spinoff stock prices.14 To estimate PPS provided by stock options, we compute the Black-Scholes delta () multiplied by the option holding ratio (the number of options over the shares outstanding) as used in Yermack (1995). Since the delta () for stock is one, the sensitivity provided by stock holdings is simply the proportions of stock holdings to the shares outstanding. Thus, PPS provided by stock options and stock holdings is obtained by adding up the two corresponding sensitivities. Summary Statistics The final sample with managerial compensation includes 124 firms and 344 executive-years for pre-parents, 123 firms and 367 executive-years for post-parents, and 122 firms and 352 executive-years for spinoff subsidiaries. Table 1 presents descriptive statistics for the data during 1990-1997. The median (mean) market values for pre-parents, post-parents, and spinoff subsidiaries are $1.9 billion ($5.7 billion), $1.8 billion ($5.9 billion), and $409 million ($1.9 billion), respectively. The median CEO in each group of firms received $1.12 million, $1.18 million, and 0.73 million in salary, bonus, and other compensation and 0.3 million, 0.52 million, and 0.3 million in stock option values, respectively. Wilcoxon rank-sum tests for comparison show that both stock option grants and restricted stock grants increase for both post-parents and spinoff subsidiaries following the spinoff distribution.15

Results
Table 2: The Sensitivities from Stock Options and Stock Holdings Stock option holdings PrePostSpinParents Parents offs .00852 .01116 .01574 .00077 .00088 .00128 .00294 .00488 .00817 .01432 .01685 .02401 0 0 0 .09777 .12008 .15338 344 367 351 Stock Holdings PrePostSpinParents Parents offs .02042 .01105 .01711 .00237 .00139 .00210 .00281 .00199 .00234 .04404 .02671 .03941 0 0 0 24652 .23942 .25553 344 367 351 Stock & Stock options PrePostSpinParents Parents offs .02894 .02222 .03286 .00251 .00172 .00264 .00852 .00855 .01356 .04657 .03297 .00495 0 0 0 .25750 .25214 .28676 344 367 351

Firms Mean Std.Err. Median Std.Dev. Min. Max. Sample

Note: The sample is 124 spinoffs during 1990-1997. All the numbers except for `Sample' are per $1,000 increase in firm value. Sensitivities are computed for 124 spinoffs during 1990-1997. PPS provided by stock option holdings is computed as the proportional ownership multiplied by the delta of the Black-Scholes formula. The sensitivity provided by stock holdings is the proportions of stock holdings. Sensitivities for `stock & stock options' are the sum of the two sensitivities above in each category.

Changing Managerial Incentives Stock options and stock ownership are the main forces driving PPS. 16 Since we have confirmed that the sensitivities from cash compensation are trivial, we concentrate on stock and stock options for the measure of PPS hereafter. Table 2 shows PPS from stock and stock option
14 Seward and Walsh (1996) consider two assumptions: (1) that the market uses the pre-spinoff volatility estimate for the post-spinoff volatility; (2) that the market has perfect foresight. While they choose the former assumption in their analysis, we employ the latter assumption because the firms' volatilities are more likely to change following spinoffs. 15 Conducting Wilcoxon rank-sum tests in this paper when they are necessary to compare two samples, we only discuss the relevant results without presenting full details to save space. 16 Murphy (1998) documents that stock option and stock ownership cover more than 95% of PPS for CEOs in most industries but utilities in 1996. Holding constant all of the other components of compensation, Hall and Liebman (1998) analyzed the change in CEO wealth resulting from revaluation of stock and stock options to emphasize the magnitude of stock and stock option holdings.

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holdings. Since the distribution of the sensitivities is skewed to the right, the median is better than the mean for comparison. From the stock and stock options, the median sensitivities for pre-parents and post-parents are about the same at $8.52 and $8.55 per $1,000 change in firm value, respectively. The Wilcoxon rank-sum test statistic in comparing the two sensitivities is -0.6465 and is not significant at the 10% level. Although the median sensitivity for the spinoff firms changes to $13.56 per $1,000 change in firm value and is significantly different from that ($8.52) for pre-parents at the 1% level, we cannot draw conclusion from this result because firm sizes are not the same. Since pre-parents distribute the fraction of their assets through spinoffs, their firm sizes are naturally reduced following spinoffs. If firms involved in spinoffs improve managerial incentives following spinoffs, we expect PPS both for post-parents and for spinoff subsidiaries to be consistent with the firm size. To control for size effects in PPS, we estimate the following equation as in Schaefer (1998) from pre-parents:
Pay - performanc e sensitivit ies = 0.0055 + 17.984 1 Market Value of firm
* Significan t at 10% level. * * * Significan t at 1% level.

t statistic : (1.8927*) (11.4819 * **); standard error : (0.00295) (1.5662);

Using the above estimation and the corresponding mean market values in Table 1, we compute the size-induced sensitivities. Since the intercept is not significant at the 5% level, we ignore it in the following computation. We compute the size-induced sensitivities with their 95% confidence interval as $7.485 ($6.20, $8.76), $7.375 ($6.11, $8.63), and $12.754 ($10.56, $14.93) per $1000 change in firm value for pre-parents, post-parents, and spinoff subsidiaries, respectively.17 The value ($7.485) is close to the observed median sensitivity ($8.52) of the corresponding pre-parents. Since the 95% confidence intervals for the size-induced sensitivities contain the corresponding median sensitivities for all three groups of firms, we cannot reject either hypothesis: H1 or H2. However, the increase in PPS for spinoff subsidiaries is indeed consistent with the size effects. It implies that PPS increases for spinoff subsidiaries, but not for post-parents adjusting for size effects. The fact that the increased sensitivities for spinoff subsidiaries are consistent with the decreased firm sizes strengthens the incentive hypothesis because the size adjustments in setting the compensation package for new CEOs of spinoff subsidiaries are a major determinant in executive compensation.18 Since firms cannot simply separate their asset base into pieces to enhance managerial incentives, spinoffs facilitate firms to distribute assets to shareholders and provide managers with the corresponding compensation packages tied to a subsidiary's own stock price.

Establishing Top Management Table 3 presents PPS by the CEO origin. The improvement in the pay-performance relations for spinoff subsidiaries which are led by the formerly pre-spinoff parents' CEO is not greater than that for the other spinoff subsidiaries which are not led by the formerly pre-spinoff parents' CEO. There is no improvement for spinoff subsidiaries with the formerly pre-spinoff parents' CEO.
17 For example, observing that the mean market value of pre-parents in Table 1 is $5,772,991 (in thousands), we compute the size-induced sensitivity with the 95% confidence interval for pre-parents as follows;

17.984
18

1 5772911

= 0.007485. (0.00620, 0.00876).

Murphy (1998) shows that industry surveys with firm size adjustments are the main determinants for managerial compensation.

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When the CEO of spinoff subsidiaries comes from the formerly pre-spinoff parents' CEO, the median sensitivities for pre-parents and the spinoffs are $15.30 and $14.00, respectively. The Wilcoxon rank-sum test statistic for comparison is 0.6819 and is not significant at the 10% level. The size effect does not have impact on these sensitivities. The firm sizes ($988 million vs. $913 million) as measured in the median market value are equivalent to each other and the Wilcoxon test statistic (0.9499) for comparison is not significant at the 10% level. By contrast there seems to be a significant improvement for the other spinoff subsidiaries to our surprise. When spinoff subsidiaries are not led by the formerly pre-parent's CEO, the median sensitivities for pre-parents and the spinoffs are $7.10 and $13.50, respectively. The Wilcoxon rank-sum test statistic is -4.4251 and is significant at the 1% level. However, it might be due to the size effect because there is a significant reduction in firm size for these spinoff subsidiaries. The median market values for pre-parents and spinoff subsidiaries are $2,083 billion and $350 million when the formerly pre-parent's CEO does not become the subsidiary's CEO.

Table 3: Sensitivities by CEO Origin

Firms CEO Mean Median Std.Dev. Min Max Med. MV ('000) Sample Pre-parents No-jump Jump .0232 .0586 .0071 .0153 .0376 .0744 0 .0001 .2346 .2575 2083258 988548 129 198 Post-parents No-jump Jump .0192 .0246 .0074 .0146 .0288 .0401 0 0 .2521 .2156 2007386 1125218 142 210 Spinoffs No-jump Jump .0282 .0568 .0135 .0140 .0427 .0743 0 0 .2867 .2355 350345 913701 126 211

Note: Jump: The CEO of the pre-parent becomes the CEO of a spinoff firm. No-jump: Someone else becomes the CEO of a spinoff firm. All the numbers except for 'Sample' are per $1,000 increase in firm value unless denoted otherwise.

To examine the size effect on the sensitivities in these firms, we compare the median sensitivities with the size-induced sensitivities in Table 4. The pre-parent's sensitivity ($7.10) is equivalent to the size-induced sensitivity ($7.70) and is contained in the 95% confidence interval ($6.40, $9.00). However, the spinoff subsidiaries' sensitivity ($13.50) is less than the size-induced sensitivity ($20.70) and is not contained in the confidence interval. Hypothesis 3 is thus rejected. When spinoff subsidiaries are not led by the formerly pre-parent's CEO, these subsidiaries experience decrease in the size-adjusted PPS, while other spinoff subsidiaries led by the formerly pre-parents' CEO do not. The results indirectly support the hypothesis on top management and are consistent with Seward and Walsh (1996) and Wruck and Wruck (2002).

Table 4: The Size-Induced Sensitivities for CEO Origin

Firms Pre-parents Post-parents Spinoffs CEO Origin No-jump Jump No-jump Jump No-jump Jump Mean MV 5421806 6345000 5554247 6488114 748476 2823721 Median Sensitivity 0.0071 0.0153** 0.0074 0.0146** 0.0135** 0.0140** Size-Induced Sensitivity with 95% C. I. 0.0077 (0.0064, 0.0090) 0.0071 (0.0059, 0.0083) 0.0076 (0.0063, 0.0089) 0.0070 (0.0058, 0.0082) 0.0207 (0.0172, 0.0243) 0.0107 (0.0088, 0.0125)

Note: Jump: The CEO of the pre-parent becomes the CEO of the spinoff firm. No-jump: Someone other than the CEO of pre-parents becomes the CEO of the spinoff firms. All the numbers except for `Mean MV' are per $1,000 increase in firm value. `Mean MV' stands for the mean market value and the numbers are in thousands. Two asterisks denote that the median sensitivities are not contained in the 95% confidence interval.

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Furthermore, when the formerly pre-parents CEO becomes new CEO of spinoff subsidiaries, the firm size and the pay-performance relations of spinoff subsidiaries are large and are equivalent to those of pre-parents. On the other hand, when the firm size of spinoff subsidiaries are small and the pay-performance relations for the pre-parents is relatively small, pre-parents CEO do not jump to become the head of spinoff subsidiaries. This pattern is consistent with the notion that self-interested managers are unlikely to embrace an increase in sensitivity and a decrease in compensation level from a small firm created from spinoffs. The pattern also reflects the strong managers behavior rather than the form of management dismissal as found by Wruck and Wruck (2002).

Managerial Incentives with Business Focus Table 5 presents PPS by changes in business focus. We find evidence against Hypothesis 4. The change in PPS for spinoff subsidiaries created from FI spinoffs is significantly positive, while that from NFI spinoffs is not. The median sensitivities of pre-parents and spinoff subsidiaries involved in FI spinoffs are $6.10 and $14.10 per $1000 increase in firm value, respectively. The Wilcoxon rank-sum test for the comparison shows that the difference is significant at the 1% level. The corresponding sensitivities of pre-parents and spinoff subsidiaries involved in NFI spinoffs are $12.90 and $13.00 per $1000 increase in firm value, respectively. The Wilcoxon rank-sum test for the comparison shows that the difference is not significant at the 10% level. Table 5: PPS by Changing Business Focus
Firms Pre-parents Business focus No-increase Increase Mean .0383 .0230 Median .0129 .0061 Standard Deviation .0024 .0431 Minimum 0 0 Maximum .2575 .2297 Median M.V. 1909497 2372006 Sample 129 198 Post-parents No-increase Increase .0247 .0170 .0140 .0064 .0290 .0317 0 0 .1242 .2521 1806297 1963601 142 210 Spinoffs No-increase Increase .0429 .0262 .0130 .0141 .0634 .0379 0 0 .2867 .2555 442804 350345 126 211

Note: The sample is 124 spinoffs during 1990-1997. All the sensitivities are per $1,000 increase in firm value unless denoted otherwise. The sensitivity provided by stock option holdings is computed as the proportional ownership multiplied by the delta of the Black-Scholes formula. The sensitivity provided by stock holdings is the proportions of stock holdings. The sensitivities reported here are the sums of the two sensitivities.

However, we find evidence supporting Hypothesis 5. There is no change in PPS for either group of firms. Post-parents seem to maintain their previous compensation contracts inherited from pre-parents. The median sensitivities for the parents involved in FI spinoffs change from $6.10 to $6.40 around the spinoff. This is consistent with the arguments by Paul (1992) and the findings by Anderson et al. (2000). The corresponding sensitivities for the parents involved in NFI spinoffs change from $12.90 to $14.00 around the spinoff. The Wilcoxon rank-sum test shows that neither difference is significant at the 10% level. To see whether the results above merely reflect the size effects on PPS, we compare the market values of the corresponding pairs. Pre-parents involved in NFI spinoffs are smaller than those involved in FI spinoffs. The median market values of the corresponding firms are $1,909,497 and $2,370,006 in thousands, respectively. The smaller size for NFI spinoffs seems to justify the higher PPS in pre-parents. However, this difference disappears in post-parents and spinoff subsidiaries. The only other significant difference in firm sizes lies between pre-parents and spinoff subsidiaries as observed in the previous section. The parent firms maintain the same level of PPS

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following spinoffs, while their size difference disappears. Spinoff subsidiaries created from FI spinoffs show increase in managerial incentives while their size changes from pre-parents are similar to those created from NFI spinoffs. The size effect does not appear to be significant in the results about business focus as shown in Table 6. All the median sensitivities for firms involved in NFI spinoffs are higher than the size-induced sensitivities and those for firms involved in FI spinoffs are equivalent to the size-induced sensitivities.

Table 6: The Size-Induced Sensitivities for Business Focus

Firms Pre-parents Post-parents Spinoffs Focus No-increase Increase No-increase Increase No-increase Increase Mean MV 5024699 6603720 5477492 6540015 2952807 1507391 Median PPS 0.0129** 0.0061 0.0140** 0.0064 0.0130** 0.0141 Size-Induced PPS with 95% C. I. 0.0080 (0.0066, 0.0093) 0.0070 (0.0057, 0.0081) 0.0076 (0.0063, 0.0090) 0.0070 (0.0058, 0.0082) 0.0104 (0.0086, 0.0122) 0.0146 (0.0121, 0.0171)

Note: The sample is 124 spinoffs during 1990-1997. All the numbers except for `Mean MV' are per $1,000 increase in firm value. `Mean MV' stands for the mean market value and the numbers are in thousands. The size-induced sensitivities are computed using the mean market value. Two asterisks denote that the median sensitivities are not contained in the 95% confidence interval and not consistent with the size-induced sensitivities.

The pay-performance relations for the subsidiaries appear to converge towards the higher sensitivities whether their parent firms improve business focus or not. The median sensitivities for both groups of spinoff subsidiaries are about the same ($13.00 vs. $14.10) and the two sensitivities are not significantly different from each other at the 10% level. The levels of the sensitivities converge to the higher sensitivity ($12.90) of pre-parents, which are involved in NFI spinoffs. The convergence towards higher sensitivities for spinoff subsidiaries seems to support the argument by Aron (1991). Unlike divisional managers of multi-divisional firms, the CEOs of spinoff subsidiaries receive a compensation package tied to its own stock price. PPS of a newly created spinoff subsidiary is no less than that of its pre-parent. Thus, the mere possibility of a future spinoff can improve current incentives for divisional managers.

Changes in Operating Performance For the measure of operating performance, we follow Barber and Lyon (1996) and take the return on asset (ROA) of the year-end operating cash flow (Compustat data item #13) divided by the year-end total assets (Compustat data item #6). We compute the changes in the ratio because the change, rather than the level, reflects a firm's previous performance. To detect abnormal performance with robustness, we use two measures of operating performance: (1) unadjusted (raw) measure and (2) size-adjusted measure. For the size-adjusted measure, we compute the median return on assets (ROA) for all firms in the same industry (defined as the first two-digit SIC code) with asset values within 20% of the asset value of the spinoff firm in the same fiscal year except for the spinoff firm and subtract the median ROA from the raw ROA of the spinoff firm to obtain the size-adjusted ROA. Obtaining the change in the size-adjusted ROA for each spinoff firm, we record the median change across all spinoffs for the results. When the number of matching firms is less than three, we relax the asset percentage from 20% to 50% to maintain at least three matches for each spinoff firm. Pro-forma Combined Firms We compute the combined ROAs following spinoffs by dividing the sum of the operating income of post-parents and subsidiaries by the sum of the total assets of the corresponding firms. Panel A of Table 7 presents the results for changes in operating performance of the pro-forma combined firm of a parent with its subsidiaries for FI and NFI spinoffs, respectively.

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We find evidence against Hypothesis 6. In panel A of Table 7 the median change in ROA during the year (-1, +1) is -0.3% for FI spinoffs. The size-adjusted change in ROA is 0.6%. No change is significant at the 10% level. These results indicate that operating performance for FI spinoffs virtually remains the same following spinoffs. The corresponding changes for NFI spinoffs are 1.4% and 3.4% and are again not significant at the 10% level. The Wilcoxon two-sample median test rejects the equality of median ROA changes between FI and NFI spinoffs for the unadjusted measures at the 5% level, while the test rejects the equality at the 10% level for the size-adjusted changes. Operating performance for NFI spinoffs substantially improves following spinoffs and the improvements are significantly greater than those for FI spinoffs.

Table 7: Changes in Operating Performance (ROA) by Business Focus Panel A. Pro-forma combined firms Period (-1, +1) (-1, 0) Focus FI NFI Z FI NFI UROA -0.3% 1.4% 2.16 0.5% 1.1% SROA 0.6% 3.4% 1.66 0.2% -0.0% Panel B. Parent firms
Period Focus UROA SROA PPS Period Focus UROA SROA PPS (-1, +1) FI NFI 0.8% 2.7% -0.0% 2.3% $0.40 $1.66 (-1, +1) FI NFI 0.1% 1.7% -0.8% 1.3% N/A N/A Z 1.50 1.33 1.65

(0, +1) Z FI NFI 0.15 -0.3% -0.0% 0.43 0.1% 0.6%

Z 0.52 0.54

(+1, +2) FI NFI Z 0.2% 0.4% -0.06 1.0% 0.5% -0.40

(+1, +2) FI NFI Z 0.0% 0.5% -0.25 0.8% 0.3% -0.42 -$0.04 $0.35 -0.49

(-1, 0) FI NFI Z 0.9% 2.6% 1.37 0.2% 1.5% 1.25 $0.16 $0.65 0.66 (-1, 0) FI NFI -0.2% 1.9% -1.2% 1.1% N/A N/A

(0, +1) FI NFI Z -0.0% -0.4% -0.69 0.1% -0.3% -0.54 $0.48 $0.96 0.34

Panel C. Spinoff subsidiaries

Z 1.97 1.01 N/A Z 1.45 1.06 N/A (0, +1) (+1, +2) FI NFI Z FI FI 0.1% 0.3% 0.43 -0.6% 0.4% 0.1% -0.3% -0.43 -1.5% 2.1% $0.55 $1.71 1.55 $1.05 $0.89 Z 1.71 2.50 0.10

Note: Median change in operating performance for 95 spinoffs during 1990-1997. In the 60 FI spinoffs, both post-spinoff parents and subsidiaries carry different two-digit SIC codes. In 35 NFI spinoffs, both carry the same two-digit SIC codes. The ROA is the ratio of operating income before depreciation (Compustat item #13) to total assets (item #6). Pre-spinoff ROAs are measured directly in the fiscal year preceding the spinoff. The post-spinoff combined ROA (UROA) is obtained by summing the operating income of the parent and subsidiary in the fiscal year following the ex-dividend year and dividing the sum by the combined parent/subsidiary end-of-fiscal-year asset value. Size-adjusted medians (SROA) are obtained by subtracting the median value for all firms (except the spinoff firm) in the same two-digit SIC code, whose asset value lies within 20% of the asset value of the parent firm. Median changes are tested against zero using the Wilcoxon sign rank test statistics. Superscript numbers represent significance at the 10% (1), 5% (2), and 1% (3) level. The Z-statistics (Z) test the equality of distributions for matched pairs of observations using the Wilcoxon sign rank test.

Our findings directly contrast with those of Daley et al. (1997) and Desai and Jain (1999). Both studies find that the operating performance for FI spinoffs is significantly higher than that for NFI spinoffs. One explanation for the contrast is the different sample period. They cover a period of the eighties, while this study covers most of the nineties. There have been significant changes in managerial incentives during the nineties. Since managerial incentives are economically minimal during the eighties (Jensen and Murphy, 1990), business focus might play a role in corporate spinoffs during the period. However, the improved managerial incentives during the nineties (Murphy, 1998) might dominate the impact of business focus on operating performance and provide a motive for spinoffs. Another explanation is that the impact of increasing business focus might be reduced over time. Since firms involved in spinoffs already have several unrelated business divisions, separating one or more unrelated divisions might not help much in improving operating performance. Though the changes in ROA for NFI spinoffs show noticeable improvements over those for

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FI spinoffs during the year (-1, +1), both changes across business focus are indistinguishable from year +1 to year +2. The unadjusted and the size-adjusted changes for FI spinoffs during the year (+1, +2) are 0.2% and 1.0%, respectively, while the corresponding changes for NFI spinoffs are 0.4% and 0.5%, respectively. No change is significant at the 10% level, implying that the difference in operating performance between FI spinoffs and NFI spinoffs disappears during the second year following the distribution. The fact that changes in operating performance for FI spinoffs are close to zero in the second year following the spinoffs is consistent with the finding by Daley et al. (1997). The corresponding ROA changes for FI spinoffs are -0.4% and +1.8% and are insignificant at the 10% level. For NFI spinoffs, they find that an ROA increases from year (+1) to year (+2) at the 10% level, weakening the business focus hypothesis. Overall, the results from the parent/subsidiary combined firms show significant improvements in operating performance for NFI spinoffs alone. The FI spinoffs do not appear to display operating performance improvements following spinoffs. We cannot support the business focus hypothesis that an increase in business focus leads to an increase in operating performance as found by the two previous studies.

Parent Firms To investigate the association between operating performance and managerial incentives, we change the method of measuring the operating performance from that in the previous section. PPS following spinoffs reflects a compensation for one CEO of a firm, either a post-parent or a spinoff subsidiary, while the operating performance of a parent/subsidiary combined firm following spinoffs reflects performance for the two. Thus, we cannot directly compare the combined operating performance with PPS. We measure the operating performance of post-parents alone. Though the size of the asset base for pre-parents is greater than that for post-parents, the same management leads the same firm and is compensated by the same firm prior to and following the spinoff. Thus, it makes sense to use the parent firms alone for comparing operating performance with managerial incentives. PPS used here may not be as robust as operating performance because we only use the unadjusted measures for the sensitivities due to the limitations in the data.19 However, the unadjusted quantities still provide us with an overall picture about the relation between managerial incentives and operating performance. Panel B of Table 7 presents the results for changes in operating performance and PPS of the parent firms by changes in business focus. We find evidence against Hypothesis 7. For FI spinoffs, the median change in ROA during the year (-1, +1) is 0.8%. The size-adjusted change in ROA is -0.0%. No change is significant at the 10% level. The corresponding changes for NFI spinoffs are 2.7% and 2.3% and are significantly greater than zero. The pattern of change in operating performance is consistent with that in the combined operating performance. However, we find evidence supporting Hypothesis 8. The large change in the ROAs for NFI spinoffs is matched with the large change in managerial incentives. The median changes in PPS are $0.40 and $1.66 per $1000 increase in firm value for FI and for NFI spinoffs, respectively. The Wilcoxon rank-sum test shows that the change of $1.66 is greater than the change of $0.40 at the 10% significance level. Improved operating performance is directly related to the higher PPS. Although subsidiaries do not exist as separate and publicly-traded companies prior to the base year, we obtain most data for pre-spinoff operating performance from subsequent annual reports. For subsidiaries, we find a similar pattern of operating performance to that for parent firms as shown in Panel C of Table 7. While most changes in ROAs for subsidiaries created from FI spinoffs are close to zero, the subsidiaries created from NFI spinoffs seem to express some degree

19 To obtain some benchmark for PPS, we would need to hand-collect compensation data from proxies of a wide array of firms similar to our spinoff firms. Even the ExecuComp database in Compustat will not provide much help in obtaining a benchmark for the sensitivities.

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of abnormal operating performance during (-1, +1). The unadjusted change in ROA is 1.7%. The Z-statistics for testing the equality of ROA changes are 1.97, supporting operating performance improvements in the subsidiaries created from NFI spinoffs alone. ROA losses for the subsidiaries created from FI spinoffs increase during the year (-1, +1), while those from NFI spinoffs remain positive. This finding contrasts with the finding by Desai and Jain (1999). Reporting that the subsidiaries distributed from NFI spinoffs substantially underperform their matching firms over the same two periods, they imply that the parent firms involved in NFI spinoffs spin off underperforming subsidiaries. On the contrary, our finding suggests that parent firms spin off well-performing subsidiaries. The difference might come from two reasons: increased managerial incentives and decreased business focus during the nineties. Their study covers a period of the eighties, while this study covers most of the nineties. It is also likely that the subsidiaries created from NFI spinoffs improve managerial incentives better than those from FI spinoffs because managers with powerful compensation packages will have enhanced incentives to deliver strong performance. The change in PPS for subsidiaries created from NFI spinoffs is modestly higher than that from FI spinoffs (1.71 vs. 0.55), while the pattern is not significantly reversed during the following year (0.89 vs. 1.05). Table 8 displays changes in operating performance and provides additional evidence supporting Hypothesis 8. For the parent firms with large enhancement in managerial incentives, the median change in ROA during the year (-1, +1) is 1.6% in Panel A. The size-adjusted change in ROA is 2.1%. Both changes are significant at the 1% level. The corresponding changes for the parent firms with the small increase in PPS are -0.3%, and -0.8% and are not significant at the 10% level. The Wilcoxon two-sample median test confirms that both median ROA changes for firms with the large increase are significantly greater than those for firms with the small increase at the 5% level. The median ROA changes during the year (+1, +2) are all insignificant, suggesting that they are not reversed in the second year following spinoffs. Examining changes in managerial incentives alone for the parent firms earlier, we find that the parent firms do not change managerial incentives following spinoffs. It now appears that although parent firms do not change managerial incentives following spinoffs on average, parent firms enhancing managerial incentives following spinoffs improve operating performance. This result is possible because we associate the changes in managerial incentives with the changes in operating performance. These two way findings on the changes in PPS and in operating performance further support the incentive hypothesis. Since the managerial incentive hypothesis is still in debate, the real impact of enhancing managerial incentives on operating performance following spinoffs is yet to be observed by both academicians and practitioners. Thus, parent firms distributing their subsidiaries through spinoffs may or may not enhance managerial incentives for their CEOs following spinoffs. However, those parent firms enhancing managerial incentives subsequently experience improved operating performance. Panel B of Table 8 presents the corresponding measures for subsidiaries, which are divided by changes in PPS of the parent firms. All the individual changes in ROAs are not significant at the 10% level, indicating that subsidiary ROAs are hardly affected by changes in PPS of the parent firms. This result is not surprising because spinoffs completely separate the distributed subsidiaries from their parent firms. The results indicate that operating performance improvements are directly related to managerial incentive enhancements for both the parent/subsidiary combined firms and the parent firms alone, which is in line with the managerial incentive hypothesis that managers deliver better performance when compensated efficiently following spinoffs. Causality might not be clear considering the notion that managers anticipating good performance following spinoffs could select compensation sensitive to performance. On the other hand, the pattern might be consistent with positive relation between growth opportunities and managerial incentives. However, our

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finding that firms involved in NFI spinoffs experience higher operating performance than those involved in FI spinoffs in the nineties weakens the business focus hypothesis that managers become more productive when managing core assets after unloading unrelated assets.

Table 8: Operating Performance Changes by PPS Panel A. Parents firms in spinoffs by own incentives
(-1, +1) (-1, 0) (0, +1) (+1, +2) Small Large Z Small Large Z Small Large Z Small Large PPS $0.96 $4.08 8.83 -$0.13 $1.93 4.35 -$0.22 $2.08 3.34 -$0.39 $0.62 UROA 0.3% 1.6% 2.11 2.0% 1.3% -0.27 -0.9% 0.3% 1.88 -0.4% 0.8% SROA -0.8% 2.1% 2.53 0.2% 1.3% 0.87 -0.7% 0.6% 1.19 0.4% 0.7% Period Z 2.10 -1.03 -0.41

Panel B. Spinoff subsidiaries by parents incentives

(-1, +1) (-1, 0) Small Large Z Small Large Z N/A N/A N/A N/A N/A N/A PPS UROA -1.0% 0.6% 1.21 -2.0% 0.3% 0.47 SROA -1.0% 0.2% 1.00 -0.9% -0.6% 0.89 Period (0, +1) Small Large $0.78 $0.81 0.7% 0.2% 0.5% -0.1% (+1, +2) Small Large -0.25 $0.83 $0.89 0.26 0.2% -0.8% -0.37 0.4% -0.5% Z -0.13 -1.08 -0.64

Panel C. Spinoff subsidiaries by own incentives Period (0, +2) (0, +1) Small Large Z Small Large PPS $0.80 $10.98 6.42 $0.10 $3.21 -0.6% 1.14 UROA 0.6% 0.2% 0.3% SROA -2.0% 1.6% 2.44 -0.8% 0.4%

Z 2.74 -0.16 1.59

(+1, +2) Small Large $0.27 $4.96 -1.2% 1.1% -0.3% 2.4%

Z 5.22 2.20 1.83

Note: For 54 `Small' changes in the sensitivities, the changes in PPS belong to the lower half among all the changes in the sensitivities for parent firms from year -1 to year +1. For 53 `Large' changes in the sensitivities, the changes in PPS belong to the upper half among all the changes in the sensitivities for parent firms from year -1 to year +1. The median PPS (PPS) is computed as in Table 3. The UROA is the ratio of operating income before depreciation (Compustat item #13) to total assets (item #6). Size-adjusted medians (SROA) are obtained by subtracting the median value for all firms (except the spinoff firm) in the same two-digit SIC code, whose asset value lies within 20% of the asset value of the parent firm. Median changes are tested against zero using the Wilcoxon sign rank test statistics. Superscript numbers represent significance at the 10% (1), 5% (2), and 1% (3) level. The Z-statistics (Z) test the equality of distributions for matched pairs of observations using the Wilcoxon sign rank test.

Spinoff Subsidiaries We now focus on the operating performance of subsidiaries to examine whether the managerial incentive enhancements induce the operating performance improvements in the subsidiaries as well. Since the subsidiaries do not exist as separate, publicly-traded companies prior to the spinoffs, we do not have managerial compensation data for subsidiaries during the year (-1) and cannot use the same time period (-1, +1) for comparison as in the parent firms. Using the time interval (0, +2) instead and ignoring changes in business focus, we divide the subsidiaries into two groups by their changes in PPS to observe the impact of managerial incentives on operating performance. If managerial incentives play a role in operating performance, we expect the large increase in PPS to lead the large improvement in operating performance as in the parent firms. Panel C of Table 8 presents the results for changes in operating performance by changes in PPS for the subsidiaries. The subsidiaries with large changes in PPS increase their CEO pay $10.98 for every $1,000 increase in firm value during the year (0, +2), while those with small changes in PPS increase their CEO compensation only $0.80 for every $1,000 increase in firm

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value over the same period. We find some evidence supporting Hypothesis 9. For the subsidiaries with the large increase in PPS, the median change in ROA during the year (0, +2) is 0.6%. The size-adjusted change in ROA is 1.6%. The corresponding changes for subsidiaries with the small increase in PPS are -0.6 and -2.0%, respectively. The Wilcoxon two-sample median test confirms that the median size-adjusted ROA change for subsidiaries with the large enhancement is significantly greater than that for subsidiaries with the small enhancement at the 5% level. To examine the timing of such changes more closely, we also investigate performance changes from year 0 to +1 and from year +1 to +2. We find that while the performance change is indistinguishable between the two groups during the period (0, +1), the performance improvement for the subsidiaries with the large increase in PPS is significantly greater than that for those with the small increase from year +1 to +2. For robustness, we also perform multivariate analysis using two measures of operating performance as dependent variables with business focus, PPS, and firm size as independent variables and find that the analysis confirms the main results supporting the managerial incentive hypothesis. Table 9 presents the results of the hypotheses. In summary, we find that there is a strong relationship between operating performance and PPS. Business focus has virtually no effect on operating performance. The evidence supports the managerial incentive hypothesis that enhanced managerial compensation packages rewritten through corporate spinoffs create value. We believe that the value creation from increased business focus reported in the literature is not a matter of increasing business focus, but a matter of enhancing managerial incentives.

Table 9: Summary of Hypotheses and the Results

Hypotheses 1. The increased PPS for spinoff subsidiaries will be equivalent to that for pre-parents adjusting for size effects. 2. PPS for post-parents will be equivalent to that for pre-parents adjusting for size effects. 3. Changes in PPS for the subsidiaries when a pre-parent's CEO becomes a subsidiary's CEO will be the same as those when someone else becomes the subsidiary's CEO adjusting for size effects. 4. Changes in PPS for spinoff subsidiaries created from FI spinoffs will be the same as those created from NFI spinoffs. 5. Changes in PPS for post-parents involved in FI spinoffs will be the same as those involved in NFI spinoff. 6. Operating performance for the pro-forma combined firms increases with business focus. 7. Operating performance for post-parents increases with business focus. 8. Operating performance for post-parents increases with PPS. 9. Operating performance for spinoff subsidiaries increases with PPS.
Note: PPS: Pay-performance sensitivity, FI: Focus-increasing, NFI: Non-focus.

Result Not rejected Not rejected Rejected

Rejected Not rejected Rejected Rejected Not rejected Not rejected

Conclusion
We present new results to better understand the sources of gains in corporate spinoffs. We find that the pay-performance relations improve following spinoff distributions in three aspects. First, we find that PPS increases for spinoff subsidiaries but remains the same for the parent firms. Second, PPS for spinoff subsidiaries does not decrease when a pre-parents CEO becomes a spinoff subsidiarys CEO adjusting for size effects. Third, the higher incentives are offered to the CEO of spinoff subsidiaries created from FI spinoffs than that of pre-parents involved in FI

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spinoffs. The results for the parent/subsidiary combined firms show that the operating performance for FI spinoffs virtually remains the same around spinoffs, while that for NFI spinoffs exhibits improvement. Focusing on the parent firms alone further drives the convincing hypothesis toward managerial incentives and away from business focus. Operating performance improvements for the parent firms involved in NFI spinoffs are significant, while those involved in FI spinoffs are not. Furthermore, changes in operating performance are consistent with changes in PPS. The parent firms with the large increase in PPS significantly improve operating performance, while those with the small increase in sensitivities do not improve their operating performance. The subsidiaries with the large increase in PPS significantly improve operating performance, while those with the small increase in sensitivities do not improve their operating performance. Changes in managerial incentives are significant motives for corporate spinoffs. Firms appear to use spinoffs as a way to rewrite managerial compensation contracts more efficiently and to improve firm performance. While the managerial incentive hypothesis and the business focus hypothesis are not mutually exclusive, the results from operating performance show that the managerial incentive effect appears to dominate the business focus effect.

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