Capital markets and corporate structure: the equity carve-outs of Thermo Electron¹

Abstract

This paper examines the innovative corporate structure of Thermo Electron Corporation which holds controlling interests in 11 units taken public in equity carve-outs. Carve-outs subject units of the company to the scrutiny of the capital markets, allow the compensation contracts of unit managers to be based on market performance, and shift capital acquisition and investment decisions from centralized control to unit managers. Thermo carve-outs substantially increase capital and R&D expenditures following carve-outs and generate significant value from their capital investments. Since the first carve-out in 1983, gains to shareholders have been substantially greater than industry and market benchmarks.

Introduction

`When we first began our spinout strategy in 1983, the goal was to forge a corporate structure tailored to the task of building profitable businesses from new technologies. By combining the entrepreneurial atmosphere of a startup venture with the financial and managerial strengths of a large, well-established company, I believe we have created a new kind of corporate enterprise – one that is uniquely capable of sustained growth in today's rapidly changing world markets' (CEO G. Hatsopoulos, 1995 annual report).

Attempts to mitigate the well-known agency conflict between shareholders and managers often involve compensating managers with stock options, company shares, or performance bonuses linked to stock values. It is an open question whether these incentives are effective in aligning the actions of senior managers with shareholder interests (Baker et al., 1988). Even if equity incentives are at least partially successful in resolving agency problems with senior managers, one could argue that such incentives are likely to be much less effective in motivating and rewarding managers at division levels. In particular, equity incentives based on the value of an entire organization are not likely to be closely linked to division-level decisions or performance, especially in multisegment or diversified firms. Centralized control over assets in such firms can also impose other costs on shareholders. Harris and Raviv (1996)describe how information asymmetries and a divergence of preferences between division and senior management can create inefficiencies in internal capital allocation process. Milgrom (1988), Meyer et al. (1992), and Bagwell and Zechner (1993)also describe how `influence' costs can be incurred as managers of poorly performing units have incentives to misrepresent investment opportunities to senior management. The conclusions of these theories illustrate how a diversified organizational structure can lead to weak incentives for division managers and poor investment decisions.

The evidence in regards to corporate diversification indicates that diversified firms have lower Tobin's q ratios (Lang and Stulz, 1994), lower market values relative to single-segment firms (Berger and Ofek, 1995), and lower stock returns relative to more `focused' firms (Comment and Jarrell, 1995). Hite and Vetsuypens (1989)also report gains in stock prices surrounding announcements of divisional management buyouts (MBOs) from `parent' firms.

This paper examines an approach that attempts to resolve both the information and incentive problems described above. Thermo Electron Corporation, a manufacturer of biomedical, recycling, and environmental monitoring equipment, has established a `satellite' structure through several equity carve-outs of the firm's wholly owned units. A carve-out initially raises investment capital for the Thermo unit. The initiation of trading in the equity market also permits the incentive and reward structures of managers and other key employees of the unit to be tied to the activities they most directly control. An important element of the Thermo Electron philosophy is that product development groups within the parent and its public subsidiaries have the opportunity to manage and control a publicly traded firm (by way of a carve-out from the parent) if the products and technologies of the unit merit acceptance in the capital market. After a carve-out, the compensation contracts of unit managers are tied to the market performance of both the unit and the parent, and unit managers assume primary responsibility for financing and investment decisions.

Thermo Electron held a majority ownership stake in seven carved out units at year-end 1995. Those units, in turn, have completed four additional carve-outs. Four units of the parent firm or the public subsidiaries have issued equity with venture capital firms but have not gone public. The company currently holds a controlling interest of at least 50% of shareholder votes in all 15 units, either directly or indirectly (through shares held by another Thermo carve-out).

Since the first carve-out in 1983, the stock performance of Thermo Electron and its publicly traded units relative to industry firms and the S&P500 index has been impressive. A $100 investment in Thermo Electron shares on 8/10/83 appreciated to $1,667 by year-end 1995, while a like investment in an equally weighted portfolio of industry firms or the S&P500 index would have increased to $524 or $381, respectively. The market performance of carved-out units has also outperformed industry and market benchmarks. For example, a $100 investment in an equally weighted portfolio of shares in Thermo units increased to $634 during a five-year period following the carve-outs. A portfolio of firms from the same industries as the Thermo units rose to $183, and the S&P500 index rose to $180 during the same period. The evidence further indicates that the gains in Thermo Electron stock can largely be attributed to the market performance of the majority-owned carve-outs.

This paper also documents substantial increases in capital investment spending by carve-outs of the company in the first and second years following their separation from the parent. For example, expenditures by Thermo units on capital goods, research and development, and acquisitions net of asset sales (all divided by the book value of unit assets) were over seven times greater in the year following the carve-out relative to the year immediately preceding the carve-out. This evidence suggests that Thermo units were underinvesting, on average, as wholly owned subsidiaries of the parent (unless, of course, the investment opportunity set increases dramatically following a carve-out, which seems unlikely). It is possible, however, that the units may be overinvesting in the post-carve-out period. This possibility seems unlikely, however, for two reasons. First, stock returns to Thermo units as well as returns on capital and R&D investments are significantly positive and greatly outpace industry firms. Second, investment expenditures by Thermo Electron and its units in post-carve-out periods are significantly less than the investment levels of rival firms.

The general consensus emanating from a large body of literature on corporate governance is that, taken as a whole, control mechanisms have largely failed (Jensen, 1993). This paper, however, illustrates a case in which a firm conceived and implemented a corporate structure that has proved to be successful in utilizing capital markets and creating value. Interestingly, this approach was undertaken without apparent external threat to the firm, replacement of senior management, or substantial management ownership of company stock. Like the turnaround at General Dynamics in the early 1990s (Dial and Murphy, 1995) and the voluntary restructuring of General Mills in the 1980s (Donaldson, 1990), the firm's success can be attributed to the insight of the firm's CEO in developing and implementing an innovative course of action.²

The paper proceeds as follows. Section 2presents a brief review on the literature on equity carve-outs and outlines possible sources of the value created through a carve-out. Section 3contains an overview of the equity carve-out approach by Thermo Electron Corporation which began in 1983. Section 4presents several measures of financial and operating performance of the company, its subsidiaries, and industry competitors. Section 5examines the investment practices of Thermo units following carve-outs as well as the role of capital markets in providing funds to the units of the firm. Section 6outlines the governance structure, compensation practices, and management turnover in the company. Section 7concludes.