Wealth effects for buyers and sellers of the same divested assets - Market Microstructure and Corporate Finance Special Issue

Financial Management (Financial Management Association), Winter, 1992 by Neil W. Sicherman, Richard H. Pettway

Neil W. Sicherman is an Associate Professor of Finance at the University of South Carolina, Columbia, South Carolina, and Richard H. Pettway is Missouri Bankers Chair Professor of Finance at the University of Missouri-Columbia, Columbia, Missouri.

* Self-offs are a unique part of the acquisitions market. The buying firm does not purchase the entire selling firm, but only a portion consisting of the divested assets or units. Further, the selling firm rather than the buying firm initiates the transaction and normally deals with only one buyer. Under such conditions, the market for divested assets may be less competitive than the broader market for corporate control.

Recent divestiture studies find that shareholders of selling firms earn abnormal gains at announcement.(1) These empirical results are consistent with recently offered management entrenchment and tax timing option hypotheses of selling-firm shareholder reactions to the announcements of sell-offs.(2) However, unlike other acquisitions, buyers of divested assets also earn positive abnormal returns.(3)

Previous studies measure the separate effects of purchases or sales of divested assets, not the effects on a matched set of buyers and sellers of the same assets. The purpose of this paper is to measure the wealth effects of both the buyers and sellers of the same divested assets to determine how these wealth gains are shared among buyers and sellers in a controlled sample. The results of this study indicate that both buyers and sellers earn positive abnormal returns at the announcement of a divestiture. These abnormal returns are affected by changes in the seller's financial condition and by disclosure of the transaction price.

I. Factors Which Impact the Allocation of Announcement Wealth Effects

In a frictionless market, sell-offs would occur if assets can be sold for a greater value than their worth as a going-concern. However, in an imperfect market, self-interested managers may be motivated to divest assets at a cost to shareholders. For example, managers may entrench by resisting hostile takeover attempts by selling so-called "crown jewels." Also, managers of distressed firms are motivated to sell assets to raise cash and avoid employment loss.(4)

The negotiating power of a divesting firm should affect the allocation of wealth changes between the buyer and the seller of divested assets. Of course, in a perfectly competitive environment negotiating power would be irrelevant. However, real assets trade in imperfect markets. Particularly in the divestiture market, sellers typically initiate the transaction and often do not seek competitive bids.(5)

Also, shareholders of the selling firms and managers of the buying firms have incomplete information about the true values of the units or divisions that are being divested. Uncertainty about the true values of the divested assets, to the outside shareholders of the divesting firms and to the buyers, may be resolved over time. However, at divestiture announcements, shareholders' reactions depend on their perception of whether a fair price has been paid (received) for the divested assets. Thus, the wealth effects resulting from sell-off announcements should be a function of shareholders' perceptions about the seller's negotiating position and the transaction price.

A. Impact of Changes in the Seller's Financial Condition

A decrease in expected cash flows increases the probability of default for a firm. The firm in a declining financial condition will find it more costly to raise cash externally through the capital markets than through a divestiture of assets or divisions. Thus, a firm may employ a sell-off to raise needed cash. Selling-firm shareholders may react positively at the announcement of these sell-offs because financial slack has increased (Myers and Majluf |12~) and the probability of default has been reduced.

However, the selling firm may lose negotiating power if the buyer is aware of the firm's change in financial condition. For example, the downgrading of a divesting firm's credit rating informs potential buyers of a weakening financial condition and places the selling firm in a negotiating disadvantage.(6) Financially weakened sellers may be forced to take a lower price for divested units than nonweakened sellers. Also, since managers have incentives to avoid financial distress, selling-firm shareholders may view skeptically sell-off announcements after the firm has been downgraded. If shareholders perceive the negotiating disadvantage or negatively perceive management's intention, abnormal returns at the sell-off announcement will be lower for downgraded firms than for firms that are not downgraded. The negotiating disadvantage should be reflected in the allocation of sell-off-announcement wealth effects between buyers and sellers.

B. Impact of Transaction Price Disclosure

Klein |6~ finds that the disclosure of transaction prices at sell-off announcements impacts selling-firm shareholders' wealth.(7) Specifically, she finds that abnormal returns for sellers are positive and significant if the transaction price paid for the divested unit is disclosed at the sell-off announcement, but not significantly different from zero if the price is not revealed.