Why the Break-Up of Conglomerate Business Enterprises Often Increases Value

Recently, throughout the world, the news has been filled with reports of corporations breaking themselves into parts. In the United States, the largest breakup ever (in dollar value) was recently announced. This was the decision of ATT (American Telephone and Telegraph), America's largest telephone and telephone equipment manufacturing equipment company, to break itself into three parts (Church, 1995). Frequently, after such a split the parts are worth more than the whole, and this will probably be the case here. Conventional financial theory has been unable to fully explain this because the mainstream theory incorporates a belief in "value additivity". Value additivity holds that the value of two cash flows will be the sum of the values of the separate flows. However, the theoretical arguments for value additivity are surprisingly weak, depending on certain unrealistic, but traditional assumptions in theoretical finance, including a lack of disagreement among investors, and certain assumptions about short selling. Even if these assumptions are reasonable (and they are not) for the U.S., they are not reasonable for many foreign countries where information is worse, and markets further from the economist's ideal. Empirically, value additivity conflicts with certain observations, notably the discounts on closed end funds and the wealth creating effects of corporate spin-offs. These effects can be explained by a theory in which different assets appeal to different clienteles, with the prices being set by the clientele that places the highest values on the assets. This paper will propose an alternative theory in which securities appeal to various clientele groups. In this alternative, differing types of investors value different streams of cash flows differently, and prices are set by the investors who will pay the most for particular streams. After explaining the theory, its predictions will be contrasted with those of value additivity. The clientele theory will be shown to be able to explain closed end fund discounts, and the gains from corporate spin-offs and other corporate reorganizations. These better explanations reveal profit opportunities for portfolio managers. Finally, the error in traditional academic arguments for value additivity will be explained This order of presentation will be used because many readers are more interested in having useful theory, than in criticisms of academic finance. But yet these arguments must be dealt with since a belief in value additivity prevents considering clientele effects on security prices. Some concluding remarks will then be made. Clientele Effects: An Alternative Theory The alternative hypothesis proposed here is that different securities appeal to different investors. Some investors' desired holdings of a particular security are zero at the current market price. Their bids for packages of securities that include securities they would not purchase at current prices, will be less than the sum of the market prices of the parts. However, the major reason for investors disagreeing about the desirability of securities is heterogeneous expectations. Estimating cash flows is difficult, and estimates differ. Investors' estimates are frequently such that they choose to hold securities that other investors, similarly situated, are selling. The investors willing to pay the most for a stock are normally those with the most optimistic views about its future returns (see Miller 1977, 1990). Obstacles to short selling (discussed further below) prevent investors whose valuation is below the market price from affecting the price by short sales. Also investors' non-marketable incomes create unique diversification needs, causing them to pay less for securities correlated with their other sources of income than the typical investor who lacks these other income sources will pay (Miller 1978). For instance, someone whose income comes from the oil industry might rationally avoid holding securities in that industry, since the value of such securities will be low at the very time when he would be using his savings to survive losing his job. …