Carve-outs¹ seem too good to be true: a financial instrument that increases a company’s stock price without sacrificing control over a valuable business unit.

It turns out that they are too good to be true. An analysis of more than 200 major carve-outs in Europe and the United States during the past 12 years shows that around the time of the announcement only 10 percent of them raised the parents’ share price by more than 12 percent. During the 2 years after the transaction, most carve-outs actually destroyed shareholder value.² There is one important exception, however: carve-outs that followed a clear trajectory to full independence (through a spin-off, for example) significantly outperformed typical S&P 500 companies (Exhibit 1).

In general, few carve-outs remain under the parent’s control. Even a minority IPO in a high-growth business brings transaction currency for acquisitions, equity funding for internal growth, and responsibilities to the shareholders, and over time these forces tend to reduce still further the parent’s control. After about five years, only 8 percent of carve-outs continue to exist as public companies clearly controlled by the parent (that is, in which the parent holds more than 50 percent of the shares). An additional 31 percent of the parents hold minority stakes of less than 25 percent. Third parties have acquired or merged with 39 percent of the carve-outs (Exhibit 2).

A parent company that goes on trying to exercise control runs the risk of losing the benefits of the carve-out and precipitating conflict with the subsidiary as it attempts to pursue its own best interests. Consider Vastar Resources, a US oil exploration and production company carved out by ARCO in 1993. At one point, Vastar found itself bidding against ARCO for exploration and production projects. ARCO resolved this conflict by shifting its focus to international projects and leaving any bidding in the US market to its subsidiary.

Executives who plan to separate subsidiaries from their parent companies through carve-outs will gain the strategic and funding benefits only by giving the subsidiaries a high degree of autonomy early on. As part of the parent company, they may have faced restrictions in seeking customers, suppliers, funding, and transaction opportunities. Before one telecom-equipment provider was carved out and subsequently spun off,³ for example, it had virtually no access to customers for its telecom hardware products that competed with those of its parent. Similarly, Palm was in a better position to close strategic alliances with AOL, Motorola, and Nokia after its carve-out from 3Com.

Initially, there may be reasons to float a minority stake in a subsidiary through a carve-out instead of floating a majority or full stake. In the United States, for example, a carve-out of a stake of less than 20 percent that is followed by a spin-off often makes it possible for a parent company to divest a subsidiary without incurring the capital gains taxes the parent could face in a trade sale or a full IPO for cash. Guidant and Palm, for instance, were carve-outs later spun off by their respective parents, Eli Lilly and 3Com, in tax-free distributions to the shareholders of the parents.

Of course, a similar tax-free divestiture could also be realized through a straight spin-off, but maintaining short-term control over a carved-out subsidiary lets its parent raise cash while preventing it from being taken over by a direct competitor. Giving the subsidiary a chance to establish itself with suppliers, competitors, customers, and investors before exposing it to the full brunt of market forces may also serve the interests of the shareholders of the parent, which benefits from a stronger spin-off or sale of the carved-out subsidiary further down the road.

As a financial tool, carve-outs can provide some benefit. But a corporate executive must avoid illusions about what they can deliver. Carving out even small stakes in subsidiaries will likely lead to complete and irreversible separation. Companies that don’t plan for this eventuality may destroy shareholder value.