Executive Summary

Tracking stock announcements are met with a positive and significant 2.55% average abnormal 2-day return. After giving an excellent description of tracking stock, the authors run a regression showing that there are some advantages of an internal capital market. The capital markets realize this and the announcement return is tied to the internal market benefit. 
 
 

This paper tries to answer the question " do diversified firms have valuable internal capital markets." The answer seems to be somewhat.

There is a much evidence (for example Comment and Jarrel 1995, Lang and Stulz 1994, and Berger and Ofek 1995) that capital markets do not "value diversification." These papers find that diversified firms trade at a discount. The authors point out that one cited reason for this discount is that internal capital markets are not efficient. This idea is Jensen's Free Cash Flow problem (Jensen 1986) and also found in Stulz (1990) and can be summarized as "cash rich firms may overinvest."

However, there is also somewhat conflicting work that suggests that internal markets might be beneficial. Many authors including Stein (1997), Weston (1970), and Williamson (1975) have pointed out that "diversified firms have at least the potential for valuable internal capital markets." The logic behind this is that market imperfections (transaction costs) can drive up the cost of trips to the capital market. 

This paper tries to determine the merits of internal markets by looking at firms who announce the creation of tracking stock. "Tacking stock is common stock of a company that is linked to a specific business within the company." (From the footnote: it "is sometimes referred to as alphabet stock, lettered stock, or targeted stock.").

The authors do an excellent job explaining tracking stock: 

Theoretically, the return on tracking stock is intended to reflect only the operating performance of the specific business segment to which it is linked. However, regardless of how many classes of tracking stock a company may have, they all represent ownership interest in the company as a whole, and do not represent a legal ownership claim in the track business segment. Thus, a tracking stock equity structure effectively splits up a diversified firm's operations into quasi-pure plays without a legal separation of corporate assets and liabilities. In particular, each class of stock continues to be responsible for all of the firm's liabilities, and the return on one tracked stock may influence the return on another, because legal ownership of assets remains with the company as a whole.

"The key distinction between a tracking stock and other forms of equity restructuring is that it preserves a firm's internal capital market."

Data and Methodology: A Lexis/Nexis search found 24 tracking stock proposals for 18 different firms. 20 were accepted by shareholders. Of the remaining 4, Kmart and RJR were rejected by shareholders and 2 were withdrawn by management (MCI and Epitope).
 
 

Interesting things about tracking stock: 

1. Newly authorized tracking stock may be sold or distributed via a special dividend.
2. Tracking stock can be issued tax-free as a class of the parent's stock while a spin-off is only tax free if the parent and subsidiary have been combines at least 5 years.
3. Often, but by no means always, tracking stock is created in the course of an acquisition. Example GM Series E was created for the acquisition of EDS and GM-H was created of Hughes Aircraft. Overall, 6 of the 20 sample proposals are the result of an acquisition.
4. Tracking stock is quite new--GM was the first in early 1980s. It is also rare. 1996 was the highest year where there were 6 proposals.
5. Liquidation rights are often based on relative market values of the outstanding equity. That is, what percentage of the firm belongs to the shareholders of the tracking stock and what percentage belongs to the parent's shareholders.
6. Dividend policy "often set to emulate dividend policies of companies operating in similar lines of business."
7. Tracking stock is usually 'callable' in the sense that the firm has the right to "redeem the [tracking stock] in exchange for cash and/or shares of another tracking stock of the company. The shares are usually converted at a premium. His example has a 15% premium.
8. Tracking stock is used in executive compensation. This is because there are better incentives if we can tie pay closer to performance.
9. A single board of directors often leads to trouble as a result of conflicts of interest. At least one firm (Pittston) requires that board members hold stock in all of the targeted stocks.

There is ample evidence that diversified firms trade at a discount; for example Berger and Ofek 1995 report that "diversification implies 6% to 12% discount." Billett and Mauer look at why firms would issue targeted stock because these "firms have implicitly expressed the belief that it is better to remain diversified." 

The authors must first look at whether these firms trade at a discount prior to issuing the targeted stock. (if this were not examine it would be possible that entrenched managers merely issued tracking stock "to claim the benefits of a spin-off without actually having to relinquish control." However, the findings suggest sample firms have a lower discount than other diversified firms.

Event Study

Looking at the 2-day event window, there is a significant 2.55% abnormal return (using the SP 500 as the market). This is roughly equivalent to the 2.1% return of spin-offs. (However, it should be noted the three day return for tracking stock is an insignificant 1.58%)

Regression

The authors create a measure of internal market performance by summing across the different divisions the product of the "segment's excess capital expenditures and its industry adjusted return on investment." The authors then run a regression and find "a strong positive relation between tracking stock announcement-period returns and [their] internal capital market measure." (in English, the larger the initial return, the more benefit of the internal market.)

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