Does a Parent–Subsidiary Structure Enhance Financing Flexibility?

I examine whether firms exploit a publicly traded parent–subsidiary structure to issue equity of the overvalued firm regardless of which firm needs funds, and whether this conveys opposite information about firm values. Using 90 subsidiary and 37 parent seasoned equity offering (SEO) announcements during 1981–2002, I document negative returns to issuers but insignificant returns to nonissuers in both samples, and insignificant changes in combined firm value and parent’s nonsubsidiary equity value in subsidiary SEOs. Firms issue equity to meet their own financing needs. My evidence contrasts with previous studies and suggests that parent–subsidiary structures do not enhance financing flexibility. CORPORATE ACQUISITIONS AND DIVESTITURES have been a constant feature of the U.S. financial markets. The combination of synergistic businesses and separation of nonsynergistic businesses is believed to increase the combined value of firms. Sometimes, however, the acquiring firm seeks only a partial stake in a target firm, or the divesting firm sells only a partial stake in a divested unit. Such partial acquisitions and equity carve-outs result in a parent–subsidiary structure in which both the parent and the subsidiary stocks are publicly traded.1 This paper examines the equity issuance decisions within such parent– subsidiary structures. Specifically, I examine whether firms exploit their parent–subsidiary structure to issue equity in the overvalued firm regardless ∗Tippie College of Business, The University of Iowa. I wish to thank Matt Billett, Jie Cai, and Jon Garfinkel for useful comments. I am very obliged to two anonymous referees, an associate editor, and Robert Stambaugh (the editor) for many comments that substantially improved this paper. Wei Li provided assistance with data collection. 1 The Black’s Law Dictionary (1999) gives the following definitions. Subsidiary corporation: A corporation in which a parent corporation has a controlling share. Controlling interest: Sufficient ownership of stock in a company to control policy and management; esp., a greater-than-50% ownership interest in an enterprise. Affiliate: A corporation that is related to another corporation by shareholdings or other means of control; a subsidiary, parent, or sibling corporation. Other internet dictionaries define a subsidiary as a company for which a majority of the voting stock is owned by a holding company, while an affiliate is a company in which another company has a minority interest. As discussed later, my sample includes cases such that one firm owns at least 25% of the equity of another firm. Strictly speaking, I should use the term “parent–subsidiary structure” when ownership exceeds 50% and the term “affiliated-firm structure” when ownership is less than 50%. However, the economics of the problem analyzed in this paper are similar between these two cases. For expositional reasons, I therefore use the term “parent–subsidiary structure” to describe my entire sample.