Journal of Corporate Finance

CORFIN-0047; No of Pages Journal of Corporate Fnance xxx (00) xxx xxx Contents lsts avalable at ScenceDrect Journal of Corporate Fnance journal omepage: www.elsever.com/locate/jcorpfn Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues Tomas J. Cemmanur a, Mark H. Lu b, a Carroll Scool of Management, Boston College, Cestnut Hll, MA 0467, USA b Gatton College of Busness and Economcs, Unversty of Kentucky, Lexngton, KY 40506, USA artcle nfo abstract Artcle story: Receved 6 November 009 Receved n revsed form 8 July 00 Accepted July 00 Avalable onlne xxxx JEL classfcaton: C7 D8 G4 G4 Keywords: Restructurng Corporate spn-offs Equty carve-outs Trackng stock ssues Insttutonal tradng Informaton producton We analyze a frm's coce between spn-offs, equty carve-outs, and trackng stock ssues and te role of nsttutonal nvestors n corporate restructurng. We model a frm wt two dvsons. Insders ave prvate nformaton about frm value and face an equty market wt retal and nsttutonal nvestors. We sow tat restructurng ncreases nformaton producton by nsttutonal nvestors (relatve to tat about te consoldated frm): te gest ncrease n nformaton producton arses from spn-offs, te next gest from carve-outs, and te lowest from trackng stock ssues. Insders wt te most favorable prvate nformaton mplement spn-offs; tose wt less favorable prvate nformaton mplement carve-outs; tose wt even less favorable prvate nformaton mplement trackng stock ssues; and tose wt unfavorable prvate nformaton reman consoldated. We explan te postve announcement effect and ncrease n analyst coverage assocated wt all tree forms of restructurng. Our model also generates a number of novel testable predctons for frms' coce between spn-offs, carveouts, and trackng stock ssues, and for nsttutonal tradng around tese tree forms of restructurng. 00 Elsever B.V. All rgts reserved.. Introducton Te pace of corporate restructurng, especally spn-offs and carve-outs, as accelerated recently. At least part of ts acceleraton seems to be drven by te vews of frms' managers and nsttutonal nvestors tat spn-offs and carve-outs (as well as oter forms of restructurng) elp to unlock dden value by correctng te undervaluaton of varous parts of a conglomerate frm. Insttutonal nvestors seem to ave a partcular preference for pure-play frms (were all projects of te frm are n related ndustres) rater tan conglomerate frms (were dfferent dvsons operate n unrelated ndustres), wc seem to be reflected Correspondng autor. Tel.: + 859 57 984; fax: + 859 57 9688. E-mal addresses: cemmanu@bc.edu (T.J. Cemmanur), mark.lu@uky.edu (M.H. Lu). Frms often explctly state tat ter motve for restructurngs s to elp analysts and nvestors better understand ter busnesses. To quote a Wall Street Journal (September, 995) report on AT&T's decson to spn off Lucent Tecnologes Inc. and NCR Corp.: Te market value of AT&T was beng bured, Mr. Allen sad. Investors couldn't understand te strategy of te combned company. Under te new setup, AT&T wll be te bggest pure play n telecommuncatons. Investors wll clearly understand t now, te carman sad... Anoter artcle from te Wall Street Journal (December 7, 99) expresses smlar vews on Adolp Coors Co.'s spn-off decson: Adolp Coors Co., n a flng wt te SEC, sad t was spnnng off ts ceramcs, alumnum, and packagng busnesses to make t easer for analysts and nvestors to evaluate te separate busnesses of Coors Brewng Co. and te tecnology, or nonbeer companes... 099-99/$ see front matter 00 Elsever B.V. All rgts reserved. do:0.06/j.jcorpfn.00.07.005 Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx n ter lower valuaton of conglomerate frms (te dversfcaton dscount ). Wle te stated argument tat spn-offs, carveouts, and oter forms of restructurng elp unlock dden value s well known among practtoners and emprcal researcers, te precse mecansm troug wc ts occurs as been controversal n te lterature. Te objectve of ts paper s to develop a teoretcal analyss explctly studyng te role of nsttutonal nvestors n corporate spn-offs, carve-outs, and trackng stock ssues and analyze a frm's coce between tese tree forms of restructurng. A number of oter ratonales ave been advanced for corporate spn-offs (e.g., Parrno, 997; Aron, 99; Nanda and Narayanan, 999; Cemmanur and Yan, 004) n te lterature. However, teoretcal analyses of oter forms of restructurng suc as carve-outs or trackng stock ssues are extremely rare, and te analyses tat do exst focus on te fact tat carve-outs rase external fnancng, treatng carve-outs as essentally spn-offs were one of te spun-off frms sells equty to outsders. In practce, owever, many frms explctly consder te alternatve forms of restructurng suc as spn-offs, carve-outs, or trackng stock ssues, and coose among tese alternatves based on te costs and benefts of tese restructurng mecansms for sareolder value. Despte ts, tere as been no teoretcal analyss so far n te lterature regardng a frm's coce between te aforementoned tree mecansms from te pont of vew of maxmzng sareolder value, and our objectve n ts paper s to develop suc an analyss. Our teory s based on te nsgt tat all tree forms of restructurng, namely, spn-offs, carve-outs, and trackng stock ssues, result n an ncrease n te extent of nformaton producton by nsttutonal nvestors (and afflated analysts) about te frm. Ts ncrease n nformaton producton arses due to two reasons. Frst, by dvdng consoldated frms nto less complex unts wt ter own fnancal reports certfed by outsde audtors, tey reduce outsde nvestors' nformaton producton cost for varous dvsons of a frm; ts drect reducton n nsttutonal nvestors' nformaton producton cost effect may be dfferent across dfferent forms of restructurng, as we argue later. 4 Second, snce dfferent nvestors may ave expertse n producng nformaton about some parts of te frm but not about oters, te aforementoned forms of restructurng allow tem to concentrate ter nvestment n tose parts of te conglomerate frm about wc tey ave an advantage n producng nformaton, tereby ncreasng ter expected profts from nformaton producton (and terefore ter ncentve to produce nformaton). Ts second specalzaton n nformaton producton effect s lkely to be smlar across te tree forms of restructurng, snce all of te restructurng forms allow nvestors to focus ter equty nvestments on tose parts of te frm regardng wc tey ave an nformatonal advantage. Te two effects of te tree forms of restructurng on outsders' ncentves to produce nformaton about te frm, and te dfferences n te synergy loss ncurred by te frm across spn-offs, carve-outs, and trackng stock ssues are te mportant drvng factors bend a frm's coce of restructurng mecansm n our model. We develop a model were te frm makes a coce between tree restructurng mecansms (spn-offs, carve-outs, and trackng stock ssues), or remanng consoldated. Te frm as two dvsons: dvson and dvson. We consder a settng wt a contnuum of frm types n wc a consoldated frm may realze a g or a low long-run cas flow wt te probablty of te g cas flow realzaton ( frm type ) prvate nformaton to frm nsders, wt outsde nvestors knowng only te probablty dstrbuton across types. Te equty market conssts of nsttutonal nvestors, wo may produce nformaton about te cas flow of te two dvsons of te frm by ncurrng a certan cost, and retal nvestors, wo ave no suc ablty to produce nformaton. Insttutonal nvestors are of two types: tose wt a comparatve advantage (low cost) for producng nformaton about dvson, and tose wt a comparatve advantage (low cost) for producng nformaton about dvson. We focus on te followng mportant dfference between spn-offs, carve-outs, and trackng stock ssues. A spn-off represents a clean break-up between parent and subsdary, resultng n two ndependent frms after te spn-off. In contrast, only a mnorty nterest n a carved-out frm s eld by outsders, wt te parent company mantanng te majorty nterest n te frm subsequent to te carve-out. Furter, n many cases, te parent and subsdary frm sare many top corporate offcers. Trackng stocks are sares of te parent company, but ter cas flows are ted to te performance of a partcular subsdary wc tey track. In partcular, n te case of trackng stock ssues, parent and subsdary ave te same management team and board of drectors. Ts ongong connecton between parent and subsdary after carve-outs and trackng stock ssues as bot postve and negatve consequences. On te one and, te ongong connecton makes t easer to mantan synerges exstng before te restructurng. On te oter and, te fact tat tere s no clean break-up between parent and subsdary makes t arder for outsders to evaluate te two frms resultng from a restructurng (relatve to te case were te two frms are cleanly separated, as n a spn-off). We capture tese two dfferences by assumng tat te reducton n nsttutonal nvestors' nformaton Te mportant role played by nsttutonal nvestors n corporate spn-offs s reflected n te followng quote from an artcle n te Fnancal Tmes (October 8, 005): Te new backlas aganst conglomerates suggests tat a more lastng sft n nvestor preferences may be takng place, drven n part by te growng nfluence of edge funds and prvate equty ouses. In publc equty markets, bg rarely as appeared less beautful. In te U.S., te most vsble sgn of ts s te break-up of companes suc as Cendant, te sprawlng lesure group bend Avs rental cars; and Orbtz travel webste, wc ts week announced a four-way demerger to try to lft ts flaggng sare prce. It follows a smlar decson by Barry Dller's InterActve Corporaton to spn-off ts Expeda travel ste, and te breakng apart of Vacom, te meda empre tat owns CBS televson network. Trackng stock, also called targeted stock, letter stock, or alpabet stock, s equty ownersp n one dvson of a dversfed frm. An equty carve-out s te sale of a porton of a wolly-owned subsdary's common stock to te publc. A corporate spn-off s a pro-rata dstrbuton of a subsdary's sares to te frm's sareolders. For te dfferences between te tree types of restructurng, see, e.g., Cemmanur and Paegls (00). 4 Emprcal researcers ave observed and documented te mproved dssemnaton of nformaton about te dfferent dvsons of a frm followng varous forms of restructurng. For example, Scpper and Smt (986) pont out tat, n te case of carve-outs, te dssemnaton of nformaton about te subsdary's fnancal poston and performance may be ncreased troug subsdary fnancal reports and addtonal prvate searc for nformaton (p55). Tey also document tat 4 of 59 frms conductng carve-outs n ter sample state tat ter motve s to mprove nvestor understandng of subsdary (Table 8). D'Souza and Jacob (000) notce tat Targeted stock ssuances mgt neverteless represent good news from an nformaton perspectve because of te compreensve fnancal statements tat frms must provde for eac targeted stock segment (p46). Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx producton cost s te gest n spn-offs, lower n carve-outs, and te lowest n trackng stock ssues, and te synergy loss s te gest n spn-offs, lower n carve-outs, and te lowest n trackng stock ssues. 5 Te equlbrum nvolves te gest set of frm types coosng to mplement a spn-off; te next lower set of frm types mplement a carve-out; te furter next lower set of frm types mplement a trackng stock ssue; and te lowest set of frm types coose to reman consoldated. We frst demonstrate tat restructurng ncreases nformaton producton by nsttutonal nvestors about eac dvson of te prevously consoldated frm. Ts s because, as dscussed before, restructurng ncreases nsttutonal nvestors' ncentves to produce nformaton n two ways: drectly by reducng ter nformaton producton cost for eac dvson, and ndrectly by allowng eac type of nsttutonal nvestor to nvest only n tose frms (dvsons) for wc tey ave a comparatve advantage n producng nformaton (tus ncreasng ter expected profts from producng nformaton). Furter, te ncrease n nformaton producton s te greatest n a spn-off because te reducton n outsders nformaton producton cost s te gest among te tree restructurng mecansms. Te ncrease n nformaton producton s smaller n a carve-out and te smallest n a trackng stock ssue. Gven te dfference n te ncrease n nformaton producton by outsders, frm nsders wt te most favorable prvate nformaton (te gest types) take dfferent restructurng decsons from tose wt less favorable prvate nformaton. On te one and, a spn-off requres te frm to ncur a great loss of synergy between dvsons, as well as te drect transacton costs nvolved. On te oter and, te benefts of a spn-off are te greatest to te gest frm types, wo are able to separate more from lower frm types n te long run due to te ncreased nformaton producton by outsders and tereby obtan ger stock prces. In contrast, medum-type frms beneft less and te lowest type frms suffer from ncreased nformaton producton. Terefore, only te gest frm types fnd t optmal to mplement a spn-off to separate temselves from te rest of frm types. 6 Te next set of frm types fnds a spn-off too costly n terms of synergy loss. Tey, owever, also beneft from ncreased nformaton producton (altoug to a lesser extent tan te gest frm types). Tey wll coose a carve-out to separate temselves from even lower frm types. Te next (even lower) set of frm types coose a trackng stock ssue to avod te ger synergy loss assocated wt a spn-off or a carve-out. At te same tme, tey also beneft from te ncreased nformaton producton due to te trackng stock ssue snce t enables tem to separate from te lowest frm types. Te lowest type frms actually lose from te ncreased nformaton producton tat would result from a restructurng (snce ts would dstngus tem more from ger type frms, reducng ter sare prce). In equlbrum, te lowest type frms fnd t optmal to reman consoldated, snce ts allows tem to at least keep all ter synerges between ter two dvsons ntact. In te gven equlbrum, spn-offs wll ave unambguously postve announcement effects, snce outsders wll nfer tat frms mplementng spn-offs are te gest frm types. Carve-outs and trackng stock ssues may also ave postve announcement effects, snce te market nfers tat tey are better tan te worst frm types, wo reman consoldated. However, te announcement to a carve-out or a trackng stock ssue wll be less favorable tan tat due to a spn-off. Te stock prce of a subset of te aforementoned ger type frms wll ncrease furter subsequent to te actual mplementaton of a restructurng, as te stock prce becomes more nformatve about true frm type as a result of furter nformaton producton by nsttutonal nvestors. 7 Our model generates tree sets of emprcal predctons. Te frst set of predctons deals wt a frm's coce between te tree forms of restructurng and oter related penomena. Our analyss predcts tat frms tat are most undervalued relatve to ter ntrnsc values (.e., were frm nsders ave te most favorable prvate nformaton) wll coose to mplement a spn-off, despte te sgnfcant losses n synergy nvolved. Frms tat are less undervalued wll mplement a carve-out to reduce synergy losses (relatve to spn-offs). Frms tat are least undervalued and tat ws to keep ter dvsons togeter under one corporate umbrella to mnmze synergy losses (but would neverteless receve some nformaton producton and te resultng valuaton benefts from avng two dstnct sares representng te frm's two dvsons tradng) wll ssue trackng stock. Our model s also able to explan several related penomena, suc as two-stage combnaton carve-outs and spn-offs (see, e.g., Tompson and Aplado, 006): frms tat temporarly ave a g synergy loss wll mplement a carve-out, and subsequently spnoff te sares eld by te parent frm to ter sareolders as soon as tese synergy losses are reduced (e.g., wen bot parent and subsdary ave created ndependent facltes tat were prevously sared or ave termnated exstng suppler customer relatonsps). Our model s also able to explan te fact tat trackng stock ssues are popular only for frms wt a wde dsparty n valuatons between te ndustres of te two dvsons nvolved. For example, trackng stock ssues were popular for old meda frms wt nternet dvsons durng te nternet bubble perod: wle management felt tat te nternet dvson could not survve 5 For smplcty of modelng, we abstract away from one mportant feature of carve-outs, namely, te fact tat, n a carve-out, te parent frm rases external fnancng by sellng a mnorty nterest n te equty of te carved-out frm to outsde nvestors. Wle ncorporatng te effect of rasng new equty fnancng wll add addtonal complexty to our analyss, all our results wll go troug essentally uncanged even n ts case as long as te amount of external fnancng rased s not too large (as s te case n practce). 6 Te broad ratonale for spn-offs underlyng our model seems to be at work n many recent spn-offs. For example, Crs Cougln, CFO of Tyco Internatonal, commented about te ratonale for te recently completed spn-offs of two of ts dvsons, namely, Tyco's ealt care busness (now called Covden) and Tyco Electroncs from te parent company: Early ndcatons became apparent out of our dscussons wt nvestors. Between 004 and 005, ter questons were all about te electroncs busness, because nvestors were lookng at wat could move wtn Tyco's dverse portfolo tat would make earnngs go up or down n a partcular perod. Tere were few questons about ealt care, our largest busness. Investors seemed to vew t smply as a sold generator of profts and cas flow (Mcknsey Quarterly, October 007). Translated nto te settng of our model, Cougln seems to be ndcatng tat one of te reasons motvatng te spnoff was tat te nformaton producton cost about te electroncs busness was ger tan tat about te ealt care busness for at least some nvestors, so tat tere would be a net valuaton beneft to a spn-off. 7 Recall tat nsttutonal nvestors ave ncentves to produce nformaton even after te frm's type s partally revealed troug ts restructurng coce. Ts s because tere s resdual uncertanty about te future cas flows of te frm even after a restructurng announcement, so tat t s proftable for nsttutonal nvestors to produce addtonal nformaton about te realzaton of te frm's future cas flows and trade on t. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

4 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx on ter own (.e., te synergy loss from any cleaner break-up suc as a spn-off or carve-out would be unacceptably large), tey neverteless felt tat te valuaton beneft arsng from ncreased nformaton producton by nternet analysts were large enoug to justfy ssung trackng stock for tese nternet dvsons. Te second set of predctons deals wt te tradng beavor of nsttutonal nvestors around restructurng. Frst, our model predcts tat, of te nsttutonal nvestors tradng n te equty of te consoldated frm, a certan fracton wll trade predomnantly n te equty of te parent frm after a restructurng, wle te remanng fracton wll trade predomnantly only n te equty of te subsdary (gven tat dfferent nsttutonal nvestors and afflated analysts may specalze n producng nformaton about dfferent parts of te frm). Second, our model predcts tat, gven tat nsttutonal nvestors produce addtonal nformaton after a restructurng, te extent of nsttutonal net buy (te extent of equty bougt mnus equty sold) n te equty of te two frms resultng from a restructurng wll be postvely related to te long-term operatng performance and long-term stock returns of tese two frms: n oter words, nsttutonal tradng wll ave predctve power for long-term operatng performance and stock returns. Fnally, te predctve power of nsttutonal tradng wll be greater for a spn-off rater tan a carve-out or a trackng stock ssue (snce te ncrease n nformaton producton by nsttutonal nvestors followng a spnoff wll be greater compared to tat n a carve-out or a trackng stock ssue). Evdence consstent wt te frst two predctons s provded by Cemmanur and He (008), wo test tese mplcatons of our model usng data on nsttutonal tradng around spnoffs derved from te Abel-Noser database. Te trd set of predctons s common to all tree forms of restructurng, toug te ntensty of varous effects may dffer across restructurng mecansms. Te predcton ere s tat te announcement effect of all tree forms of restructurng wll be postve, and te extent of nformaton producton by outsders wll ncrease subsequent to all tree. 8 Furter, our model s able to explan tree wdely documented emprcal regulartes regardng restructurng: () te number and qualty of analysts coverng te frm ncrease and te degree of nformaton asymmetry decreases followng restructurng 9 ; () focus-ncreasng forms of restructurng are assocated wt ger announcement returns compared wt non-focus-ncreasng ones 0 ; () te gans around te announcement dates are postvely related to te degree of nformaton asymmetry of frms pror to restructurng. As dscussed before, restructurng leads outsders to produce more nformaton about te frm, and, gven tat a sgnfcant proporton of te nformaton about frms s produced by fnancal analysts (Frankel and L, 004), we would expect te number and qualty of analysts coverng te frm to ncrease after a restructurng. Furter, snce te nformaton produced by outsders s partally reflected n te frm's stock prce troug tradng, a restructurng also makes te stock prce more nformatve and reduces te nformaton asymmetry about te frm. Terefore, our model explans stylzed fact (). Our analyss sows tat te ger te reducton n outsders' cost to produce nformaton due to a restructurng, te ger te announcement return. Consequently, compared to a non-focus-ncreasng restructurng, a focus-ncreasng one wll ave a ger announcement return snce te latter wll be assocated wt a ger reducton n outsders' nformaton producton cost. Ts explans stylzed fact (). Fnally, we also sow tat te ger te degree of nformaton asymmetry of te frm pror to a restructurng, te ger s te announcement return. Snce te ger te degree of nformaton asymmetry, te more undervalued g ntrnsc value frms are, te announcement effect of a restructurng wll be greater n ts case, explanng stylzed fact (). Te rest of ts paper s organzed as follows. Secton brefly summarzes te related lterature. Secton descrbes te setup of our model, and Secton 4 caracterzes te equlbrum of our model. Secton 5 summarzes testable mplcatons and secton 6 concludes. Te proofs of all lemmas and propostons are confned to te Appendx.. Related lterature Ts paper s related to te teoretcal as well as te emprcal lterature on spn-offs, carve-outs, and trackng stock ssues. We wll frst dscuss te related teoretcal lterature. Aron (99) argues tat a spn-off can mprove te ncentve sceme offered by te frm to dvsonal managers snce te stock prce of one dvson s a muc cleaner sgnal of manageral productvty tan wen te dvson belongs to te parent frm. Nanda and Narayanan (999) model a frm's coce between sellng te combned frm's equty and sellng stock n one dvson (eter to a prvate party or to te publc, wc s a carve-out n te latter case) to rase external captal. In ter paper, spn-offs elp uneart dden value, but troug a mecansm dfferent from tat n our paper: spn-offs elp reduce te commnglng of cas flows from te two dvsons of te frm. Cemmanur and Yan (004) argue tat spn-offs create value by ncreasng te probablty of a takeover of eter te parent frm or te subsdary or bot, and ts eter 8 Extant lterature as documented postve stock prce reactons to announcements of restructurngs. See Daley et al. (997) for spn-offs, Scpper and Smt (986) for carve-outs, and D'Souza and Jacob (000) for trackng stock ssues. 9 See, e.g., Zuta (999) and Cemmanur and Paegls (00) for evdence on trackng stock offerngs, Fu (00) for evdence on carve-outs, Krsnaswam and Subramanam (999) and Huson and MacKnnon (00) for evdence on spn-offs. 0 A restructurng s focus-ncreasng wen te two dvsons of te frm belong to dfferent ndustry groups, and s sometmes referred to as an unrelated restructurng. Vj (00) fnds tat focus-ncreasng carve-outs are assocated wt ger announcement returns, and Daley et al. (997) and Desa and Jan (999) fnd te same pattern for spn-offs. See Burc and Nanda (00) and Krsnaswam and Subramanam (999) for evdence on spn-offs and Fu (00) for evdence on carve-outs. In te case of a focus-ncreasng restructurng, te two dvsons of te frm operate n two dfferent ndustres, wc makes t arder for outsders to value te consoldated frm before a restructurng snce analysts usually specalze n a gven ndustry so tat a restructurng wll sgnfcantly reduce outsders' nformaton producton cost. In contrast, outsders' nformaton producton cost for a consoldated frm wt two dvsons operatng n te same ndustry s not too g to begn wt, and te reducton n outsders' nformaton producton cost due to a restructurng can be expected to be smaller. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx 5 motvates te managers to work arder (n te absence of an actual takeover) or forces te ncumbent management to relnqus control to a more competent rval (n te case of a takeover). Habb et al. (997) argue tat spn-offs mprove te manager's nvestment decsons wen nvestors are better nformed tan te management by allowng te manager to nfer outsders' nformaton more effcently. Tey, owever, do not model nformaton producton by outsde nvestors. Nanda (99) argues tat a frm wt fnancng needs wll resort to a carve-out only wen te parent s undervalued by te market and offers an explanaton for te postve prce reactons to te announcements of carve-outs. Zuta (999) argues tat trackng stock ssues are a way to mtgate te manageral agency problem. Ts paper s also broadly related to te lterature on nformaton producton n fnancal markets; examples nclude Grossman and Stgltz (980) and Verrecca (98), among oters. More specfcally, t s related to Boot and Takor (99), wo examne te effect of ssung multple fnancal clams tat partton a frm's total asset cas flows on nvestors' ncentves to produce nformaton about te value of te frm. Fulger and Lukn (00) analyze a settng n wc frms coose between debt and equty wen outsders can engage n nformaton producton about te frm. A vast emprcal lterature exsts on spn-offs, carve-outs, and trackng stock ssues. Te man motvatons for spn-offs examned n te lterature nclude te followng: expropraton of wealt from bondolders to equty olders (Parrno, 997; Hte and Owers, 98; Scpper and Smt, 98; Maxwell and Rao, 00), relaxaton of tax and regulaton constrants (Scpper and Smt, 98), facltaton of takeover of te parent and te subsdary (Cusats et al., 99), re-creaton of value destroyed n prevous acqustons (Allen et al., 995), and effcency mprovement (Gertner et al., 00; An and Dens, 004; Cemmanur and Nandy, 006). Te emprcal evdence regardng Nanda's (99) predcton tat frms rase captal troug a carve-out wen te parent s undervalued and te subsdary s overvalued s mxed: wle some studes fnd support for te stated predcton (Slovn et al., 995; Hand and Skantz, 999; Powers, 00), oters contradct t (Vj, 00; Hulburt et al., 00). Allen and McConnell (998) argue tat managers value control of assets and undertake carve-outs only wen te frm s captal constraned. Motvatons for and te sources of value ncreases arsng from trackng stock offerngs documented n te lterature nclude an ncreased ablty to reward dvson managers for ter productvty (Logue et al., 996), preservaton of te nternal captal market (Bllet and Mauer, 000), and mproved montorng and greater nformaton on ndvdual frm dvsons (D'Souza and Jacob, 000; Cemmanur and Paegls, 00). Fnally, ts paper s related to te lterature on nsttutonal tradng around corporate spn-offs: n partcular, t s related to Cemmanur and He (008), wo test te predctons of our model for nformaton producton by nsttutonal nvestors around corporate spn-offs, and fnd supportng evdence.. Te model Te model conssts of four dates: tmes 0,,, and. At tme 0, a frm wt two dvsons operates as a consoldated frm, and te equty market assgns a value to te frm. At tme, frm nsders decde weter to announce a spn-off, a carve-out, a trackng stock ssue, or to reman consoldated, and te market updates te market value of te frm based on te frm's announcement. At tme, te restructurng takes place f t s announced at tme ; oterwse te frm remans consoldated. Subsequently, nvestors produce nformaton about te frm's tme- cas flow, and sares are traded among nvestors. At tme, te frm's cas flows are realzed and dstrbuted to sareolders. Tere s also a rsk-free asset n te economy, te return on wc s normalzed to zero. All agents are rsk neutral... Restructurng versus consoldated frms Te consoldated frm as two dvsons, wt a fracton α of te tme- cas flow arsng from dvson, and te remanng α from dvson, were α (0,). 4 If te frm remans consoldated, only te stock of te wole frm s traded, wle f te frm mplements a restructurng (.e., eter a spn-off, a carve-out, or a trackng stock ssue), eac dvson as ts own stock. Tere s a contnuum of frm types, denoted by p, unformly dstrbuted on te nterval [0,]. Te tme- cas flow from dvson of a type p frm,sαx H wt probablty p and αx L wt probablty p. Smlarly, te tme- cas flow from dvson of a type p frm,s( α)x H wt probablty p and ( α)x L wt probablty p. Te cas flows from te two dvsons of te frm are ndependent. 5 We normalze te number of sares of te consoldated frm to one. If te frm breaks up ts stock by mplementng a restructurng, we assume tat eac dvson of te frm as one sare of stock (.e., we also normalze te number of sares n eac dvson to one). Tere s a loss of synergy assocated wt a restructurng. Furter, ts loss of synergy s te gest wen te frm conducts a spn-off and te lowest wen te frm conducts a trackng stock ssue. Specfcally, te synergy loss assocated wt a spn-off, a carve-out, and a trackng stock ssue are W, Wb, and W, respectvely, were W N Wb N W N 0. Te synergy loss s reflected n te In addton to Boot and Takor (99), several oter papers compare te effects of tradng baskets of securtes versus ndvdual securtes on endogenous nformaton collecton by nvestors usng a Kyle (985) type settng: see, e.g., Subramanyam (99), wo compares te effect of tradng an ndex versus ndvdual securtes on nformaton collecton, or Goldman (005), wo compares te effect on nformaton collecton of tradng te varous dvsons of a frm bundled as a sngle securty or as multple securtes (eac representng a sngle dvson). However, none of te above papers ncorporate te role of te frm manager (or s prvate nformaton about te frm or ts dvsons), so tat tey are unable to adequately analyze a frm's coce between a conglomerate frm or a spn-off (or ts coce across varous restructurng mecansms suc as spn-offs and carve-outs); neter can tey explan te postve announcement effects tat ave been documented upon te announcements of spn-offs, carve-outs, and trackng stock ssues. 4 We assume two dvsons for te purpose of tractablty. All results old qualtatvely wen te frm as more tan two dvsons. 5 Gven tat we allow te actual cas flow realzatons to be ndependent across dvsons, allowng for te probablty of a g cas flow to be dfferent across dvsons would only complcate our results wtout cangng te qualtatve nature of tese results. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

6 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx tme- cas flow of te frm, and dvded between te two dvsons proportonally. For example, te net cas flow of te two dvsons are x αw and x ( α)w, respectvely, after accountng for te synergy loss f te frm mplements a spn-off... Frm nsders' prvate nformaton and nformaton producton by outsders Frm nsders know te true frm type p, wereas outsde nvestors only know te pror dstrbuton of p, wc s unformly dstrbuted over [0, ]. Tere are two types of outsde nvestors: nsttutonal nvestors and retal nvestors (lqudty traders). Retal nvestors are pure lqudty traders and ter demand for te frm's equty s exogenous. 6 Te total aggregate demand (n terms of number of sares) from tese retal nvestors, u, s unformly dstrbuted on te nterval [, ],.e., u U½ ; Š: ðþ If te frm conducts a restructurng, te aggregate demand from te lqudty traders for eac dvson's stock remans u. 7 Insttutonal nvestors, unlke retal nvestors, ave te ablty to produce nformaton about te two dvsons of te frm. Tere are two types of nsttutonal nvestors: type and type. Type nvestors ave a comparatve advantage n producng nformaton about dvson : f te frm remans consoldated, by ncurrng a cost of C, eac type nvestor observes te tme- cas flow of dvson wtout nose. For smplcty, we assume tat te nformaton producton cost of a type nvestor about te cas flow of dvson s nfnte. Smlarly, type nvestors ave a comparatve advantage n producng nformaton about dvson : f te frm remans consoldated, by ncurrng a cost of C, eac type nvestor observes te tme- cas flow of dvson wtout nose; te nformaton producton cost of type nvestor on dvson 's cas flow s nfnte. If te frm conducts a restructurng, te nformaton producton costs of type and type nvestors (about dvsons and, respectvely) wll decrease because eac dvson s now a pure-play unt and easer to value. Furter, ts reducton n nformaton producton cost s te greatest wen te frm conducts a spn-off and te smallest wen te frm conducts a trackng stock ssue. Specfcally, te nformaton producton costs to type nvestors assocated wt a spn-off, a carve-out, and a trackng stock ssue are C, C b, and C, respectvely, were C N C N C b N C N 0. Smlarly, te nformaton producton costs to type nvestors assocated wt a spn-off, a carve-out, and a trackng stock ssue are C, C b, and C, respectvely, were C N C N C b N C N 0. Tat s, a restructurng mproves nsttutonal nvestors' nformaton producton tecnology, by makng t easer for tem to access nformaton about te ndvdual cas flows of eac dvson. Insttutonal nvestors are wealt-constraned, and we model ts constrant by assumng eac nvestor can buy only one sare of te consoldated frm's stock wen te frm remans consoldated; eac nsttutonal nvestor can buy eter α sare of dvson 's stock or sare of dvson 's stock n te case of a restructurng.8 α Wle nsttutonal nvestors ave te ablty to produce nformaton, tey may not necessarly coose to do so, and may nstead coose to trade n te frm's equty as unnformed (dscretonary) traders. In secton, were we caracterze te equlbrum of te model, we wll solve for te number of eac type of nsttutonal nvestor coosng to produce nformaton about te two dvsons of te frm. Unnformed nsttutonal nvestors (UIIs) are te margnal nvestors, and tey submt bds to clear te market after observng te total demand from te lqudty and nformed traders. 9 We assume tat tere are enoug unnformed nsttutonal nvestors n te market to absorb te total order flow from te lqudty and nformed traders. Te equty market s perfectly compettve so tat bot te unnformed and nformed nsttutonal nvestors make an expected net return of 0. In oter words, n equlbrum, eac nsttutonal nvestor wll be ndfferent between producng and not producng nformaton. In te case were te frm remans consoldated, denote te total order flow from retal and nformed nsttutonal nvestors by y=z +z +u, were z and z are te total order flow from type and type nformed nsttutonal nvestors, respectvely. In te case of a restructurng, denote te total order flows for te two dvsons' stocks by y =z +u and y =z +u, respectvely. Te market-clearng value of te consoldated frm at tme s te expected value of ts future cas flows condtonal on te total order flow from lqudty traders and nformed nsttutonal nvestors: V N = Ex ½ + x jy; NŠ: ðþ 6 We can tnk of te pure lqudty traders as nvestors wo trade te stock to edge ter own nvestment rsks. Alternatvely, tey could trade te stock for purely beavoral reasons. 7 Ts s te approprate assumpton ere snce after a restructurng, one sare of te combned frm's stock s dvded nto one sare of dvson 's stock and one sare of dvson 's stock. 8 Ts assumpton s consstent wt te assumpton tat a fracton α of te frm's tme- cas flow comes from dvson, and te remanng α from dvson, and tat nsttutonal nvestors ave only a certan amount of wealt devoted to tradng n te equty of te frm. Wle we coose to make assumptons on nsttutonal tradng drectly n terms of number of sares for tractablty, t s reasonable to assume tat, gven tat eac ndvdual dvson generates only a fracton of te cas flows of te combned frm, nsttutonal nvestors can buy a proportonately larger number of sares n eter of te two dvsons resultng from a restructurng relatve to te number of sares tey can buy n te combned frm. 9 Tus, followng te standard role played by market makers n mcrostructure models, we assume tat market-clearng prces are set by UIIs, wo observe only te total order flow for eac securty, but unable to dstngus between orders placed by nformed nsttutonal nvestors and retal (lqudty) nvestors. Furter, for tractablty, we assume tat dfferent UIIs set prces for te two dvsons' stocks. Terefore, UIIs settng te prce for dvson 's stock do not observe te total order flow for dvson 's stock. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx 7 In te case of a restructurng, te market-clearng value of dvson s te expected value of ts future cas flow condtonal on te total order flow for dvson 's stock mnus te proportonal synergy loss arsng from te restructurng: V R = Ex ½ jy ; RŠ αw R ; ðþ were R stands for a spn-off, a carve-out, or a trackng stock ssue. Smlarly, te market-clearng value of dvson s te expected value of ts future cas flow condtonal on te total order flow for dvson 's stock mnus te proportonal synergy loss arsng from te restructurng: = Ex ½ jy ; RŠ ð αþw R : ð4þ V R.. Te objectve functon of frm nsders Followng a standard assumpton n te lterature (see, e.g., Ross, 977), we assume tat te frm cares about bot current and future market values. 0, Tus, wen makng te decson at tme on weter or not to conduct a restructurng, te frm maxmzes te wegted average of ts tme and tme market values. In oter words, te frm cooses eter consoldaton or one of te tree types of restructurng to maxmze te followng objectve functon: max γv + ð γþev ½ Š; ð5þ were γ [0,] s te wegt of te frm's tme- market value n te frm's objectve functon, and V t s te market value of te wole frm at tme t. 4. Market equlbrum Defnton of equlbrum: Te equlbrum concept we use s Perfect Bayesan Equlbrum (PBE). An equlbrum conssts of () a coce of te frm at tme on weter to announce a restructurng, and f yes, wc type of restructurng; () a coce made by type and type nsttutonal nvestors at tme regardng weter to produce nformaton; () a decson made by nformed nsttutonal nvestors regardng ow muc to trade at tme ; (v) a prce set by UIIs at tme after observng te total order flow from retal nvestors and nformed nsttutonal nvestors; (v) a system of belefs formed by nvestors at tme about te type of te frm after observng te frm's restructurng decson. Te aforementoned set of prces, coces, and belefs must be suc tat (a) te coce of eac party maxmzes s or er objectve, gven te coces and belefs of oters; (b) te belefs of all partes are consstent wt te equlbrum coces of oters; furter, along te equlbrum pat, tese belefs are formed usng Bayes' rule; (c) any devaton from te equlbrum strategy by any party s met by belefs of oter partes wc yelds te devatng party a lower payoff compared to tat obtaned n equlbrum. Two broad categores of equlbra may exst (dependng on parameter values): () partal poolng equlbra, were frms take dfferent restructurng decsons, tus revealng te range of ter frm types; () poolng equlbra were all types of frms make te same restructurng decsons, regardless of ter type. We wll start wt one type of partal poolng equlbrum, n wc some frms coose a spn-off, some a carve-out, some a trackng stock ssue, and some consoldaton. We ten caracterze oter partal poolng equlbra n wc not all four coces are observed and poolng equlbra n wc all frms coose te same strategy. 4.. Coce between spn-offs, carve-outs, trackng stock ssues, and consoldated frms We caracterze te exstence and propertes of te followng equlbrum: te gest set of frm types (p [q,]) coose a spn-off, te next lower set of frm types (p [q,q )) coose a carve-out, te next lower set of frm types (p [q,q )) coose a trackng stock ssue, and te lowest frm types (p [0,q )) coose to reman consoldated, were 0bq bq bq b. 4... Informaton producton and te tradng of sares At tme, type and type nsttutonal nvestors frst decde weter or not to become nformed. After tat, nformaton producton and tradng take place, and nformed nsttutonal nvestors trade wt lqudty traders and UIIs. Te followng lemma descrbes te amount of nformaton producton and te market value of te frm wen te frm remans consoldated at tme. 0 We can alternatvely assume tat te frm cares about market values at tree dates: tmes,, and. Snce all nformaton asymmetry s resolved at tme, assumng tat te frm cares about tme- as well does not cange te qualtatve nature of our results, provded tat te frm places some wegts on tme- and tme- market values as well. Frm nsders may care about ntermedate market values of te frm's equty for varous reasons. For example, te frm may ws to rase captal troug equty fnancng at te prevalng market prce; te compensaton of te management may be ted to te current and future stock prces; te frm may be subject to ostle takeover at undervalued prce f ts stock prce s too low. Ts assumpton can be translated to an assumpton about maxmzng te long-term wealt of current sareolders, snce tey may ws to lqudate some of ter sare oldngs at dates and for lqudty reasons. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

8 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx Lemma. If a frm remans consoldated at tme, te numbers of type and type nsttutonal nvestors producng nformaton are and, wc are caracterzed by Eqs. (A.) and (A.) n te Appendx. Frm nsders' expected market value of a type p frm at tme wen t remans consoldated s: EV p;n = ½α + ð αþ Š px H + ð pþx L + ½ α ð αþ Š 0:5q X H + ð 0:5q ÞX L : ð6þ Wen te frm remans consoldated, type nsttutonal nvestors produce nformaton about dvson and trade te sares of te consoldated frm, were {, }. Te expected payoff to eac nformed nvestor decreases wt te number of nformed nvestors. Snce te market for nformaton producton s perfectly compettve, te number of nformed nsttutonal nvestors s suc tat te equlbrum expected proft from becomng nformed equals te cost of nformaton producton. Te followng lemma descrbes te amount of nformaton producton and te expected combned market value of te two dvsons of te frm at tme wen te frm conducts a restructurng. Lemma. () If te frm conducts a spn-off at tme, te numbers of type and type nsttutonal nvestors producng nformaton are and, wc are caracterzed by Eqs. (A.4) and (A.5) n te Appendx. Frm nsders' expectaton of combned market value of te two dvsons of a type p frm at tme s: EV p;s = ð + Þ px H + ð pþx L ð Þ +q + X H + q XL W: ð7þ () If te frm conducts a carve-out at tme, te numbers of type and type nsttutonal nvestors producng nformaton are b and b, wc are caracterzed by Eqs. (A.6) and (A.7) n te Appendx. Frm nsders' expectaton of combned market value of te two dvsons of a type p frm at tme s: EV p;c = b + b px H + ð pþx L q + q + b b X H + q q X L Wb : () If te frm ssues trackng stock at tme, te numbers of type and type nsttutonal nvestors producng nformaton are and, wc are caracterzed by Eqs. (A.8) and (A.9) n te Appendx. Frm nsders' expectaton of combned market value of te two dvsons of a type p frm at tme s: EV p;t = + px H + ð pþx L + q + q X H + q q X L W: ð8þ ð9þ In te case of a restructurng, a type {, } nsttutonal nvestor decdes weter or not to produce nformaton about dvson. If tey decde to produce nformaton, tey wll trade dvson 's stock based on te prvate nformaton tey ave. Te expected proft to eac nformed type nsttutonal nvestor decreases wt te number of nformed type nsttutonal nvestors. Snce te market for nformaton producton s perfectly compettve, te equlbrum number of nformed type nsttutonal nvestors s suc tat te payoff from nformaton producton equals te cost of nformaton producton. We wll compare te extent of nformed tradng about te two dvsons n spn-offs, carve-outs, trackng stock ssues, and consoldated frms n Proposton. 4... Coce between a spn-off, a carve-out, a trackng stock ssue, and a consoldated frm Te followng proposton caracterzes frms' coce between a spn-off, a carve-out, a trackng stock ssue, and a consoldated frm. Proposton. Coce between a spn-off, a carve-out, a trackng stock ssue, and a consoldated frm Assume tat te synergy loss assocated wt a spn-off, a carve-out, or a trackng stock ssue s moderate, suc tat W N W N Wb N W N W, were W and W are defned n te Appendx. Furter, let condtons (A.) to (A.6) old. Ten, n equlbrum: () frms wt type p [q,]coose a spn-off; () frms wt type p [q,q ) coose a carve-out; () frms wt type p [q,q ) coose a trackng stock ssue; and (v) frms wt type p [0,q ) coose to reman consoldated, were q,q, and q are determned by Eqs. (A.0) to (A.). Te frms' coce between a spn-off, a carve-out, a trackng stock ssue, or a consoldated frm arses from a comparson of te costs and benefts of tese alternatves. A restructurng facltates nformed tradng and brngs te market value of te frm closer to ts true value. Te ger te frm type, te ger te beneft from a restructurng, snce more nformed tradng ncreases te cance tat te true frm qualty wll be revealed by prce, wc results n a ger market value for ger value frms at tme. Te ncrease n nformed tradng s te greatest n a spn-off, lower n a carve-out, and te lowest n a trackng stock ssue. However, tere s a synergy loss n a restructurng, and ts synergy loss s te greatest n a spn-off, lower n a carve-out, and te lowest n a trackng stock ssue. Frms coose between a spn-off, a carve-out, a trackng stock ssue, or a consoldated frm based on ts trade-off. Snce te gest qualty frms beneft te most from more nformed tradng, tey fnd t optmal to coose Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx 9 a spn-off to nduce te maxmum amount of nformaton producton and separate tem from te rest of te frm types. Te second gest set of frm types fnd t too costly to conduct a spn-off because te synergy loss s too g and tey beneft less from ncreased nformed tradng compared to te gest types of frms. Terefore, tey fnd t optmal to conduct a carve-out. Smlarly, te trd gest set of frm types coose a trackng stock ssue, snce t can ncrease nformed tradng and dstngus tem from te lowest frm types. Gven tat tey beneft less from an ncrease n nformed tradng, te trd gest set of frm types prefer a trackng stock ssue to a carve-out, snce a trackng stock ssue enables tem to reduce te synergy loss compared to a carve-out. Fnally, te lowest frm types fnd t suboptmal to mplement any form of restructurng, snce tey actually lose from an ncrease n nformed tradng, and terefore do not ws to ncur any synergy loss. Tey terefore reman consoldated n equlbrum. Te followng proposton compares te amount of nformed tradng at tme wen te frm remans consoldated wt tat wen te frm conducts a spn-off, a carve-out, or a trackng stock ssue. Proposton. Informed tradng n spn-offs, carve-outs, trackng stock ssues, and consoldated frms In te equlbrum caracterzed n Proposton, te amount of nformed tradng at tme s te greatest wen te frm mplements a spn-off, te next greatest wen te frm mplements a carve-out, te next greatest wen te frm mplements a trackng stock ssue, and te least wen te frm remans consoldated:.e., α N b α N α N and α N b α N α N. Te amount of nformed tradng at tme s te greatest wen te frm conducts a spn-off, te next greatest wen te frm mplements a carve-out, followed by frms conductng a trackng stock ssue, and s te least wen te frm remans consoldated. Compared to a consoldated frm, a frm conductng a restructurng offers two advantages to nformed traders to collect prvate nformaton. Frst, te nformaton producton costs decrease after a restructurng and ts wll gve nformed traders a ger ncentve to produce nformaton. Second, wealt-constraned nformed traders can specalze tradng only n te dvson about wc tey ave prvate nformaton and buy more sares of tat dvson and earn ger profts after a restructurng. In contrast, f te frm remans consoldated, nformed traders are forced to trade te sares of te wole frm and buy a smaller number of sares. Wle te second advantage s te same for all tree types of restructurng, te frst advantage s te greatest for a spn-off, followed n magntude by a carve-out and te least for a trackng stock ssue. Ts explans te orderng n te amount of nformed tradng subsequent to te tree forms of corporate restructurng. Corollary. Consder te specal case were tere s no reducton n nsttutonal nvestors' cost of producng nformaton about eter of te two dvsons of te frm after a trackng stock ssue;.e., C = C and C = C. Furter, let condtons (A.7) and (A.8) old. In te equlbrum caracterzed n Proposton, tere wll be more nformed tradng n te sares of frms conductng a trackng stock ssue tan tose remanng consoldated:.e., α N, and α N : Te Corollary demonstrates tat te second effect dscussed (specalzaton n nformaton producton) by tself s able to generate an ncrease n nformaton producton about frms conductng trackng stock ssues even n te absence of te frst effect dscussed above:.e., even n te absence of a decrease n nsttutonal nvestors' cost of nformaton producton about te two dvsons of te frm after a trackng stock ssue. Eac of te prevously stated two effects ndvdually contrbute to a sgnfcant ncrease n nformaton producton after frms undergong restructurng over tat about frms remanng consoldated. Te followng proposton caracterzes te market reacton to te announcement of a frm's spn-off decson. Proposton. Announcement returns n spn-offs, carve-outs, and trackng stock ssues Assume condtons (A.9) troug (A.) old. In te equlbrum caracterzed n Proposton, te announcement return s postve f a frm announces a restructurng at tme ; furter, te announcement return s te gest for frms announcng a spn-off, te next gest for frms announcng a carve-out, te next gest for frms announcng a trackng stock ssue:.e., ΔV S NΔV C NΔV T N0. At tme 0 (wen all frms reman consoldated), te market gves all frms te average value of frms n te economy, and ger type frms are undervalued wle lower type frms are overvalued. At tme, wen frms announce te restructurng decson, te market updates frm value accordngly, partally nferrng te prvate nformaton of frm nsders. Snce te gest type frms announce a spn-off, te next gest type frms announce a carve-out, and te next gest type frms announce a trackng stock ssue n equlbrum, te ncrease n market value of frms announcng a spn-off wll be te gest, and te next gest ncrease wll be for frms announcng a carve-out, followed n magntude by frms announcng a trackng stock ssue. Proposton 4. Announcement returns and te reducton n nformaton producton costs n restructurng In te equlbrum caracterzed n Proposton, for frms tat announce a restructurng, te tme- market value ncreases wt te V magntude of te reducton n nsttutonal nvestors' nformaton producton costs due to te restructurng:.e., S N 0, V S C C V N 0, C V C C C C b N 0, C V C C b N 0, T V C C N 0, and T C C N 0. Wle we focus only on trackng stock ssues n ts corollary snce t s te closest to a consoldated frm n terms of nformaton producton by outsders, we can derve smlar results for carve-outs and spn-offs. Tat s, n te specal case were tere s no reducton n outsders' cost of producng nformaton about eter of te two dvsons of te frm after a carve-out or a spn-off, tere wll neverteless be more nformed tradng n te sares of frms conductng a carveout or a spn-off tan tose remanng consoldated. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

0 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx Proposton 4 states tat te market value of te frm upon te announcement of a restructurng ncreases wt te magntude of te reducton n nsttutonal nvestors' nformaton producton costs due to te restructurng. Ts s because, wen te reducton n nsttutonal nvestors' nformaton producton costs s large, te prce becomes more nformatve after te restructurng, and t s more lkely tat true frm qualty s detected by te market. Terefore, te beneft of mmckng ger type frms and mplementng a restructurng wll be lower for lower type frms wen te magntude of te reducton n outsders' nformaton producton cost s larger, makng tem less lkely to pool wt ger type frms and obtan a ger market value after te restructurng. Consequently, n equlbrum, only frms wt a ger ntrnsc value fnd t wortwle to conduct a restructurng wen te reducton n outsders' nformaton producton costs s large. Correspondngly, te market gves frms mplementng a restructurng a ger valuaton n ts case, leadng to ger value ncrease upon te announcement of a restructurng. Proposton 5. Predctve power of nformed nsttutonal tradng n restructurng In te equlbrum caracterzed n Proposton, for frms tat mplement a restructurng, te tme- market value ncreases wt te order flow from nformed nsttutonal nvestors:.e., EVS N 0, EVS N 0, EVC N 0, EVC N 0, EVT N 0, and EVT N 0. z z z z z z At tme, nformed nsttutonal nvestors observe te cas flows of te frm tat wll be realzed at tme. Tey wll place a buy order f te cas flow s g and a sell order f te cas flow s low. Snce te aggregate order flow from retal nvestors s exogenous and ndependent of te tme- cas flow, te total order flow, on average, s ger wen te tme- cas flow s ger, resultng n te market value of te stock beng also ger. Terefore, tere s a postve relaton between te tme- market value of a frm and te order flow from nformed nsttutonal nvestors. 4.. Oter possble equlbra So far, we ave consdered only one type of equlbrum, namely, a partal poolng equlbrum n wc te gest frm types coose a spn-off, te next lower set of frm types coose a carve-out, te next lower set of frm types coose a trackng stock ssue, and te lowest set of frm types reman consoldated. For ts equlbrum to exst, we need te synergy loss assocated wt a spnoff, a carve-out, or a trackng stock ssue to be moderate, so tat W N W N Wb N W N W. In ts subsecton, we explore te possblty of oter equlbra wen te synergy loss s extremely g or extremely low. Proposton 6. Equlbra wt g synergy losses () If te loss of synergy s g n all tree types of restructurng so tat W N W b N W N W, ten all types of frms reman consoldated n equlbrum; () f te loss of synergy s g n spn-offs and carve-outs and moderate n trackng stock ssues so tat W N W b N W N W N W, ten frms wt type p [q T,] coose a trackng stock ssue and frms wt type p [0,q T ) coose to reman consoldated; () f te loss of synergy s g n spn-offs and moderate n carve-outs and trackng stock ssues so tat W N W N W b N W N W, ten frms wt type p q T ; coose a carve-out, frms wt type p ½q T ; q T Þ coose a trackng stock ssue, and frms wt type p ½0; q T Þ coose to reman consoldated. Te poolng equlbrum wt all types of frms remanng consoldated exsts wen te synergy loss from a restructurng s large. Wen te synergy loss s large, ger type frms fnd t too costly to use a restructurng to dstngus temselves from lower type frms, snce te ncrease n market value s not enoug to cover te synergy loss assocated wt te restructurng. Terefore, ger type frms coose to reman consoldated and pool wt lower type frms. If te synergy loss assocated wt a spn-off or carve-out s g, but tat assocated wt a trackng stock ssue s moderate, ten a spn-off or carve-out s too costly for even te gest frm types. However, g frm types fnd t optmal to use a trackng stock ssue, wc s assocated wt moderate synergy losses, to ncrease nformed tradng and separate temselves from lower frm types. Lower frm types wll coose to reman consoldated, snce tey do not beneft from ncreased nformed tradng after a trackng stock ssue and tey can save te synergy loss arsng from a restructurng by remanng consoldated. If te synergy loss assocated wt a spn-off s g, but tat assocated wt a carve-out or trackng stock ssue s moderate, ten a spn-off s too costly for even te gest frm types. However, te gest frm types fnd t optmal to conduct a carve-out because a carve-out ncreases nformed tradng more tan a trackng stock ssue. Terefore, based on te trade-off between te costs and benefts assocated wt a carve-out, te gest frm types fnd t optmal to ncur te ger cost of synergy loss assocated wt a carve-out to separate temselves from te rest of frm types. Te medum frm types also beneft from ncreased nformed tradng, but to a lesser degree compared to te gest frm types. Tey fnd te synergy loss assocated wt a carve-out too g and wll nstead coose a trackng stock ssue to separate temselves from te lowest frm types. Te lowest frm types wll coose to reman consoldated: tey do not beneft from ncreased nformed tradng after a restructurng and remanng consoldated can save te synergy loss arsng from any restructurng. Proposton 7. Equlbra wt low synergy losses () If te loss of synergy s low n all tree types of restructurng so tat W N W N Wb N W, ten all types of frms coose a spn-off; () f te loss of synergy s moderate n spn-offs and low n carve-outs and trackng stock ssues so tat W N W N W N Wb N W, ten frms wt type p [q S,] coose a spn-off and frms wt type p [0,q S ) coose a carve-out; () f te loss of synergy s moderate Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx n spn-offs and carve-outs and low n trackng stock ssues so tat W N W N Wb N W N W, ten frms wt type p q C ; coose a spn-off, frms wt type p ½ q C ; q C Þ coose a carve-out, and frms wt type p ½0; q C Þ coose a trackng stock ssue. Te poolng equlbrum wt all types of frms conductng a spn-off exsts wen te loss of synergy assocated wt a restructurng (even tat assocated wt a spn-off) s qute small. It s obvous tat ger frm types ave ncentves to conduct a spn-off because dong so wll ncrease nformed tradng at tme and ts wll lead to ger tme- market values. Even te lowest frm types ave ncentve to pool wt ger frm types and conduct a spn-off. Te cost of mmckng s small because te synergy loss assocated wt a spn-off s small. Conductng a spn-off wll allow te lowest frm types to fully pool wt ger frm types at tme, and partally pool wt tem at tme (recall tat nformaton producton by nsttutonal nvestors wll separate tem only partally at tme ). If tey nstead coose to reman consoldated, te market wll nfer tat tey are of te lowest frm types and ter market value wll be lower at bot tme and tme. If te synergy loss assocated wt a spn-off s moderate, but tat assocated wt a carve-out or trackng stock ssue s low, ten te lowest frm types fnd t too costly to mmc troug a spn-off. Instead, tey wll coose to pool wt medum frm types troug a carve-out. Only te gest frm types fnd t optmal to bear te cost of a spn-off and separate temselves from te rest of frm types. Terefore, n equlbrum, frms wose type s above te cutoff value q S wll conduct a spn-off, wereas frms wt type below te cutoff value q S wll conduct a carve-out. If te synergy loss assocated wt a spn-off or carve-out s moderate, but tat assocated wt a trackng stock ssue s low, ten te gest set of frm types coose a spn-off to beneft from te greatest ncrease n nformed tradng assocated wt te spn-off. Te next gest set of frm types fnds t too costly to conduct a spn-off. At te same tme, tey beneft from ncreased nformed tradng. Tradng off te synergy cost and valuaton beneft assocated wt a carve-out, tey coose to conduct a carve-out. Te rest of lower frm types coose to conduct a trackng stock ssue. Note tat even te lowest frm types fnd t optmal to pool wt ger frm types troug a trackng stock ssue, snce te synergy loss assocated wt a trackng stock ssue s low. 5. Emprcal mplcatons We glgt some of te emprcal mplcatons of our model below. () Propensty to restructure and te coce between spn-offs, carve-outs, and trackng stock ssues: Our model as several predctons for frms' propensty to restructure and ter coce between varous forms of restructurng, n partcular, between spn-offs, carve-outs, and trackng stock ssues. One of te reasons tat ger type frms mplement a restructurng n our settng s because ts reduces nsttutonal nvestors' nformaton producton costs. If a frm's two dvsons operate n dfferent ndustres, te reducton n outsders' nformaton producton cost due to te restructurng tends to be g, so tat ger type frms are more lkely to mplement a restructurng. Our model terefore predcts tat we wll observe more focus-ncreasng restructurng tan non-focus-ncreasng restructurng. Consstent wt ts, bot Daley et al. (997) and Desa and Jan (999) fnd tat te number of focus-ncreasng spn-offs s more tan twce tat of non-focus-ncreasng spn-offs (60 versus 5 and 0 versus 4, respectvely). We also provde a novel predcton ere tat f te earnngs patterns of te frm's two dvsons are qute dfferent, te frm s more lkely to conduct a restructurng compared to frms wt smlar earnngs patterns from te two dvsons. Furter, f te synergy loss between te two dvsons nvolved n a restructurng s low wle te two dvsons are n unrelated ndustres (so tat te reducton n outsders' nformaton producton cost due to te restructurng s lkely to be g), te frm s more lkely to coose a spnoff rater tan a carve-out. In contrast, f te potental synergy loss due to a spn-off s lkely to be g, te frm s lkely to coose a carve-out, especally f te two dvsons nvolved are n related ndustres (so tat te ncremental reducton n outsders' nformaton acquston costs from a spn-off over a carve-out s low). We can tnk of trackng stock ssues as a restructurng mecansm were te synergy loss s even smaller compared to carve-outs, but were tere s a less substantal reducton n outsders' nformaton acquston costs. Tus, n te rare nstances were frm nsders feel tat potental synergy loss arsng from spn-offs and carve-outs are lkely to be very g, but tere s neverteless te need to ncrease nformaton producton by outsders, te frm wll coose to ssue trackng stock rater tan mplementng a spnoff or a carve-out. () Market reacton to te announcements of spn-offs, carve-outs, and trackng stock ssues: Our model predcts tat te market reacton to te announcement of a spn-off wll be postve, and tat te stock market reacton to a spn-off wll be more favorable on average tan tat to a carve-out or to a trackng stock ssue. Evdence consstent wt ts predcton s provded by Hte and Owers (98), Mles and Rosenfeld (98), Scpper and Smt (98), Daley et al. (997), Anecdotal evdence seems to support ts predcton. For example, Georga-Pacfc offers trackng stock on ts tmber operatons because te earnngs on ts pulp, paper, and buldng products busnesses are too volatle (te Wall Street Journal, Sept. 8, 997). Ts predcton s dfferent from te predcton tat we wll see more focus-ncreasng tan non-focus-ncreasng restructurngs, snce, even f a frm's two dvsons operate n te same ndustry, ter earnngs patterns can be very dfferent. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx Krsnaswam and Subramanam (999), and Desa and Jan (999) for spn-offs, and Scpper and Smt (986), Allen and McConnell (998), and Vj (00) for carve-outs. Evdence comparng te announcement effect of spn-offs wt carveouts and trackng stock ssues s provded by Cemmanur and Paegls (00), wose fndngs also broadly support our model predctons. () Comparson of te market reacton to announcements of focus-ncreasng versus non-focus-ncreasng spn-offs, carve-outs, and trackng stock ssues: Our model predcts tat te ger te reducton n outsders' cost of nformaton producton due to a restructurng, te ger te announcement return (see Proposton 4). Snce focus-ncreasng forms of restructurng are assocated wt ger reductons n outsders' cost of producng nformaton about ntrnsc frm value, we predct tat focus-ncreasng restructurng leads to ger announcement returns compared to non-focus-ncreasng ones. Ts s consstent wt te fndngs of Vj (00) for carve-outs, and Daley et al. (997) and Desa and Jan (999) for spn-offs. Ts predcton s also consstent wt Burc and Nanda's (00) fndng tat te value ncrease after spn-offs s postvely related to te degree of dvsonal dversty of frms pror to spn-offs. (v) Two-stage combnaton carve-outs and spn-offs: Our analyss provdes a ratonale for te wdely observed practce of frms frst mplementng a carve-out, and ten, after one or two years, mplementng a spn-off of te equty eld by te parent frm to sareolders (see, e.g., Tompson and Aplado, 006). Wle ts practce may at frst seem puzzlng (wy not mplement a spn-off rgt away and let te ndvdual frms rase any external fnancng requred?), our teoretcal analyss ndcates tat ts s te rgt strategy n terms of preservng synerges n te sort-run. By dong a carve-out, te frms are mnmzng sort-run synergy losses. As te two frms (dvsons) resultng from a carve-out buld separate facltes wc were prevously sared (say, n about two years after te carve-out), te potental synergy losses tat would result from a spn-off become smaller, wle tere are stll ncremental nformaton producton benefts to be ganed from a spn-off over a carve-out. At ts stage, te parent frm wll mplement a spn-off of te equty t olds n te carved-out frm to ts sareolders, tus reapng te ncremental benefts arsng from te ncreased nformaton producton resultng from a pure spn-off. In summary, two-stage restructurng may be a mecansm troug wc frms can reap te valuaton benefts of ncreased nformaton producton wle mnmzng te synergy losses arsng from te restructurng. (v) Te cange n nformaton asymmetry, level of nformaton producton, and te announcement effect of spn-offs, carve-outs, and trackng stock ssues: Our model predcts tat te ger te reducton n nsttutonal nvestors' nformaton producton costs after a restructurng, te ger te announcement return (see proposton 4). Te fndngs of Fu (00) on carve-outs and Krsnaswam and Subramanam (999) on spn-offs support ts predcton. Proposton of our model predcts tat te amount of nformaton producton wll be ger about frms conductng a spn-off, a carve-out, or a trackng stock ssue compared to tat about consoldated frms. Furter, ncreased nformaton producton wll lead to more nformatve stock prces, reducng te level of nformaton asymmetry facng tese frms n te equty market. Consstent wt ts predcton, several studes fnd eter ncreased analyst coverage or reducton n nformaton asymmetry (or bot) for frms after restructurng. Cemmanur and Paegls (00) fnd tat analyst coverage ncreases for frms subsequent to spn-offs, carve-outs, and trackng stock ssues. Oter evdence ncludes Fu (00) for carve-outs, Krsnaswam and Subramanam (999) and Huson and MacKnnon (00) for spn-offs, Glson et al. (00) for focus-ncreasng trackng stock offerngs, carve-outs, and spn-offs, and Zuta (999) for trackng stock ssues. Our model also predcts tat te greater te reducton n outsders' nformaton producton costs due to a restructurng, te greater te ncrease n te level of nformaton producton subsequent to te restructurng (see proposton 4). Fu (00) fnds tat te reducton n nformaton asymmetry s more pronounced wen a carve-out s ntended to refocus te parent's operatons, and Huson and MacKnnon (00) fnd smlar results for spn-offs. Tese fndngs are consstent wt te predctons of our model, snce focus-ncreasng restructurng are lkely to be assocated wt a larger reducton n outsdes' nformaton producton costs compared to non-focusncreasng ones. (v) Insttutonal tradng around spn-offs, carve-outs, and trackng stock ssues: Our model as several predctons for te tradng beavor of nsttutonal nvestors around restructurng. Frst, our model predcts tat, of te nsttutonal nvestors tradng n te equty of te consoldated frm, a certan fracton wll trade predomnantly n te equty of te parent after a restructurng, wle te remanng fracton wll trade predomnantly only n te equty of te subsdary (gven tat dfferent groups of nsttutonal nvestors ave a comparatve advantage n producng nformaton about dfferent parts of te frm). Second, our model predcts tat, gven tat nsttutonal nvestors produce addtonal nformaton after a restructurng, te extent of nsttutonal net buy (extent of equty bougt mnus equty sold) n te equty of te two frms resultng from a restructurng wll be postvely related to te long-term operatng performance and stock returns of tese two frms: n oter words, nsttutonal tradng wll ave predctve power for subsequent returns. Fnally, te predctve power of nsttutonal tradng wll be greater for a spn-off rater tan for a carve-out or a trackng stock ssue (snce nsttutonal nvestors collectvely produce more nformaton subsequent to a spn-off compared to tat after a carve-out or a trackng stock ssue). Evdence consstent wt te frst two predctons stated earler s provded by Cemmanur and He (008), wo specfcally test te predctons of our model usng te Abel-Noser database of nsttutonal tradng. (v) Comparson of operatng performance n spn-offs versus carve-outs and trackng stock ssues: Wle we do not explctly model mprovements n operatng performance subsequent to restructurng, our results are consstent wt mprovements n operatng performance after all tese forms of restructurng, and also ave ndrect predctons for te relatve magntude of Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx operatng performance mprovements after spn-offs, carve-outs, and trackng stock ssues. Our model predctons are consstent wt te mprovements n operatng performance followng a restructurng beng greatest for spn-offs, less for carve-outs, and te least for trackng stock ssues. Furter, wtn a gven form of restructurng, our analyss mples tat performance mprovements wll be greater for focus-ncreasng rater tan non-focus-ncreasng restructurng. Ts s because, gven tat te extent of ncrease n nformaton producton over a consoldated frm s greatest after spn-offs, less n carve-outs, and least after trackng stock ssues, te long-term (tme n our model) stock prce wll reflect te operatng performance of ndvdual dvsons (frms) most closely (.e., wt te least nose) after a spn-off and wll be more nosy after carve-outs and trackng stock ssues. Tus, our model mples tat stock-based ncentve compensaton for managers wll be most effectve n mprovng operatng performance after a spn-off and less effectve n te case of carve-outs and trackng stock ssues. Smlar arguments apply for te relatonsp between performance mprovement n focus-ncreasng versus non-focus-ncreasng restructurng. Evdence consstent wt operatng performance mprovements followng spnoffs s provded by Cemmanur and Nandy (006), Daley et al. (997), and Desa and Jan (999). Daley et al. (997) and Desa and Jan (999) document tat performance mprovements for non-focus-ncreasng spn-offs are smaller relatve to focus-ncreasng ones; Mcaely and Saw (995) document tat performance mprovements are smaller for carve-outs. Fnally, Hausalter and Mkkelson (00) document tat trackng stock ssues exbt smaller performance mprovements compared to spn-offs and carve-outs. 6. Concluson Ts paper as developed a teory of te role of nsttutonal nvestors and afflated analysts n corporate restructurng, and as analyzed a frm's coce between spn-offs, carve-outs, and trackng stock ssues, for te frst tme n te lterature. We consder a settng wt a contnuum of frm types were nsders of a frm wt two dvsons ave prvate nformaton about ter true values and face an equty market consstng of retal nvestors (lqudty traders) and nsttutonal nvestors. Insttutonal nvestors may engage n costly nformaton producton about te dvsons of te frm, wt some nvestors avng a comparatve advantage n producng nformaton about dvson, and oters avng a smlar comparatve advantage for dvson. We sow tat, n te descrbed settng, restructurng ncreases nformaton producton by nsttutonal nvestors (relatve to tat about a consoldated frm), wt te gest ncrease n nformaton producton assocated wt spn-offs, te next gest assocated wt equty carveouts, and te lowest assocated wt trackng stock ssues. In equlbrum, nsders wt te most favorable prvate nformaton coose to mplement spn-offs; tose wt less favorable prvate nformaton mplement carve-outs; tose wt even less favorable prvate nformaton mplement trackng stock ssues; and tose wt unfavorable prvate nformaton retan a consoldated structure. In addton to explanng te postve announcement effect and te ncrease n analyst coverage tat as been emprcally documented followng all tree forms of restructurng, our model generates a number of novel testable predctons for frms' coce between spn-offs, carve-outs, and trackng stock ssues, and for nsttutonal tradng around tese tree forms of restructurng. Acknowledgments For elpful comments and dscussons, we tank Brent Ambrose, Paul Clds, Hujng Fu, San He, Yawen Jao, Brad Jordan, Anzela Knyazeva, Dong Lee, De Lu, Ron Mcaely, Joe Peek, Mcael Rebello (te WFA dscussant), and Tong Yao. We also tank semnar partcpants at Boston College, Pekng Unversty, Unversty of Kentucky, te Western Fnance Assocaton meetngs, te Fnancal Management Assocaton meetngs, and te Cna Internatonal Conference n Fnance n X'an for elpful comments. Specal tanks to an anonymous referee and te edtor, Annette Poulsen, for very useful comments. All errors and omssons are our own. Appendx A. Proofs of Lemmas and Propostons Proof of Lemma. At tme, f a frm remans consoldated, te market knows tat te frm type s between 0 and q, and te probablty of tme- cas flow beng X H s q 0 pdp = q. Consder te followng four cases: q 0 dp ). Wt probablty q 4 =αx H and x =( α)x H, so tat te total order flow s unformly dstrbuted on te nterval [ + +,+ + ]. ). Wt probablty q q [ +,+ ]. ). Wt probablty q q [ +, + ]. v). Wt probablty q [, ]. =αx H and x =( α)x L, so tat te total order flow s unformly dstrbuted on te nterval =αx L and x =( α)x H, so tat te total order flow s unformly dstrbuted on te nterval, x =αx L and x =( α)x L, so tat te total order flow s unformly dstrbuted on te nterval Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

4 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx Snce te two dvsons are symmetrc ex ante, we can assume tat te parameters are suc tat. Unnformed nsttutonal nvestors (UIIs from now on) set te sare prce as follows:. Wen yn+, te UIIs know tat x =αx H and x =( α)x H, and te reasonng s as follows: f t s not true tat x =αx H and x =( α)x H, ten z +z, and terefore y +, wc contradcts yn+. Te UIIs wll terefore set a prce of X H.. Wen + by +, te UIIs know tat wt probablty q =αx H and x =( α)x H, and wt probablty q =αx H and x =( α)x L. Te UIIs wll terefore set a prce of αx H + ð αþ q XH + q X L.. Wen by +, te UIIs know tat wt probablty q 4 q =αx H and x =( α)x H, wt probablty q, 4 q x =αx H and x =( α)x L, and wt probablty q 4 q =αx L and x =( α)x H. Te UIIs wll terefore set a prce of X H + ð q ÞX L. 4 q 4. Wen + + by, te UIIs know tat wt probablty q, x =αx H and x =( α)x H, wt probablty q q =αx H and x =( α)x L, wt probablty q q =αx L and x =( α)x H, and wt probablty q, x =αx L and x =( α)x L. Te UIIs wll terefore set a prce of q XH + q X L. 5. Wen + by + +, te UIIs know tat wt probablty q +q =αx L and x =( α)x H, wt probablty q +q =αx H and x =( α)x L, and wt probablty q +q =αx L and x =( α)x L. Te UIIs wll terefore set a prce of q X H +X L. +q 6. Wen + by +, te UIIs know tat wt probablty q =αx L and x =( α)x H, and wt probablty q =αx L and x =( α)x L. Te UIIs wll terefore set a prce of αx L + ð αþ q XH + q X L. 7. Wen y +, te UIIs know tat x =αx L and x =( α)x L. Te UIIs wll terefore set a prce of X L. To calculate te expected proft of eac type and type trader, consder te followng four cases: (). Wt probablty q, x =αx H and x =( α)x H. Te order flow from nformed traders are z = and z =. Snce te aggregate order flow from pure lqudty traders s unformly dstrbuted over [, ], te dstrbuton of te total order flow observed by UIIs s as follows: y ( +,+ + ] wt probablty, y ( +,+ ] wt probablty, y (, + ] wt probablty, and y [ + +, ] wt probablty. Te expected condtonal profts for eac type and type trader are terefore: E π jx = αx H ; x = ð αþx H = E π jx = αx H ; x = ð αþx H = q X H X L ð Þð αþ + + 4 q : (). Wt probablty q q =αx H and x =( α)x L. Te order flow from nformed traders are z = and z =. Te dstrbuton of te total order flow observed by UIIs s as follows: y ( +,+ ] wt probablty, y (, + ] wt probablty, y [ + +, ] wt probablty, and y ( +, + + ] wt probablty. Te expected condtonal profts for eac type and type trader are terefore: E π jx = αx H ; x = ð αþx L = E π jx = αx H ; x = ð αþx L = ð Þ q ð αþ XH X L ð4α αq + Þ X H X L 4 q + ð Þ α q X H X L ðα + αq + q Þ X H X L : +q (). Wt probablty q q =αx L and x =( α)x H. Te order flow from nformed traders are z = and z =. Te dstrbuton of te total order flow observed by UIIs s as follows: y (, + ] wt probablty, y [ + +, ] wt probablty, y ( +, + + ] wt probablty, and y ( +, + ] wt probablty. Te expected condtonal profts for eac type and type trader are terefore: E π jx = αx L ; x = ð αþx H = E π jx = αx L ; x = ð αþx H ð q = 4α + αq Þ X H X L ð Þ α q X H X L 4 q ð α αq Þ X H X L +q ð Þ q ð αþ X H X L Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005 :

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx (v). Wt probablty q, x =αx L and x =( α)x L.Teorderflow from nformed traders are z = and z =.Te dstrbuton of te total order flow observed by UIIs s as follows: y [ + +, ] wt probablty, y ( +, + + ] wt probablty, y ( +, + ] wt probablty,andy (, + ] wt probablty. Te expected condtonal profts for eac type and type trader are terefore: E π jx = αx L ; x = ð αþx L = E π jx = αx L ; x = ð αþx L = q XH X L ð Þð αþ + + +q : 5 Te (uncondtonal) expected profts of eac type and type trader are q ð q Þ X H X L αð Þ 8+q q +q q E½π Š = 4 q ð Þð+q Þ and E½π Š = q ð q Þ X H X L ð αþ 8+q q +q q : 4 q ð Þð+q Þ In equlbrum, we ave E[π ]=C and E[π ]=C, wc lead to C 4+4q q α 8+q q + q q α 6 + 0q 5q = αq ð q Þ X H X L +q q α +q q C αq ð q Þ X H X L + α 8+q q ða:þ and 8+q q ð αþ C 8+q q = 4+4q q q X H X L 4+q 4q + : ða:þ q Te proof of Eq. (6) s smlar to tat of Eq. (7). Q.E.D. Proof of Lemma. At tme, f a frm conducts a spn-off, te market knows tat te frm type s between q and, and te probablty of tme- cas flow beng X H s pdp q = +q. Type nformed traders trade te sares of dvson 's stock wle type dp q nformed traders do not. Type nformed traders know te true values of te tme- cas flow and eac can trade sares, so te α total order flow for dvson 's stock from type nformed traders s z = α wen x =αx H and z = α wen x =αx L, were s te number of type nformed traders. Te UIIs observe te total order flow for dvson 's stock from te lqudty and nformed traders, y =u+z. Wen y N α, te UIIs know tat x =αx H, and te reasonng s as follows: f x =αx L, ten z = α, and y = u + z α (snce u ). Terefore, y N α reveals to UIIs tat x =αx H. Smlarly, wen y b + α, UIIs know tat x =αx L. Wen y + α ;, UIIs learn notng from te order flow. Consder te followng four cases: α () wt probablty +q α =αx H, and u N α, so tat y N α and te prce of te stock s V S =α(x H W). Eac nformed trader earns zero proft n ts case. () Wt probablty +q α =αx H, and ub α, so tat y + α ; and te α prce of te stock s V S = α +q X H + q XL W. Eac nformed trader earns a proft of q X H X L n ts case. () Wt probablty q α =αx L, and ub + α, so tat y b + α and te prce of te stock s V S =α(x L W). Eac nformed trader earns zero proft n ts case. (4) Wt probablty q α =αx L, and u N + α, so tat y + α ; and α te prce of te stock s V S = α +q X H + q XL W. Eac nformed trader earns a proft of +q X H X L n ts case. Te expected proft for eac type nformed trader s terefore gven by E π S = q X H X L α ; ða:þ Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

6 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx wc decreases wt. Snce te market for nformaton producton s perfectly compettve, te number of nformed traders s suc tat te expected proft from producng nformaton equals te cost of dong so,.e., E π S = C ; wc leads drectly to " # C = α q X H X L ; ða:4þ and smlarly, " # C = ð αþ : ða:5þ q X H X L Frm nsders' expected market value of dvson of a type p frm at tme s α +q X H + q + ð pþ α αxl + ð pþ α = px H + ð pþx L + ðα Þ +q EV p;s = p α αxh + p α XL α +q X H + q X H + q XL XL αw: αw Smlarly, frm nsders' expected market value of dvson of a type p frm at tme s EV p;s = px H + ð pþx L ð Þ +q + α X H + q XL ð αþw: Te expected combned market value of te type p frm at tme s E[V p, S ]=E[V p, S ]+E[V p, S ], wc leads to Eq. (7). Smlar to te proof of te case were te frm conducts a spn-off, we can sow tat, f a frm conducts a carve-out at tme, te numbers of type and type traders are gven by " C b = α b # ðq + q Þð q q Þ X H X L ; ða:6þ " C b = ð αþ b # ðq + q Þð q q Þ X H X L ; ða:7þ and te expected combned market value of te two dvsons of te type p frm at tme s EV p;c = b + b Þ px H + ð pþx L q + q + b b X H + q q X L b W: If a frm conducts a trackng stock ssue at tme, te numbers of type and type traders are gven by " # = α ðq + q Þð q q Þ X H X L ; ða:8þ " = ð αþ C # ðq + q Þð q q Þ X H X L ; ða:9þ and te expected combned market value of te two dvsons of te type p frm at tme s Q.E.D. EV p;c = + px H + ð pþx L + q + q X H + q q X L W: Proof of Proposton. At tme, f a frm announces a spn-off, outsders' equlbrum nference s tat te frm type s between q and. Te market value of te frm s ten +q X H + q XL W. Smlarly, f a frm announces a carve-out, te market value Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx 7 of te frm s q + q X H + q q X L W. b If a frm announces a trackng stock ssue, te market value of te frm s q + q X H + q q X L W. Ifafrm does not announce a restructurng, outsders nfer ts market value to be q XH + q XL. Te utlty of a type p frm from coosng a spn-off s U S ðpþ = γ +q X H + q XL W + ð γþ ½ + Š px H + ð pþx L + ð Þ +q X H + q XL W and te utlty of te type p frm from coosng a carve-out s U C ðpþ = γ q + q X H + q q X L W b + ð γþ b + b px H + ð pþx L + b b q + q X H + q q X L Incentve compatblty condtons requre tat frms wt type p [q,] prefer a spn-off to a carve-out, and frms wt type p [q,q ) prefer a carve-out to a spn-off:.e., U S (p) U C (p) 0 for p [q,] and U S (p) U C (p) 0 for p [q,q ). Note tat ð q U S ðpþ U C Þ X H X L ðpþ = γ + ð γ Þf + b b px H + ð pþx L + ð Þ +q X H + q XL b b q + q X H + q q X L g W + W; b wc ncreases n p snce N b and N b under condton (A.). Terefore, f U S (p=q ) U C (p=q )=0, te ncentve compatblty condtons old for all p [q,]. U S (p=q ) U C (p=q )=0 leads to ð q Þ X H X L γ + ð γ 8 < αc Þ + ð αþc + : ð+q Þ ðq q : b W Þ αc b + ð αþc b 9 = ð q q Þðq + q Þ ; + W W b =0: ða:0þ : Smlarly, ncentve compatblty condtons requre tat frms wt type p [q,q ) prefer a trackng stock ssue to a carve-out, and frms wt type p [q,q ) prefer a carve-out to a trackng stock ssue, wc olds wen U T (p=q ) U C (p=q ) =0 under condton (A.4). Ts leads to te condton ðq q Þ X H X L γ + ð γ 8 ðq q Þ αc b + ð αþc b < Þ + : ð q q Þðq + q Þ 9 Þ α C + ð αþ C = ð q q Þðq + q Þ ; + W W b =0: ða:þ ðq q Incentve compatblty condtons requre tat frms wt type p [q,q ) prefer a trackng stock ssue to a consoldated frm, and frms wt type p [0,q ) prefer a consoldated frm to a trackng stock ssue, wc olds wen U T (p=q ) U N (p=q )=0 under condtons (A.5) and (A.6). Ts leads to te condton q X H X L γ + ð γþ + ð γ α ð Þ X H X L ð q Þ q +4C +q q 44+q 4q + q ðq q Þ α C + ð αþ C Þ ð q q Þðq + q Þ W =0: +C 4 q + q Te values of q, q, and q are smultaneously determned by Eqs. (A.0) troug (A.). Te condtons W N W N W b N W N W ensure tat q (0,), q (0,), and q (0,), were W and W are defned n Eqs. (A.) and (A.7). Q.E.D. Proof of Proposton. Te amount of nformed tradng from type nvestors n spn-offs, carve-outs, and trackng stock ssues are α, b α, and α, respectvely, because eac type nvestor s allowed to trade sares of dvson 's stock. In contrast, te amount α of nformed tradng from type nvestors n a consoldated frm s because eac type nvestor s allowed to trade one sare of te consoldated frm's stock. Smlarly, te amount of nformed tradng from type nvestors are α, b α, α, and, respectvely. From Eqs. (A.4), (A.5), (A.6), and (A.7), we know tat " # b C = α C ðq + q Þð q q Þ X H X L q X H X L ; ða:þ Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

8 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx and " b C = ð αþ b # C ðq + q Þð q q Þ X H X L : q X H X L Te condton ( ) q N ð q q Þðq + q Þmax C ; C bc bc ensures tat α N b α and α N b α. Smlarly, te condton ( ) C ð q q Þðq + q ÞN ð q q Þðq + q Þmax b C ; b C C ensures tat b α N α and b α N. Te condtons α C C 4+4q q α 8+q q N ðq + q Þð q q Þ X H X L αq ð q Þ X H X L +q q + q q α 6 + 0q 5q + α 8+q q C α +q q αq ð q Þ X H X L ða:þ ða:4þ ða:5þ and C 8+q q ð αþ C 8+q q N ðq + q Þð q q Þ X H X L 4+4q q q X H X L 4+q 4q + ða:6þ q ensure tat α N and α N. Q.E.D. Proof of Corollary. Wen C = C and C = C, condton (A.5) becomes C C 4+4q q α 8+q q N ðq + q Þð q q Þ X H X L αq ð q Þ X H X L +q q + q q α 6 + 0q 5q + α 8+q q C ; α +q q αq ð q Þ X H X L ða:7þ and condton (A.6) becomes C 8+q q ð αþ C 8+q q N ðq + q Þð q q Þ X H X L 4+4q q q X H X L 4+q 4q + : ða:8þ q Terefore, we ave α N and α N wen C = C and C = C under condtons (A.7) and (A.8). Proof of Proposton. Te frm value at tme 0 s te expected value of te frm's tme- market value:.e., V 0 = q 0 q XH + q + q q + q q XL dq + q q + q q X H + q q X L W dq X H + q q X L W b = XH + XL ðq q Þ W ðq q ÞW b ð q ÞW: dq + +q q X H + q XL W dq Te market value of a frm announcng a spn-off s V S = +q X H + q XL W; Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx 9 wc mples a market value cange of and and ΔV S = V V S 0 = q XH X L + ðq q Þ W + ðq q ÞW q b W: Smlarly, ΔV C = V C V 0 = q + q ΔV T = V T V 0 = q + q Under condtons q q q X H X L X H X L q + q X H X L X H X L + ðq q Þ W + q + q + ð q + q Þ W + q q ð ÞW b + ð q ÞW; ð ÞW b + ð q ÞW: + ðq q ÞW W b N 0; ða:9þ + ðq q Þ W + ð q +q ÞW b N 0; ða:0þ X H X L we ave ΔV S NΔV C NΔV T N0. Q.E.D. + ð q + q Þ W + ðq q ÞW b + ð q ÞW N 0; ða:þ Proof of Proposton 4. Defne ΔC =C C. It s obvous from Eq. (A.4) tat C b0, wc mples N 0. Tat s, te amount of ΔC nformed tradng n a spn-off ncreases n te reducton n type nvestors' nformaton producton cost. Because g qualty frms beneft more from nformed tradng tan low qualty frms, te value of q wll ncrease wen tere s more nformed q tradng:.e., ΔC N 0. By te can rule, we ave V S = V S q C C q ΔC N 0 snce V S = XH X L V N 0. Te proofs of S N 0, q C C V C N 0, V C N 0, V T N 0, and V T N 0 are smlar. Q.E.D. C C b C C b C C C C Proof of Proposton 5. After a frm mplements a spn-off at tme, nformed type nsttutonal nvestors observe te tme- cas flow of dvson, and tey collectvely place an order of z = α wen x =αx H and z = α wen x =αx L. Followng cases () to (4) outlned n te proof of Lemma, te market prce of dvson s EV S = X H + ðα Þ +q X H + q XL αw wen z = α and EV S wen z = α = X L + ðα Þ +q X H + q XL αw S E V :.e., N 0. Te proofs of EV S N 0, EV C N 0, EV C N 0, EV T N 0 and EV T N 0 are smlar. Q.E.D. z z z z z z Proof of Proposton 6. In te equlbrum n wc all frms reman consoldated, te market value of a type p frm tat remans consoldated s XH + XL at tme, and te expected market value s ½α + ð αþ Š px H + ð pþx L + ½ α ð αþ Š at tme. If te type p frm cooses te out-of-equlbrum strategy and conducts a spn-off, XH + XL te market value s X H W at tme, and te expected market value s also X H W at tme (no nformaton producton n ts case snce te expected proft s 0 for nformed traders due to te fact tat te tme- cas flow of te frm wll be X H for sure). Te ncentve compatblty condton s terefore γ 0:5X H +0:5X L + ð γþf½α + ð αþ Š px H + ð pþx L + ½ α ð αþ Š 0:5X H +0:5X L g N X H W for all p [0,]. Snce te left sde of te gven condton s ncreasng n p, as long as te ncentve compatblty condton olds for p=0, te condton olds for all p [0,]. Furtermore, te numbers of type and type nformed traders are gven by = C ; α X H X L ; ða:þ Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

0 T.J. Cemmanur, M.H. Lu / Journal of Corporate Fnance xxx (00) xxx xxx C = : ð αþ X H X L Pluggng te value of,, and p=0 n condton (A.) yelds te value of W W = γ X H X L + ð γþ X H X L C C : ða:þ Wen W N W b N W N W N W, te synergy loss s too g n spn-offs or carve-outs, but not n trackng stock ssues. Terefore, frms wt type p [q T,] coose a trackng stock ssue to ncrease outsder nformaton producton to separate temselves from low qualty frms. Frms wt type p [0,q T ) coose to reman consoldated because tey beneft less from more nformed tradng and remanng consoldated can avod te synergy loss. In ts equlbrum, at tme, f a frm announces a trackng stock ssue, outsders' equlbrum nference s tat te frm type s between q T and. Te market value of te frm s ten +q T X H + qt XL W. Smlarly, f a frm remans consoldated, outsders nfer ts market value to be qt XH + qt XL. Smlar to te arguments outlned n te proof of proposton, te value of q T s determned by U T (p=q T ) U N (p=q T )=0. Followng te same arguments, wen WN W N W b N W N W, te synergy loss s too g n spn-offs, but not n carve-outs or trackng stock ssues. Frms wt type p q T ; coose a carve-out, frms wt type p ½ q T ; q T Þ coose a trackng stock ssue, and frms wt type p ½0; q T Þ coose to reman consoldated. Q.E.D. Proof of Proposton 7. In te equlbrum n wc all frms conduct a spn-off, te equlbrum market value of a type p frm s XH + XL W at tme, and te expected market value s + px H + ð pþx L + XH + XL W at tme, were " # = α C X H X L ða:4þ and " # = ð αþ C X H X L : ða:5þ If te type p frm cooses te out-of-equlbrum strategy and remans consoldated, te market value at tme s X L, and te expected market value at tme s also X L (no nformaton producton n ts case snce te expected proft s 0 for nformed traders due to te fact tat te tme- cas flow wll be X L for sure). Te ncentve compatblty condton s terefore γ XH + XL W + ð γþ ð + Þ px H + ð pþx L + ð Þ XH + XL W N X L ða:6þ for all p [0,]. Snce te left sde of te gven condton s ncreasng n p, as long as te ncentve compatblty condton olds for p=0, te condton olds for all p [0,]. Pluggng te values of,, and p=0 n Eq. (A.6) yelds te value of W W = γ X H X L + ð γþ½αc + ð αþc Š: ða:7þ Wen W N W N W N W b N W, te synergy loss s moderate n spn-offs and low n carve-outs or trackng stock ssues, frms wt type p [q S,] coose a spn-off to separate temselves from lower types. All oter frms (type p [0,q S )) pool togeter by coosng a carveout. No frm as an ncentve to coose a trackng stock ssue or a consoldated frm because dong so wll reveal tem to be te lowest frm type. If te loss of synergy smoderate n spn-offs and carve-outs and low n trackng stock ssues so tat W N W N W b N W N W, ten frms wt type p q C ; coose a spn-off, frms wt type p ½ q C ; q C Þ coose a carve-out, and frms wt type p ½0; qc Þ coose a trackng stock ssue. Te lowest frm types fnd tat mmckng troug a carve-out s too costly and tey fnd t optmal to conduct a trackng stock ssue to pool wt frms wt ger ntrnsc values. Q.E.D. References An, S., Dens, D., 004. Internal captal markets and nvestment polcy: evdence from corporate spnoffs. Journal of Fnancal Economcs 7, 489 56. Allen, J., McConnell, J., 998. Equty carve-outs and manageral dscreton. Journal of Fnance 5, 6 86. Allen, J., Lummer, S., McConnell, J., Reed, D., 995. Can takeover losses explan spn-off gans? Journal of Fnancal and Quanttatve Analyss 0, 465 485. Aron, D.J., 99. Usng te captal market as a montor: corporate spnoffs n an agency framework. Rand Journal of Economcs, 505 58. Bllet, M.T., Mauer, D.C., 000. Dversfcaton and te value of nternal captal markets: te case of trackng stock. Journal of Bankng and Fnance 4, 457 490. Boot, A., Takor, A., 99. Securty desgn. Journal of Fnance 48, 49 78. Burc, T., Nanda, V., 00. Dvsonal dversty and te conglomerate dscount: evdence from spn-offs. Journal of Fnancal Economcs 70, 69 98. Cemmanur, T., He, S., 008. Insttutonal tradng, nformaton producton, and corporate spn-offs. Workng paper. Boston College. Cemmanur, T., Nandy, D., 006. How are value created n corporate spn-offs? A look nsde te black box. Workng paper, Boston College. Please cte ts artcle as: Cemmanur, T.J., Lu, M.H., Insttutonal tradng, nformaton producton, and te coce between spn-offs, carve-outs, and trackng stock ssues, J. Corp. Fnance (00), do:0.06/j.jcorpfn.00.07.005

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