C. Risks Specific to StubsSince our sample is so small, it is useful to discuss some events that did not
occur but might be expected to occur in a larger sample. Events that might
have a negative impact on arbitrage investors include canceling the spin-off
or changing the distribution ratio by lowering the number of subsidiary
shares that each parent shareholder receives. If the expected ratio changes,
then the stub can go from negative to positive without any change in prices.
Cancelation of the distribution can occur for several reasons. First, if the
firm does not receive IRS approval, the spin-off is not tax-free and will prob-
ably be canceled. Our impression is that IRS rejection is a low-probability
event. Second, the firm might change its mind and cancel the spin-off even if
the IRS does approve. Although the parents in our sample stated their inten-
tion to distribute their ownership, this statement is not legally binding. An
example that occurred in our larger sample of eighteen carve-outs is Block-
buster. The parent, Viacom, stated in an SEC filing four months after the
carve-out that it would wait until Blockbuster’s share price was higher before
completing the separation. In this example, Viacom’s decision is not much of
a negative event for the stub strategy of shorting the subsidiary, since the dis-
tribution is canceled only in the state of the world in which the subsidiary
price remains low. Nevertheless, it is always possible for a canceled spin-off
to cause the trading strategy to reap negative returns.
Another reason a distribution can be canceled is a takeover by a third
party or shareholder pressure. We have already discussed the case of Xpe-
dior, whose parent was acquired. As shown in table 4.3, this acquisition did
not prevent the stub strategy from earning high returns. Another example
from our sample is PFSWeb. Prior to the carve-out the parent firm received
an unsolicited takeover bid that was conditional on canceling the spin-off,
and later a large shareholder in the parent publicly objected to the spin-off
and threatened legal action. Despite these events, the carve-out and distri-
bution took place as planned.
These examples highlight the fact that the trading strategy is not riskless.
It is worth noting, however, that many of these unpredictable events seem
likely to benefit strategies that buy parent shares and short subsidiary
shares. Takeover of the parent company (with the usual takeover premia),
shareholder pressure to increase value to parent shareholders, or cancela-
tion of the distribution due to low prices of the subsidiary all are positive
for the strategy.
Since returns are high and the risks seem both quite low and almost en-
tirely idiosyncratic, it appears that these subsidiaries are overpriced relative
to the parent shares. However, with only six pairs of firms and only twenty-
one months of returns, this evidence is not conclusive. It is possible that
there was some negative event capable of generating large losses to the arbi-
trage strategy that just did not come up during the period we studied. To
MISPRICING IN TECH STOCK CARVE-OUTS 147