reinventing a corporation: the “satellite” structure of thermo electron

Journal of Applied Corporate Finance S U M M E R 1 9 9 8 V O L U M E 1 1 . 2

Reinventing a Corporation: The ‘‘Satellite’’ Structure of Thermo Electron by Jeffrey Allen, Southern Methodist University

38JOURNAL OF APPLIED CORPORATE FINANCE

REINVENTING ACORPORATION: THE“SATELLITE” STRUCTUREOF THERMO ELECTRON

by Jeffrey Allen,Southern Methodist University*

38BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

*The central tenets of this article were first presented in my paper, “CapitalMarkets and Corporate Structure: The Equity Carve-outs of Thermo Electron,”published in Journal of Financial Economics, Vol. 48 (1998).

1. The Lucent Technologies and Allstate carve-outs rank as the largest IPOsto date in the U.S. These equity carve-outs by AT&T and Sears Roebuck weresubsequently followed by spin-offs of the majority interests held by the parentfirms.

2. “Keeping the Entrepreneurial Spirit Alive,” Harvard Business Review, 1995.

ince the early 1980s, there have beenover 600 initial public offerings by whollyowned units of corporations in the U.S.These subsidiary IPOs, commonly re-

company, which is engaged in several technology-oriented businesses, including the development andmanufacture of analytical, biomedical, recycling andenvironmental monitoring equipment, has com-pleted 19 carve-outs since 1983. A chart depicting theorganizational structure of the company is shown inFigure 1.

Besides the sheer number of carve-outs, therelationship between Thermo Electron and its pub-licly traded units is quite different from that of otherfirms and their carved-out subsidiaries. Managementof Thermo Electron does not view this “satellite”structure as an intermediate step in the eventualseparation of a division or subsidiary from theparent, but rather as an ongoing and continuouslyrepeatable organizational form. Also in contrast tothe practice of many companies, Thermo Electron’scarve-outs raise capital for the exclusive use of thesubsidiaries—no funds are received by or trans-ferred to the parent.

The structure devised by the company is in-tended to preserve the benefits enjoyed by smallentrepreneurial organizations without sacrificingmany of the advantages enjoyed by larger firms. Akey element in the approach is an incentive structurethat is tied directly to the equity performance of boththe public units and the parent. Referring to thecompany prior to the “satellite” era, CEO GeorgeHatsopoulos stated that “tying incentives to thecompany’s stock price was an ineffective way ofrewarding employees for their contributions—people’s rewards did not correspond to what hap-pened in their own part of the business.”2

ferred to as “equity carve-outs” or “spin-outs,” arequite different from either traditional IPOs or con-ventional, pro rata spin-offs. The most notabledifference in the case of equity carve-outs is thatparent companies typically retain majority owner-ship in the public subsidiaries following the restruc-turing. Nevertheless, subsidiary IPOs do tend toresult in significant increases in managerial au-tonomy since the public subsidiaries are generallygoverned by separate management teams and boardsof directors (though such boards often includerepresentatives nominated by the parent). Second,unlike conventional spin-offs, carve-outs raise newcapital—funds that are most often used for invest-ment purposes or to retire debt. Since carve-outs onaverage raise more than $80 million, the offering canbe an important source of capital for either the issueror the parent.

Equity carve-outs may also improve the visibil-ity of a particular unit with high growth potential, orthey may simply serve as the initial step in theeventual sale or spin-off of the assets. Notable equitycarve-outs in recent years include those of AssociatesFirst Capital and Hertz by Ford Motor Co., LucentTechnologies by AT&T, and Allstate Insurance andDean Witter by Sears Roebuck & Co.1

But far and away the most active firm in carvingout subsidiaries is Thermo Electron Corporation,which is based in Waltham, Massachusetts. The

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VOLUME 11 NUMBER 2 SUMMER 199839

Another important element in the structure ofthe company is that parent management is notdirectly involved in the day-to-day operation of thepublic subsidiaries. Autonomy in strategic decisions,capital acquisition, and capital spending is aimed atproviding the public subsidiaries with the flexibilityto respond quickly to changing market conditions.

Majority-owned units of the company are head-quartered in several states including Texas, NewMexico, California, Connecticut, and Minnesota, aswell as several in Massachusetts. Despite somegeographical dispersion and independent manage-ment teams, however, the public units are not fullyshielded from extensive scrutiny by the majorityshareholder. Representatives of the parent firm,including CEO Hatsopoulos, are on every board.Besides some oversight by headquarters, certainother potential advantages of large organizations areretained in the structure, including centralized re-porting, administrative, financial, and legal services.The company views such services as a valuable

resource to unit management that would not other-wise be available to independent companies ofsimilar size.

The combination of an entrepreneurial atmo-sphere with the financial and administrative sup-port of a larger organization is used extensively bythe company to attract and retain management andtechnical talent.3 Thermo Electron managementunderstands the importance of commercializingresearch and development projects, and the struc-ture of the organization is designed to attract, retain,and reward those individuals most directly involvedin this process. In fact, the company made theremarkable claim in a 1995 Forbes article that “nodeveloper or entrepreneur has ever left ThermoElectron.”

The eventual viability of this organizationalstructure ought to depend on its success in creatingvalue, maintaining growth, and retaining key em-ployees. Managers in virtually any industry will attestthat maintaining significant growth over time or

3. An article appearing in Institutional Investor (9/93) describes how “ThermoElectron’s divisions constantly compete to become the next (carve-out).”

FIGURE 1THERMO ELECTRONCORPORATION AND ITSPUBLICLY-TRADED UNITS*

*Dates are in month and year of each carve-out. Percentages are the fraction of outstanding shares held by the parent (directlyor combined with shares held by other Thermo units) as of 12/96.


consistently beating the average growth rates in anindustry is a challenging task. When evaluatedagainst these criteria, Thermo Electron has been verysuccessful in achieving and maintaining substantialrevenue and earnings growth, and, ultimately, increating value for its shareholders. From the firstcarve-out in 1983, the total return to Thermo share-holders has been almost four times that of a portfolioof comparable industry firms—and more than fivetimes the return of the S&P 500.

Of course, it is unlikely the success of thecompany can be attributed solely to the satelliteform of organization (or any other single factor).Nonetheless, the company’s board of directors isclearly conscious of the benefits of the unusualorganizational design, describing it in thecompany’s 1994 proxy statement as “the principalelement in the corporation’s success during thepast ten years.”

In this article, I describe the structure of ThermoElectron in more detail, examine the stock andoperating performance of the parent company andthe public subsidiaries, and elaborate on the benefitsand costs of such an unusual organizational design.I also examine several aspects of equity carve-outsthat I believe are crucial to completing a successfulrestructuring that will ultimately enhance the valueof shareholders’ investment.

BACKGROUND OF THERMO ELECTRON

George Hatsopoulos, an MIT researcher andprofessor of mechanical engineering, foundedThermo Electron in 1956. The original idea behindthe formation of the company was to develop acommercial application for thermodynamics—theconversion of heat directly into electricity. Thecompany went public in 1967 and listed on the NYSEin 1980.

The firm led a rather obscure existence in itsearly years. The stock appreciated only modestlyduring the first 15 years of trading, severely laggingthe S&P 500 index as well as a portfolio of firms inthe same industry. But then in the early 1980s, thecompany began to develop several new productsand technologies. One such product was a heart-assist pump that had been developed by VictorPoirier, a key employee the company wanted to

retain. The project required additional capital, sothe company offered 700,000 Thermedics sharesdirectly to the public in what was to become thefirst in a long series of equity carve-outs. In addi-tion to receiving capital for the project, Poirier alsoreceived options on an additional 20,000 shares. Ina unique departure from carve-outs completed byother firms, the Thermedics offering was precededby an issue of 80,000 shares to a venture capitalfirm—a practice that has continued in subsequentThermo carve-outs. Additional equity carve-outsfollowed in 1985, two in 1986, and 1987. The first“second generation” carve-out of a unit by a Thermopublic subsidiary occurred in 1989 when Thermedicsoffered a minority interest in its ThermoCardioSystems unit (the original heart-assist de-vice). Additional carve-outs from the parent or bythe public subsidiaries of the company have oc-curred in each year since 1991.4

The company and its subsidiaries currentlydevelop and manufacture environmental monitor-ing and analysis instruments, biomedical products,medical equipment and systems, recycling equip-ment, alternative energy systems, and industrialprocess equipment. In addition to the public subsid-iaries, which are all traded on the American StockExchange, the company conducts business throughwholly owned subsidiaries and subsidiaries that arepartially owned by private investors—principallyventure capitalists. Business units are deemed readyfor a carve-out when management expertise is inplace and the products or technologies of the unithold sufficient growth potential to attract capital ina public offering.

STOCK AND OPERATING PERFORMANCEOF THERMO ELECTRON

Value created for shareholders over extendedperiods is the ultimate criterion for evaluating corpo-rate success, especially returns in excess of themarket as a whole or other firms in comparable linesof business. Since the company’s first carve-out in1983, Thermo Electron shareholders have earnedreturns that have greatly exceeded those of either theS&P 500 Index or a portfolio of industry firms, not tomention the sparse returns earned by companyshareholders prior to the first carve-out.

4. Further information on the history of the company is detailed in a HarvardBusiness School case by Carliss Baldwin and Joetta Forsyth (1992).


Figure 2 tracks the changes in the value of a $100investment in the company from the date of the firstcarve-out (August 10, 1983) through the end of 1996.During this period, the nominal value of an invest-ment in Thermo Electron appreciated nearly 1900%!By comparison, an investment in a portfolio ofindustry firms had a total return of about 500% duringthe period—and the S&P index gained about 350%.By contrast, the total return to Thermo shareholdersfrom early 1969 (the first date Thermo stock priceswere reported in the Wall Street Journal) through theend of 1979 was a negative 8%.

Not surprisingly, the company has also achievedsubstantial growth in net revenues and earningssince 1984. Operating results for the company atthree-year intervals are shown in Table 1. Nominal

revenues were over 10 times greater in fiscal 1996than they were in 1983, the year of the first carve-out.Moreover, operating income as a percentage of netrevenue has more than doubled since 1981.

It should be noted that operating income as apercentage of the assets of the company has onlyrecently come close to the levels of the early 1980s.The decline and eventual rebound of this measureis due in large part to numerous acquisitions ofsmaller companies that Thermo Electron and theunits of the company have made in recent years.Since start-up firms with new technologies do notoften generate positive cash flow, the company hasabsorbed some assets without a correspondingearnings contribution. Nevertheless, the trend in thismeasure in recent years has been favorable.

TABLE 1CONSOLIDATEDOPERATINGPERFORMANCE OFTHERMO ELECTRON

FIGURE 2VALUE OF $100 INVESTEDIN THERMO ELECTRONSTOCK, AN EQUALLYWEIGHTED PORTFOLIO OFSIZE-MATCHED INDUSTRYFIRMS, AND THE S&P 500COMPOSITE INDEX*

*On the date of the carve-out of the Thermedics unit (8/10/83). Industry holding period return calculations assume quarterlyrebalancing and dividend payments are reinvested.

1981 1984 1987 1990 1993 1996

Net revenues 230.9 234.9 383.4 708.0 1354.5 2932.6Operating incomea / Net revenues 6.5% 7.2% 5.8% 8.0% 12.0% 13.6%Operating incomea / Assets 7.9% 8.7% 5.2% 6.3% 6.6% 7.7%Long-term debt / Assets .243 .227 .310 .234 .319 .301Interest Coverageb 2.98 2.24 3.37 3.44 4.07 4.13Market to Book 1.11 1.44 1.49 1.97 2.32 2.94Employees (K) 3.0 3.0 3.9 6.1 8.8 17.8

a. Earnings before interest, taxes, depreciation and amortization (EBITDA)b. EBITDA / Interest expense

The combination of an entrepreneurial atmosphere with the financial andadministrative support of a larger organization is used extensively by the company

to attract and retain management and technical talent. In fact, the company made theremarkable claim in a 1995 Forbes article that “no developer or entrepreneur has

ever left Thermo Electron.”


Financial leverage measured as book values oflong-term debt to total assets has increased to over30% in the 1990s. The use of debt by the company,however, is in line with firms in comparable indus-tries. Coverage of interest expense (EBITDA/inter-est), however, has increased in each of the reportingperiods dating back to 1984.

The market-to-book ratio, which many view asan estimate of the growth potential of the com-pany, has increased substantially since the early1980s. This increase may be due in part to theactive development of new technologies that werecreated or otherwise acquired by the company andits subsidiaries. The number of employees of theconsolidated firm has also grown exponentially sincethe mid-1980s.

STOCK AND OPERATING PERFORMANCE OFPUBLIC SUBSIDIARIES

From a conceptual view, the satellite structure isintended to create an environment where divisionalmanagers have both sufficient autonomy and powerfulincentives to innovate and respond to changes inmarket conditions. Although the stock performance ofThermo Electron dating back to the first carve-out hasbeen impressive, perhaps a more direct way to mea-sure the success of the satellite organizational model isto examine the value created by the public subsidiariesthemselves rather than the entire corporation.

Table 2 presents holding period stock returns tothe 19 Thermo Electron carve-outs during the initialfour years following their IPOs.5 The average return

TABLE 2PERCENTAGE STOCKRETURNS TO THERMOELECTRON PUBLICSUBSIDIARIES

5. For those subsidiaries that have not been public four years, stock returnsfrom the IPO through 6/30/97 are reported in the table.

Months Relative to Carve-Out

(0,12) (13,24) (25,36) (37,48) (0,48)

Thermedics –12.0 +123.8 +100.5 +1.0 +299.0Thermo Env. Systemsa –8.7 –36.3 +189.5 +6.2 +78.8Thermo Instrument Sys. +53.1 +11.7 +93.4 –24.2 +150.7Thermo TerraTechb –20.5 +36.2 +310.1 +4.4 +363.9Thermo Powerc –47.4 –11.9 +91.7 +17.4 +4.2Thermo Cardiosystems +73.5 +84.3 +25.8 +6.2 +327.3ThermoTrexd +28.9 +7.9 +14.9 +172.8 +335.7Thermo Fibertek +62.3 +12.5 +80.3 –21.5 +158.5Thermo Remediation +28.1 +34.4 –39.5 –21.1 –17.9ThermoLase +583.3 +32.9 –48.4 –25.3*

Thermo Ecoteke +51.0 +16.9 +21.7*

ThermoSpectra +3.6 –28.4 –3.6*

ThermoQuest +0.8 +19.8*

Thermo Sentron –41.4 –1.3*

Thermo Optek +0.9 +4.1*

Trex Medical –6.3 +6.2*

Thermo Fibergen –21.6 –5.0*

Thermo Bioanalysis +21.4 +15.4*

Thermedics Detection –10.9*

Average +38.8 +18.0 +69.7 +11.6 +188.9Average net of industry portfolio +25.7 +10.2 +72.0 +0.5 +160.0Average net of S&P 500 +19.8 +3.6 +51.2 –4.4 +103.2

a. Formerly Thermo Analytical, merged by Thermo Instrument Systems, 1/90b. Formerly Thermo Process Systemsc. Formerly Tecogen Inc.d. Formerly Thermo Electron Technologiese. Formerly Thermo Energy Systems*Through 12/97


gain during the four-year period was an impressive189%. In addition, the average raw return for thepublic subsidiaries is positive in each of the fouryears following the carve-outs. Moreover, at the timeof this study, eight of the nine carve-outs that havebeen public at least four years had achieved positivegains in stock values. The best-performing of thesenine carve-outs, the Thermo TerraTech unit, achieveda four-year return of 364% after going public.

For comparison purposes, the returns to aportfolio of industry firms and the S&P 500 indexwere subtracted from the returns of each of theThermo Electron public subsidiaries. In each annualperiod and in the entire four-year period followingthe carve-outs, the Thermo units outperformed bothbenchmarks with the exception of the S&P 500 inyear +4. The gain over the industry portfolio duringthe entire period was +160% while the gain in excessof the S&P 500 was +103%. The average holdingperiod stock returns of the carve-outs, industry firms,and the S&P 500 index during the initial five years oftrading in the public equity markets is also showngraphically in Figure 3.

In addition to exceptional stock performance, arecent study I conducted of Thermo Electron’spublicly traded subsidiaries found additional evi-dence of improvements in operations after goingpublic. For example, the public subsidiaries (and thecompany as a whole) have been very successful increating value from capital investments and research

& development expenditures. The ratio of expendi-tures on capital goods, R&D and in acquiring assetsoutside the company relative to total net assetsincreases dramatically following carve-outs from theparent.6 The units are also able to modestly reducethe cost of sales as a fraction of revenue followingcarve-outs, but these are offset by substantial in-creases in general and administrative spending.7

HOW CAN EQUITY CARVE-OUTSCREATE VALUE?

The eventual success of a carve-out in creatingvalue for shareholders is likely to depend on theability of the firm to capitalize on the benefits of thenon-traditional relationship between the unit andthe former parent firm as majority shareholder. Myown research suggests that there are five factors thatare crucial in whether or not carve-outs ultimatelycreate value for shareholders:

(1) the end-use of the offering proceeds by eitherthe parent or subsidiary;

(2) the extent of bureaucracies in the firm prior tothe carve-out;

(3) the retention of centralized functions or syner-gies between firms where appropriate;

(4) the extent of autonomy/decision rights grantedto unit management; and

(5) the ongoing nature of the relationship betweenthe unit and parent following the carve-out.8

FIGURE 3HOLDING PERIODRETURNS TO AN EQUALLYWEIGHTED PORTFOLIO OFTHERMO ELECTRONCARVE-OUTS, SIZE-MATCHED INDUSTRYFIRMS, AND THE S&P 500INDEX RELATIVE TO THEDATE OF THE CARVE-OUT

6. Some of this increase in investment spending, however, is likely due to thenature of the corporate development cycle of the newly public firms and not duesolely to restricted investment as wholly owned subsidiaries of Thermo Electron.

7. All public subsidiaries of the corporation participate in a corporate servicesagreement with the parent whereby the parent provides certain administrative andlegal functions to the units.

8. For a more detailed discussion of equity carve-outs and details on thefrequency of carve-outs, see the paper I co-authored with John McConnell,“Equity Carve-outs and Managerial Discretion,” Journal of Finance, Vol. 53(1998).

The “satellite” structure is intended to preserve the benefits enjoyed by smallentrepreneurial organizations without sacrificing many of the advantages enjoyed bylarger firms. A key element is an incentive structure that is tied directly to the equity

performance of both the public units and the parent.


These five aspects of carve-outs are not mutu-ally exclusive, and in the remainder of this article Iwill summarize how carve-outs can create value infour general categories: (1) organizational motives;(2) strengthening of incentives to increase value;(3) increased managerial autonomy; and (4) postcarve-out operational improvements.

Organizational Motives and Decision-MakingRights

In both my own and others’ studies of equitycarve-outs, we find evidence that equity carve-outsoften occur when parent firms are performing poorlyor have extensive financial leverage relative to theirindustries. The academic evidence indicates, how-ever, that if the primary impetus behind a publicstock offering by a subsidiary is simply to acquirecapital for an underperforming parent, the benefitsof a parent-public subsidiary organizational struc-ture are likely to be overshadowed by the operatingproblems within the parent firm. In these situations,a “crown jewel” subsidiary is offered up merely toraise funds and not necessarily to improve thestructure or operations of the organization. Thisappeared to be the dominant organizational motivefor carve-outs such as Occidental Petroleum’s carve-out of IBP Inc., B.F. Goodrich’s IPO of Geon Co., andAlco Standard’s carve-out of Alco Health Services—all cases where the raising of equity capital for thefirms involved did not result in increased share-holder value. In contrast, as stated earlier, theproceeds of the carve-outs by units of ThermoElectron do not go to the parent, but rather directlyto the subsidiaries to fund their expansion andinvestment opportunities.

Since the majority of parent firms conductingequity carve-outs are poor performers, previousresearch conducted by John McConnell and mesuggests that the largest gains in stock values atannouncements of carve-outs occur when manage-ment indicates that the funds raised will be paid outto creditors or shareholders. We view the decision topay out proceeds of the carve-out by poorly per-forming firms as a way to preserve the value gainscreated by the carve-out itself. If funds were retained,a poor performer may waste the capital in projects thatare not likely to increase the value of the entire firm.

Another difference between Thermo Electron’sapproach and that of many other companies is in theallocation of “decision rights” between the parentand the public subsidiaries. The conventional wis-dom about carve-outs is that they ought to producea structure that is less bureaucratic and more flexiblein meeting the expectations of the marketplace. Suchan approach could be interpreted as a prescriptionfor increased decentralization in investment or op-erating decisions. It should be pointed out, however,that while Thermo Electron is certainly an advocateof decentralization, the company does not decentral-ize all decision-making rights to the public units. Infact, a key element in the Thermo Electron approachis that administrative activities unrelated to the focusof the unit’s operations continue to be managed atthe parent level, not duplicated by the unit.

The objective of this unusual blend of central-ized and decentralized decision-making is to retainthe intra-firm advantages of full ownership whileimproving the responsiveness of the units of theorganization to their respective business environ-ment.9 As John Hatsopoulos, president and CFO ofthe company (and brother of the founder George)stated in a corporate press release, “We found thatthe only way we could sustain the process of creatingnew businesses was to be able to maintain thebenefits of a small company while preserving theadvantages of a big company.”

Incentives

A key element in the carve-outs of ThermoElectron is the creation of equity-based incentives forunit management through stock option programstied to the performance of the public subsidiaries.Senior management of the parent also participates instock option plans in both the parent and theindividual public units. While the granting of em-ployee stock options is based on several factors suchas base salary and years of service, the exercise ofthese options in recent years by senior managers hasmore than tripled the base salaries and performancebonuses granted as “regular” compensation.

Thermo executives, including CEO GeorgeHatsopoulos, have often cited the benefits of entre-preneurial incentives in the process of developingnew technologies and making sound business deci-

9. In a 1988 Journal of Applied Corporate Finance (Vol. 1 No. 3) article, DavidGlassman describes how a spin-out (carve-out) or spin-off can reduce bureau-

cracy in organizations leading to improvements in flexibility and decision-making processes.


sions. Stock options granted in the public subsidiaryare clearly superior to equity incentives based on aconglomeration of divisions in terms of rewardingactivities that unit managers most directly control.The “objectivity” of external capital markets inevaluating performance is also likely to have advan-tages over systems based on accounting earnings orsales targets. Unlike sales and accounting measures,stock prices are publicly known, information isreadily available, and they are not subject to manipu-lation or “gaming” by the managers being evaluated.As John Hatsopoulos once put it, “We believe thatWall Street is a far better grader [of managementperformance] than we are.”10

If there are benefits to tying managers’ re-wards to the performance of the public subsidiar-ies, top management also believes that it’s impor-tant to encourage cooperation by the subs with theparent and the other units of the company. For thisreason, only 40% of the stock options granted tounit managers are based on the performance oftheir subsidiary. An additional 40% are granted inthe stock of the parent and the remaining 20% ofstock options are granted in the other Thermosubsidiaries.

This approach to evaluating and rewardingsuperior performance appears to have been ex-tremely effective in helping the company attract andretain key employees. As mentioned earlier, in astatement made to Forbes magazine in 1995, thecompany said that “no developer or entrepreneurhas ever left Thermo Electron.”

Autonomy

Following an equity carve-out, the parent firmas majority shareholder may elect to maintain tieswith the former unit that are similar to the relation-ship of the firms prior to the carve-out. For ex-ample, management of the parent may elect to playan active role in overseeing the unit, even to thepoint of retaining the chief executive’s position forthe parent CEO.11 A more common arrangement incarve-outs, however, is for the parent to appointofficers or board members of the parent for elec-tion to the board of the subsidiary. Either the

chairman or chief executive of the parent alsocommonly retains the position of chairman in thepublic subsidiary.

In order for the bureaucratic rigidity that cangrow up in some firms to be sufficiently reduced inan equity carve-out, executives of the parent mustrelinquish a degree of decision-making authority tounit managers—especially with respect to day-to-day operations. The success of Thermo Electron inimplementing the satellite structure is based on thepremise of delegating a large measure of authority tounit management. As George Hatsopoulos put it:

I do not believe that you can create new busi-nesses and attract entrepreneurial teams that aremotivated enough to make these new businessessucceed without giving them a sense of indepen-dence. You cannot easily motivate entrepreneurswithin the context of a bureaucracy.

This need not mean that unit management doesnot receive guidance and expertise from parentmanagement as occasions warrant. It simply meansthat most operational decisions are made at the unitlevel by unit managers. It can be argued that parentfirms whose managers insist on retaining full controlare likely to squander many of the gains that comefrom a more decentralized structure.

A second distinctive aspect of decentralizeddecision rights at Thermo Electron is in the processof acquiring capital. In most corporations, an internalcapital market exists where senior managementallocates corporate resources among competingdivisions. The question of whether or not this is themost efficient allocation process is a matter ofdebate—most senior managers likely believe it isand most unit or divisional managers tend to believeotherwise. In contrast, the public subsidiaries ofThermo Electron hold the primary responsibility ofacquiring capital from outside sources to fund theiracquisitions and investment opportunities. If directfunding by external capital markets is indeed moreefficient than a centralized allocation process withina firm, the autonomy created by equity carve-outscan improve the investment process and increase thevalue of the firm.

10. The Kansas City Star, 12/9/94.11. As an example, Leslie Wexner, chairman and chief executive of The

Limited Inc., holds the same positions with Intimate Brands and Abercrombie &Fitch, carve-outs of the company completed in 1995 and 1996.

The company does not decentralize all decision-making rights to the public units. Infact, a key element in the Thermo Electron approach is that administrative activities

unrelated to the focus of the unit’s operations continue to be managed at theparent level.


Operational Improvements

A motive often cited by parent managers inannouncements of equity carve-outs is that theprocess of taking a wholly owned subsidiary publicwill disclose relevant financial information that willensure proper valuation of the entire firm in thecapital markets.12 One of the problems with thisargument, however, is there is no evidence that themarket corrects a prior “valuation error” by substan-tially raising the value of the parent firms after thecarve-outs. In a study of post carve-out stock returnsto parents and subsidiaries following equity carve-outs, Professor Anand Vijh of the University of Iowafinds that parent firms, on average, continue tounderperform several market benchmarks.13 Duringthe three years following carve-outs, parent firms inthe study underperform several market benchmarksby 4% to 16% depending on the benchmark selected.The poor performance, however, was more pro-nounced for parent firms that carved out units in the1980s than in the 1990s, although the latter hasremained slightly negative.

A more reliable way to create value in a carve-outis to improve the focus of the units of the firm in a waythat leads to improvements in business decisions andpractices. Decentralized control over operationscoupled with direct equity incentives for unit man-agement can be expected to lead efficiency gains,more promising investments of capital, and strategicmoves in and out of lines of business that willultimately be in the best interests of shareholders.

And, in fact, the public units of Thermo Electronalso show efficiency gains and dramatic increases ininvestment spending soon after their IPOs. In theyear following carve-outs, capital spending as afraction of net sales increases by an average of 300%!At the same time, the cost of sales/net sales ratiodeclined by an average of 8%—even while sellingand administrative costs relative to net sales in-creased by an average of 70%.

The study by Professor Vijh also providesadditional insight into the gains in shareholder valuethat can be created in equity carve-outs. He reportsthat gains in stock prices surrounding announce-ments of carve-outs are significantly greater in those

cases where the number of industry segments of theparent is at least four. The size of these market gainscan be interpreted as both an indictment of the old,bureaucratized conglomerate structure and an en-dorsement of Thermo Electron’s attempt to create asmall-firm environment within a larger company.

COSTS AND RISKS OF EQUITY CARVE-OUTS

While there is substantial upside potential to amore decentralized, incentive-driven organizationcreated by one or more equity carve-outs, theoffering of a minority interest in a subsidiary is notwithout risk or associated costs. For starters, theaverage cost of an equity carve-out is similar to aconventional IPO in terms of underwriting fees anddiscounts, legal and filing fees, and over-allotmentoptions granted to underwriters. But there is onesignificant difference in the cost of an equity carve-out versus a traditional IPO:14 carve-outs of subsid-iary units are generally priced much closer to themarket’s value of the firm at the end of the first dayof public trading, thus avoiding the underpricingassociated with conventional IPOs.15 In total (includ-ing minimal underpricing), the average cost of anequity carve-out can be expected to range from 6-9%of the offering proceeds.

Embarking on a strategy of carving out one ormore wholly owned units is also not without risksbeyond the initial offering. First, seasoned managers ofthe parent may question the ability of unit managers tosuccessfully operate the public company. Parent man-agers must give up hands-on control of the unit and itsoperations and be willing to be play more of anadvisory role. The expected benefit is that a carve-outprovides unit managers with an opportunity to provetheir skills and gain valuable experience. Such anopportunity has been successfully used by ThermoElectron to attract and retain key developers andmanagers—a crucial element in the success of mostorganizations.

A second area of concern involves the relation-ship between the parent as majority shareholder andthe group of shareholders who hold the remainingminority interest. Opportunistic behavior by theparent with regard to the public subsidiary (such as

12. For example, this was the motive stated by Ford Motor Co. atthe announcements of the Associates First Capital and Hertz publicofferings.

13. “Long-term Returns from Equity Carve-outs: Why All Equity Issues Are NotCreated Equal,” forthcoming in Journal of Financial Economics.

14. In the Vijh study of a large number of equity carve-outs, the median levelof underpricing is significantly below traditional IPOs at only 2.5 percent. Initialday returns for Thermo Electron carve-outs are similar.

15. In a 1991 Journal of Finance article, Jay Ritter reports that the average IPOis priced 14 percent below its closing price on the initial trading day.


exclusive supply agreements or pricing discounts)may lead to protests or legal action by minorityowners. The possibility for such actions—which inturn conjure up the prospect of minority shareholdersuits in the future—could cause the subsidiaries shareprices to trade below their otherwise fair values.

A third drawback to carve-outs involves thefrequent disclosure of financial information requiredof public companies. On the other hand, however,it is possible that uncertainty about the performanceof a consolidated unit or potential cross-subsidiza-tion of resources to a unit that is performing poorlywould result in a discounted value of the entire firm.It’s clear that public disclosures eliminate the abilityto conceal poorly performing operations during adevelopment phase or industry downturn. Of course,shareholders and would-be investors prefer to re-ceive financial information on the performance ofunits of a consolidated firm, but this data is alsodisclosed to competing firms in great detail followinga carve-out. Costs associated with additional filingswith the SEC and other public disclosures must alsobe considered.

CONCLUSIONS AND COMMENTARY

In the process of completing several first- andsecond-generation equity carve-outs dating back to1983, Thermo Electron Corporation has devised aninnovative and highly unusual corporate structure.The satellite organization of the company effectivelyuses the capital markets to evaluate and rewardmanagement performance in a way that has beenattempted by few other firms. The combination ofentrepreneurial incentives, centralized administra-tive services, decentralized control, and unit-levelaccountability in the capital markets has led to anorganization that excels in commercializing tech-nologies and in creating shareholder value.

A distinctive feature of the company is that theparent and several first-generation carve-outs serveas incubators of new technologies and suppliers ofstart-up capital to fund research ventures and prod-

uct development. A comparison could be drawnbetween the company and a venture capital fund orpartnership, but with some important differences.First, unlike venture capitalists, the company is inbusiness to originate and develop new technologiesand lines of business, not simply to supply capital tosuch ventures. Second, potentially valuable tiescontinue to exist between Thermo units that havegone public through ownership positions (as, forexample in the cases of second-generation carve-outs). Managers in the subsidiaries also receiveequity options in the parent and the other publicentities of the firm. Interestingly though, venturecapital firms do play a role in the carve-outs ofThermo Electron. Unit shares are generally placedprivately with venture capital firms before thoseunits are spun out from the parent.

Important and yet to be answered questionsremain regarding the extensive satellite network ofThermo Electron. First, at what point do the costs ofreporting separate information including SEC filingsfor each public entity outweigh the benefits of de-centralization and greater autonomy? Will the track-ing of stock ownership and stock options for hun-dreds of employees (many of whom move betweenentities) become unwieldy and expensive to man-age? Is it possible that the organization will eventu-ally become so intertwined that flexibility is lost?

To date, few firms have attempted to implementa structure similar to Thermo Electron as a means toimprove incentives and reduce the bureaucraciesthat arise under centralized control systems. Despitethe unwillingness of many firms to adopt what mightbe viewed as a radical approach, certain firms wouldundoubtedly benefit from at least some aspects ofthe Thermo Electron structure. The past success ofthe company is compelling. The extensive use ofcapital markets in not only providing funds but alsoin monitoring and rewarding division managementhas transformed a rather obscure organization intoa company that has excelled at maintaining growth,commercializing innovations, and enhancing share-holder value.

JEFFREY ALLEN

is Assistant Professor of Finance at Southern MethodistUniversity’s Edwin L. Cox School of Business.

Only 40% of the stock options granted to unit managers are based on theperformance of their subsidiary. An additional 40% are granted in the stock of the

parent and the remaining 20% are in stock of the other subsidiaries.

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reinventing a corporation: the “satellite” structure of thermo electron

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