Allocative efficiency of internal capital markets: Evidence from equity carve-outs by diversified firms

Abstract

We examine whether equity carve-outs (ECOs) lead to improvements in the functioning of the internal capital markets (ICM) of diversified firms. Divestitures, including spin-offs, sell-offs, and equity carve-outs, can be employed by firms to improve allocative efficiency. Equity carve-outs, unlike other forms of divestiture, leave the parent's ICM largely intact but provide the opportunity to enhance internal and external corporate governance mechanisms that can improve the parent's ICM. Using a US sample of 354 equity carve-outs completed between 1980 and 2013, we find that the allocative efficiency of parents is augmented significantly following transaction completion. This increase in allocative efficiency is driven by improvements in both the external and internal governance characteristics of parent companies, consistent with the expectation that motivates equity carve-outs.